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

http://www.canadianbusiness.com/my_money/investing/article.jsp?content=20061128_104144_5424

PE ratio, PEG and EPS Growth rates

A high PE ratio by itself means that either

• the valuation is very expensive (where the stock price is high as compared to its EPS) or
• it has such great potential for growth that investors are willing to accord it with a high PE ratio.

In general, the lower the PE ratio, the better it is.

For high growth stocks, we also look at the PEG ratio (PE ratio/ EPS Growth rate). For high growth stocks, their PE ratio if viewed on absolute basis is usually very high. How do we then decide if it is still "cheap" enough for us to hold or even buy? We use the PEG ratio to see whether its growth is at a faster rate as compared to its appreciation in value (i.e. high PE ratio). If PEG is low despite a high PE ratio, this would indicate the growth in earning (higher EPS growth) is much faster than the increase in its valuation (higher PER), and hence could justify our holding or even buying the stock.

Earnings Growth, Earnings Yield and PEG

PEG relates, or normalizes, the PE to the growth rate.

• With PEG, apparently high PE ratios are supported by forward growth.
• PEG thus becomes a better tool to compare stocks with different PEs and different underlying growth assumptions.

By itself, it's hard to tell whether a PE is good or bad.

A stock with a PE of 30 may be a better deal than another stock with a PE of 15. Why? Because of growth.

• A stock of a no-growth company with a PE of 15 will never achieve an earnings yield beyond 7.5% (1/15).
• Meanwhile, the company with a PE of 30, with a growth rate of 20%, eventually achieves an earnings yield greater than 20%.

Enter the practice of normalizing PE by the growth rate.

• To do that, we divide all PEs by the company's growth rate to create a ratio known as (Price/earnings)/growth, or PEG for short.
• G is the growth rate, expressed as a whole number (that is, the percentage times 100).
• So, a company with a PE of 30 and a growth rate of 20% has a PEG of 1.5.

This gives a standard for comparison.

• Company A with a PE of 18 and a growth rate of 12% has the same PEG as Company B with a PE of 30 and a growth rate of 20%.
• Are the two PEs the same? 30 versus 18?
• Clearly not - until the underlying growth fundamentals are identified, apply PEG, and find out they are indeed priced equally.

The table below shows the relationship between future earnings yield, PE, and PEG. Watch what happens to PEG and future earnings yields as growth assumptions rise.

http://spreadsheets.google.com/ccc?key=toPlORpn7n23_xeRq2vYALQ

Low PEG ratios (less than 2) correspond to high future earnings yields.

You can see:

PEG = 2 scenario corresponds to a future earnings yield of 13%.
PEG = 1.30 correlates to 20%, and,
PEG = 1 correlates to a future earnings yield of 31% on today's investment price.

On the other hand, if:

PEG = 4, the implied future earnings yield is only 8.1%.

So, what is a "good" PEG ratio?

It all depends on the implied future rate of return you're looking for, which depends on

• (1) investment objectives,
• (2) risk tolerance, and
• (3) current risk-free (bond) interest rates.

A PEG of 2.7 or less: implies a future earnings yield of 10% or more.

A PEG of 2.7 or more: implies a future earnings yield of 10% or less. This is probably less return at more risk than most investors desire.

As a guide:

A PEG of 1 or less: this is great (but hard to find)

A PEG between 1 and 2: this is good.

A PEG between 2 and 3: this is marginal.

A PEG over 3: should probably be avoided.

How to use PEG

Company Simpson:

Recent PE 17.6 based on:

• a share price of $33 and
• TTM earnings of 1.87.

Earnings yields would thus be 1/17.6, or 5.7%.

What is the significance?

This investment could be compared to a long-term Treasury security as a prospective investment.

Treasury security: today yielding about 4.5%.

Which investment is better?

An investment in Simpson returns more, and, although riskier, it affords the opportunity for gain through growth.


The difference in earnings yield illustrates the basic risk/return tradeoff between investing in corporate equities versus safe fixed-income Treasuries.

----

You still don't know whether Simpson's PE ratio of 17.6 is attractive or compelling.

Long-time tech high-flyer Cisco Systems is at PE ratio to 27.4.

While banking stalwart Bank of America is at PE ratio of 10.


Why the difference?

The primary reason is growth.

Investors pay higher PEs for companies with greater growth prospects.

Greater prospects mean greater earnings and greater earnings yields sooner.

So when comparing businesses, one popular way to "normalize" PEs is to compare them to their respective company's growth rate.

From this comparison, you get a ratio known as PE to growth, or PEG:

Price/Earnings to growth (PEG) = (PE)/(EPSGR)

If the earnings growth rate of :

• Cisco is 25%, while
• Simpson's is 10% and
• Bank of America's is 5%,

then their respective PEG is:

• 27.4/25 or 1.1 for Cisco,
• 17.6/10 or 1.76 for Simpson, and
• 10/5 or 2 for Bank of America.

Now if you are confident in the sustainability of the growth rates, you'd pick Cisco as the best investment, because its PE is modest compared to its growth rate.

----

So, the lower the PEG, the better.

But if the low PEG is driven by high growth rates, you'd better be confident in the growth rate assumption.

Nothing falls faster than a growth stock that suddenly stops growing.

For years, Starbucks had been a high PE and high growth story, with PE ratios exceeding 30 and growth rates exceeding 20%. When the growth rate slowed just a bit in early 2007, the stock lost a third of its value.


----

Projecting growth rates can be tricky, and for that reason, value investors tend to shy away from stocks where growth appears temporary or hard to justify long term.

What rate should you use?
What the company has already achieved?
What the analysts project it to do?
Over what period?
When will the growth rate run into the law-of-large numbers-wall?
What growth rate did those Krispy Kreme Investors use in the 2000 - 2004 period?

Most of them ended up with a sticky mess.

The big question , of course, in picking Cisco as the "best investment," is the sustainability of the growth rate.

Simpson, while trailing a bit, may be a safer and better long-term investment.

Summary: It is okay to assume a high growth rate, so long as it is sustainable growth, based on sustainable business and marketplace fundamentals.