Peter Lynch is renowned for his “buy what you know” philosophy and stellar track record managing Fidelity’s Magellan Fund. While Lynch looked for companies he understood, he also relied heavily on quantitative metrics to find attractive investments. Validea has created a model based on Lynch’s approach that scores stocks according to key criteria he emphasized. When combined with momentum factors, this strategy aims to identify reasonably priced growth stocks that are also trending upwards in price – a potent combination for potential outperformance.
Understanding Validea’s Lynch Model
At the core of Validea’s Lynch-inspired strategy is the PEG ratio, which Lynch popularized as a way to value growth stocks. The PEG ratio divides a stock’s price-to-earnings (P/E) ratio by its earnings growth rate. Lynch believed that the faster a company was growing, the higher P/E multiple investors should be willing to pay. A PEG ratio below 1.0 is considered attractive, as it indicates a stock may be undervalued relative to its growth rate.
Beyond the PEG ratio, Validea’s Lynch model examines several other factors:
- Earnings growth: The strategy favors companies with consistent earnings growth between 20-50% annually.
- Debt levels: Lower debt-to-equity ratios are preferred, as they indicate financial strength.
- Inventory-to-sales: For retailers and manufacturers, rising inventory levels relative to sales can be a red flag.
- Free cash flow: Positive and growing free cash flow is viewed favorably.
- Net cash position: Companies with more cash than debt on their balance sheets get bonus points.
Adding Momentum to the Mix
While Lynch’s approach was primarily focused on fundamental factors, adding a momentum component can potentially enhance returns. Stocks exhibiting strong price momentum often continue to outperform in the near to medium term due to factors like positive earnings surprises, increasing analyst coverage, and self-fulfilling investor behavior.
By combining Lynch’s value-oriented growth strategy with momentum factors, investors can identify stocks that not only appear fundamentally attractive but are also backed by positive market sentiment. This dual approach may help avoid “value traps” – stocks that look cheap on paper but lack catalysts for price appreciation.
Let’s examine five stocks that currently score highly on both Validea’s Lynch model and momentum factors:
IES Holdings, a provider of electrical and technology solutions for various industries, scores an impressive 93% on Validea’s Lynch model. The company’s fundamentals align closely with Lynch’s criteria:
- PEG ratio of 0.48, well below the 1.0 threshold
- Strong earnings growth rate of 40% based on 3-5 year averages
- Very low debt-to-equity ratio of just 1.96%
- P/E ratio of 19.03, reasonable for its growth rate
Additionally, IESC shows strong momentum, scoring 100% on Validea’s Twin Momentum model and 89% on its Momentum Investor model. The stock has delivered an 83.77% return over the past year (excluding the most recent month), indicating significant price strength.
Stride, an education technology company, also earns a 93% score from Validea’s Lynch model. Key factors include:
- Attractive PEG ratio of 0.35
- Impressive earnings growth rate of 49.6%
- Reasonable debt-to-equity ratio of 39.99%
- P/E ratio of 17.52, which appears low given the growth rate
LRN demonstrates strong momentum as well, scoring 100% on the Twin Momentum model and 89% on the Momentum Investor model. The stock has gained 81.59% over the past year (excluding the most recent month).
Shoe retailer Shoe Carnival also scores 93% on the Lynch model:
- PEG ratio of 0.45, indicating potential undervaluation
- Solid earnings growth rate of 34.1%
- Extremely low debt-to-equity ratio of 0.00%
- P/E ratio of 15.34, which looks attractive given the growth rate
SCVL shows strong momentum characteristics as well, scoring 100% on the Twin Momentum model. The stock has delivered an 80.94% return over the past year (excluding the most recent month).
4. Dick’s Sporting Goods Inc (DKS)
Sporting goods retailer Dick’s also earns a 91% score on Validea’s Lynch model:
- Favorable PEG ratio of 0.56
- Strong earnings growth rate of 34.5%
- Reasonable debt-to-equity ratio of 55.20%
- P/E ratio of 19.46, which appears justified by the growth rate
DKS demonstrates solid momentum, scoring 100% on the Twin Momentum model. The stock has gained 82.76% over the past year (excluding the most recent month).
5. Benchmark Electronics Inc (BHE)
Electronics manufacturing services provider Benchmark scores 93% on the Lynch model:
- Very attractive PEG ratio of 0.47
- Impressive earnings growth rate of 48.8%
- Reasonable debt-to-equity ratio of 26.44%
- P/E ratio of 22.87, which looks fair given the strong growth
BHE also shows strong momentum characteristics, scoring 100% on the Twin Momentum model. The stock has delivered a 58.57% return over the past year (excluding the most recent month).
By combining Peter Lynch’s value-oriented growth approach with momentum factors, investors can potentially identify attractively priced stocks with strong fundamental characteristics that are also benefiting from positive market sentiment. The stocks highlighted here demonstrate qualities that both Lynch and momentum-focused investors might find appealing.
