It is not an over-exaggeration to say that Peter Lynch was the greatest mutual fund manager of all time. His storied career as the head of Fidelity's Magellan Fund has never been duplicated by any other money manager before or since. In the thirteen years that Lynch ran the fund, he racked up average annual investment returns of 29.2%. Over that same period of time, the S&P 500 returned an average of 15.8%.
Here's the interesting thing. The approach that Lynch used to achieve those returns, and which he championed in his book, "One Up On Wall Street", is remarkably simple. That simplicity reveals itself in three of his basic principles.
Peter Lynch is famous for lots of witty phrases. One of my favorites is that "stocks are not lottery tickets. There's a company behind every stock and they go up for a reason". In simplest terms, the "reason" a stock increases in value over time is directly related to the performance of the underlying business.
A company that is growing, and whose earnings are accelerating, will generally see a commensurate increase in its stock's value. On the contrary, a company whose business is in decline and whose earnings are deteriorating will generally see a corresponding drop in its stock price. And, while there is nothing magic about the fundamental reason that some stocks rise while others fall, there is more to owning a stock than there is to owning a lottery ticket.
You don't need to think too much about buying a lottery ticket. It's a game of chance, and no inquiry, examination, or analysis is going to change that. On the other hand, a stock requires one to do a bit of homework before making an investment. Absent that, you're just flying blind. But, Lynch's approach to research is still pretty simple; own good businesses that are growing.
Look at the company's balance sheet and make sure that it isn't over leveraged. Understand the business it's in and how it compares to the competition. Then, try to own those that are growing the fastest, have the deepest, widest moats around them, and have the best prospects for maintaining those attributes into the foreseeable future.
Peter Lynch's approach to research is all about understanding a company before buying it. And, he was pretty good at it. During his tenure at Magellan, Lynch owned several stocks that quadrupled (four-baggers) or quintupled (five-baggers) in value. And, he would joke that most of them were very simple companies with very simple products. In other words, those companies were easy to understand. There are two takeaways from this.
The first is that you don't have to be a PhD in quantum mechanics to be a successful investor. Knowing what you own, and owning what know, allows you to better understand potential risks and future opportunities in a company's underlying business. The more complicated a business, the less likely it is to understand the competitive challenges it faces (unless maybe you're a PhD in quantum mechanics). The second takeaway is that if you know what you own, you're not likely to get overwhelmed with panic if it declines in value during one of the stock market's regular and normal corrections.
Investing in stocks requires balancing risk and reward. Unfortunately, risk and reward don't always present themselves at the time an investment is made. More often, they become obvious only after owning the stock.
As time goes by, the discipline of holding onto winning positions and letting them blossom is critical to getting that balance right. Just as important, however, is letting go of losing positions. And, another of Peter Lynch's clever aphorisms is that the stocks you own don't know that you own them. So, they won't be insulted if you sell them.
Investments that fail to provide the promise they held when you bought them shouldn't be held because you love the companies or the products they make. This is especially the case if they fail to deliver earnings growth or something in their fundamental makeup changes.
Let your winners run. But, don't get too attached to them. At the point where the fundamentals change, let them go. Likewise, don't get too attached to losing positions thinking that they might rebound.
To answer that question, we turn to the Validea quantitative model based on Peter Lynch's strategy of buying growth at a reasonable price. Using it, we have uncovered five stocks that score high in Lynch's three primary "growth" categories: Fast Growers, Stalwarts, and Slow Growers. To determine if the stock offered value, Lynch would then divide a stock's price-to-earnings ratio by the growth rate, to get what is known as the PE/G ratio. The lower the PE/G ratio, the better.
According to the Lynch model, earnings growing from 20% to 50% make a firm a fast grower. Winnebago Industries, Inc. (WGO), the well-known manufacturer of camping trailers and RVs; Advanced Drainage Systems (WMS), maker of a full line of PVC pipe and systems to remove water from where it isn't wanted; and Carnival, Plc (CUK), the luxury cruise line operator; all pass this test. All three of these stocks have a PE/G below 0.50.
Lynch defines well-established companies with good potential even though earnings growth rates are below 20% as Stalwarts. Home builder Toll Brothers (TOL) passes this test. TOL also has a PE/G below 0.50.
Companies that are growing consistently under 10% and pay a handsome dividend are considered by the Peter Lynch model as Slow Growers. The big money-center bank, JPMorgan Chase (JPM), passes this test with a solid dividend yield of about 3.2%. JPM's yield-adjusted PE/G is just below 1.0, but that is still attractive enough to pass that specific criterion in Validea's model.
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Disclosure: I am/we are long TOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.