Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This week’s issue looks at the Peter Lynch-inspired P/E/Growth Investor strategy, which is up more than 47% this year and more than 81% since its inception more than six years ago. Below is an excerpt from the newsletter along with several top-scoring stock ideas based on the Lynch investment strategy.

Taken from the September 18, 2009 issue of The Validea Hot List

Guru Spotlight: Peter Lynch

Picking the greatest mutual fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff — a number of investors have put up the types of long-term track records that make it difficult to pick just one who was “The Greatest”.

If you were to rank Peter Lynch at the top of the list, however, you’d probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments’ Magellan Fund, Lynch produced a 29.2 percent average annual return — nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron’s, over the last five years of Lynch’s tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren’t impressive enough, try this one: If you’d invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch’s book One Up On Wall Street was a big part of what put me on the right track. Lynch didn’t use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch’s approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.

Just what was it about Lynch’s approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock — you buy the company’s products, like its marketing, etc. — you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments — undergarment manufacturer Hanes — was his wife’s affinity for the company’s new pantyhose years ago.

But while his “buy-what-you-know” advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals — that’s why I was able to computerize it — and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.

The P/E/Growth ratio, or “PEG”, divides a stock’s price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.

To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America’s largest retailer. In his book “One Up On Wall Street”, he notes that Wal-Mart’s P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch’s tenets: that a good company can grow for decades before earnings level off.

The PEG wasn’t the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of “GARP” — Growth At A Reasonable Price — investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were “fast-growers” — those growing earnings per share at an annual rate of at least 20 percent — his use of PEG as a way to make sure he wasn’t paying too much for growth really makes him a hybrid growth-value investor.

One Size Doesn’t Fit All

One aspect of Lynch’s approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was “fast-growers”. These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn’t want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).

The other two main categories of stocks Lynch examined in his writings were “stalwarts” and “slow-growers”. Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well — Wal-Mart and IBM are current examples of “stalwarts” based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.

“Slow-growers”, meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.

One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you’d divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.

Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.

Beyond The PEG

While Lynch applied different criteria to his different stock categories, the PEG wasn’t the only criterion he applied to all stocks. He also made an astute observation about inventory, which can be applied not only to fast-growers but other firms as well. He viewed it as a red flag when inventory increased more quickly than its sales. (Inventory piling up indicates the products aren’t as in-demand as the company had hoped.) My Lynch-based model thus likes the inventory/sales ratio to stay the same or decrease from year to year, but will allow for an increase of up to 5 percentage points if all other financials are in order.

Another crucial variable Lynch applied to all categories of stocks: the debt/equity ratio. He liked firms to be conservatively financed, and the model I base on his writings requires firms to have debt/equity ratios no greater than 80 percent.

There is an exception to this test, however: For financial firms, debt is often a required part of business. Recognizing this, Lynch didn’t apply the debt/equity ratio to financials. Instead, he looks at how a company’s equity compares to its assets for a sign of financial health, and at how much of a return it is generating on those assets for a sign of its profitability.

The model I base on Lynch’s writings calls for financial firms to have an equity/assets ratio of at least 5 percent, and a return on assets of at least 1 percent.

A Market-Beater

Using these fundamental tests, the Validea Lynch-based portfolio has put together a strong track record. Since its inception more than six years ago, it has gained 81.1% percent, while the S&P 500 has gained just 6.5%. The portfolio really excelled in 2003, 2004, 2005, and 2006, before stumbling on tough times in 2007 and 2008, along with the rest of the market. But it has had an exceptional 2009, gaining 47.2%, more than doubling the S&P 500’s return for the year.

Now, here’s a look at the stocks that currently make up my 10-stock Lynch-based portfolio. As you can see, there are some big winners in there right now: