Invest like the masters: Peter Lynch

From MoneySense magazine, November 2006

Invest like the masters: Peter Lynch

Peter Lynch

He achieved 29%-a-year gains by looking for fast-growing firms trading at reasonable prices. We've applied his philosophy to turn up 10 of today's most interesting prospects

Peter Lynch caught the stock bug in his youth while caddying at his local golf course. One of the golfers was the president of Fidelity, the huge mutual fund firm in Boston. He invited Lynch to join his firm — and the move proved to be fortunate for everyone as the former caddie turned into the Tiger Woods of investing.

How good was Lynch? Well, he coined the term "10-bagger" to describe a stock that grows to be worth 10 times its original price. Most investors would be very happy to pick a few 10-baggers in their lifetimes — but if you had invested in Fidelity's Magellan fund when Lynch started managing it, you would have nabbed a 28-bagger. Yes, a $1,000 investment in Fidelity's Magellan fund in 1977 would have blossomed into $28,000 by the time Lynch retired in 1990. That's a remarkable average annual return of 29.2%.

Aside from providing blowout returns, Lynch wrote three investment books in which he expounds on his methods and investment philosophy. His bestsellers, One Up On Wall Street and Beating the Street, are probably the most useful tomes for most investors.

As you'll discover in those books, Lynch is the most growth-oriented of our four master investors, but he still keeps a keen eye on value. To find stocks that Lynch might like, we started with what he calls fast growers. These are stocks of small aggressive companies that are growing their earnings at a rate of between 20% and 25% a year. Lynch notes, "If you choose wisely, this is the land of the 10- to 40-baggers, and even 200-baggers. With a small portfolio, one or two of these can make a career." They sure seemed to work for him.

But Lynch also keeps an eye on price and he is most interested in stocks with P/E ratios lower than their growth rates. If a company grows at 20% a year, then Lynch would only be interested if it traded at a P/E ratio of less than 20. Similarly, he would only buy a 25% grower if it went for less than a P/E ratio of 25 — hopefully, much less.

Because Lynch likes small companies with room to grow, we began by narrowing our search to U.S. firms with market capitalizations between $200 million and $1 billion (all figures in U.S. dollars). Since we wanted fast growers, we demanded earnings-per-share growth of between 20% and 25% a year over the last five years. In keeping with Lynch's rule, we narrowed our list down to these fast growers that had smaller P/E ratios than their growth rates. Lynch also prefers firms with solid balance sheets, so we stuck to companies with more equity than debt. From the short list of stocks that passed all of these tests, we selected 10 of the best prospects with the lowest P/E-to-growth ratios to be Lynch's leaders.

Of course, our list would only be the first step for Lynch, who believes in exhaustively checking out any stock he buys. His first rule of investing is, "Investing is fun, exciting, and dangerous if you don't do any work." Wise investors should take heed.


Lynch's leaders

Company Industry
Price* P/E 5-yr annual EPS Growth Debt/Equity

North Pittsburgh SystemsTelecom
$25.17 11.1 24.1% 0.24
FNB UnitedRegional banks
$18.63 10.8 23.1% 0.49
United America IndemnityInsurance
$22.47 12.0 23.1% 0.24
Center Financial Corp.Savings and loans
$23.78 14.9 24.0% 0.44
Columbia Banking SystemSavings and loans
$32.01 16.1 24.1% 0.10
Credit Acceptance Corp.Credit services
$29.68 15.8 23.6% 0.81
SchawkMarketing services
$18.22 16.2 23.4% 0.53
Nara BancorpRegional banks
$18.29 14.9 20.8% 0.24
Heritage CommerceRegional banks
$23.14 16.4 21.6% 0.39
Option CareHome health care
$13.39 20.7 25.0% 0.42

Source: msn.com, Sept. 29, 2006
*In U.S. dollars

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