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How Peter Lynch Earned 29% For 13 Years

TradingPub Admin | April 25, 2014

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The event yesterday was a success! Our guest, an analyst for GuruFocus.com, presented at the TradingPub on his approach to the equity market. He shares how he finds value in stocks along with how he uses the Peter Lynch Chart to invest successfully.

For those who may not be familiar with Peter Lynch, he headed the Fidelity Magellan fund for 13 years and averaged annualized return of 29.3% for that period of time. He invested in stocks famously known as “ten baggers”. That simply is the financial term for stocks that increased in value by tenfold. Peter Lynch bought more than 100 of them for Magellan and became a well know growth/value investor, whose footsteps our guest is trying to decode and apply with his own investing. What separated Peter from the rest of Wall Street is that he had discipline and stuck to his rules.

There are 6 major types of stock investments identified by Lynch that this GuruFocus analyst shares during his presentation:

Slow Growers are typically large and aging companies expected to grow slightly faster than GDP. Those are known to pay generous, regular dividends because they do not have other uses of cash to expand the business. A good example here are utilities companies, like Alabama Power.

Stalwarts are medium growers with 10-12% annual earnings growth. Lynch sought 30-50% gain from these stocks and they typically provide good protection during recessions and downturns. Examples here are KO, BMY, PG, K, MMM.

Fast Growers are normally small, aggressive new enterprises growing 20-25% a year. Those are the ones that can potentially become 10-baggers and more. The stock does not need to belong to fast growing industry, sometimes there can be only one company in one industry like that. Here you have to look for a clean balance sheet and profitability and be careful not to buy at the end of growth phase. Examples include NFLX, TSLA, SSYS, CMG, BRLI.

Cyclical stocks are those of companies in industries that expand and contract in cycles. Normally those rises are coming out of recession and the falls follow a downturn.  Many mistake them as stalwarts but these are smaller in cap.  Timing is everything with buying these and some examples include: autos, airlines, tires, steel, chemicals.

Turnarounds are stocks of companies that have been battered, depressed or near bankruptcy. These are growers who offer high risk and big rewards.  They are typically very risky to invest in you always have to focus on their debt load and structure.  Examples include RSH, CROX, BBRY.

Asset Plays are also referred to as “net-net’s” and they belong to companies sitting on assets worth more than stock price.  Assets could be cash, real estate, mineral rights, patents,  TV stations, tax loss carry-forwards, subscribers, etc. Examples: BBRY in 2012, MSN last year

Out of these 6 categories, our GuguFocus analyst has found it is most effective to actually focus on 2 categories:Stalwarts  &  Fast growers.

Stalwarts are the companies that exhibit 10-12% annual earnings growth and are generally mid to large cap familiar stocks. In his opinion, the best tool for identifying buying opportunities is the Peter Lynch Chart:

Apple

Peter Lynch 1

Practically this chart shows what the current stock price is in comparison to the earnings of a company. At GuruFocus they looks to make a trade in a stock whose price is below the earnings and has room to "catch up". The graph above shows an example of APPL stock from August of 2013. Here are a few more examples of stocks depicted using the Peter Lynch Chart:

Microsoft

Peter Lynch 2

Walgreen Company

Peter Lynch 3

You can easily see in those charts that the prime opportunities occurred when the blue line was above the green line. Typically when earnings exceed the current price of a stock they are in a sense undervalued.

So here are some guidelines on what to look for to identify those opportunities among fast growing stocks:

  •  Small, aggressive new enterprises
  •  Growing 20-25% a year
  •  Land of 10-baggers and “bragging rights” gains
  •  Lynch’s Rule of Thumb: P/E ratio less than growth rate
  •  Best tool for identifying buying opportunities:

PEG Ratio

PEG = P/E ratio ÷ growth rate

PEG < 1 meets Lynch’s test

The ideal fast grower, according to Peter Lynch is a market Cap < $5 billion company with a Debt to Equity ratio of less than 0.4. The company has predictable revenues and earnings and the 5-year EBITDA growth of 20-35% while the 10-year EBITDA growth > 15%. Those companies will also have a PEG < 1.0.

The Prefect Stock according to Peter Lynch will also have the following traits:

  1. The name sounds dull or ridiculous (Automatic Data Processing, Bob Evans, Pep Boys – Manny, Moe & Jack)
  2. It does something dull (Crown, Cork & Seal made bottle caps)
  3. It does something disagreeable (Safety-Kleen cleaned greasy auto parts and restaurant grease traps)
  4. It’s a spin-off
    • a)     Parent companies don’t want to see spun off divisions in trouble
    • b)     Usually have strong balance sheets
    • c)     Look for heavy insider buying 1-2 months after spin-off
  5. Institutions don’t own it and analysts don’t follow it
  6. Rumors abound it (involved with toxic waste and/or mafia)
  7. There’s something depressing about it (funeral homes, etc)
  8. It’s in a no-growth industry
  9. It’s got a niche (moat)
  10. People have to keep buying it (drugs, soft drinks, razor blades, cigarettes)
  11. It’s a user of technology (those that use it, not make it)
  12. The insiders are buying
  13. The company is buying back shares

While it may seem like a good bit of work to "find the right stock", GuruFocus has actually put together a monthly newsletter dedicated to highlighting opportunities that come from the above analysis.  If you want to leverage the research of professional analysts who are applying this method for their own accounts, take a look at the trial offer below to gain access for a full year for only $97. 

To Access a Year of the Peter Lynch Portfolio 29 Newsletter -

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New issue of the Newsletter is issued on the 1st of each month and all trades are taken in their real money portfolio. If you sign up you will get:

Fast Growers below Lynch value

Stalwarts at historical & market discount

Original Peter Lynch charts

Full write-up on each pick

Portfolio traded and balanced with real money

Long term holdings targeting 30–1,000% gains

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