Picking Stocks Like Peter Lynch

The Powerful Chart That Made Peter Lynch 29% A Year For 13 Years

6/26/2013 

In his excellent book One Up on Wall Street, Peter Lynch, the best mutual fund manager ever, revealed a powerful charting tool that helped him to achieve a gain of 29.2% in his portfolios for 13 years. In this chart, Peter Lynch drew the stock price and the earnings per share together and aligned the value of $1 in earnings per share to $15 in stock price. He wrote in pages 164-165 of the book:

“A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.”

To see how this Peter Lynch Chart works, we applied it to the top holdings of Warren Buffett, the most successful investor ever: Wells Fargo (WFC), Coca-Cola (KO), IBM (IBM), American Express (AXP) and Wal-Mart (WMT). The Peter Lynch Chart of Wells Fargo is below, where the green line is the Price Line, and the blue line is the Peter Lynch Earnings Line. When the Price Line is well below the Peter Lynch Earnings Line, the stock is a buy.

Among these top five holdings of Warren Buffett, we found that Wells Fargo is the most undervalued. Wal-Mart and IBM are about fair valued. We then compared this result with the trading activities of Warren Buffett. To our surprise, we found that Warren Buffett was buying Well Fargo heavily and adding to Wal-Mart and IBM.

Is this just a coincidence? Does Warren Buffett only buy the stocks that are undervalued as measured by the Peter Lynch Chart? Is Warren Buffett using this powerful tool, too?

We don’t know the answer to the question. But we know that great minds think alike!

Now this powerful charting tool is available at GuruFocus.com. You can create it in just two clicks for any of the more than 50,000 stocks covered by GuruFocus.com.

We applied this tool to the portfolios of George Soros, Carl Icahn and other investment Gurus tracked at GuruFocus.com. We even developed a screen for this strategy that makes it easy to find stocks that are traded well below Peter Lynch’s Earnings Line.

Certainly buying stocks that are traded well below their Earnings Line is not the only criterion Peter Lynch used to achieve his 29%-a-year results. We also added his other requirements such as strong balance sheet and solid growth into the screener. When I limit my Peter Lynch screen to only the stocks that are owned by Warren Buffett, I found eight other companies that Warren Buffett owns and Peter Lynch would be buying. All of these eight companies have strong balance sheet, solid growth and reasonable valuations. One of them is of course Wells Fargo. Warren Buffett loves it so much that he made it his largest holding.

Now both Warren Buffett and Peter Lynch are working for me! I have added these stocks to my watch list.

http://www.forbes.com/sites/gurufocus/2013/06/26/the-powerful-chart-that-made-peter-lynch-29-a-year-for-13-years/

Historical and Performance F.A.S.T. Graphs™

Channeling Peter Lynch

http://online.barrons.com/article/SB50001424052748704382404578571404089572628.html

What can F.A.S.T. Graphs™ do for you and your investments?

http://www.fastgraphs.com/

www.fastgraphs.com

A Dozen Things I’ve Learned About Investing From Peter Lynch

1. “Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.” It is far more productive for an investor to focus their time and energy on systems which are potentially understandable in a way which might reveal a mispriced asset. George Soros said once: “Unfortunately, the more complex the system, the greater the room for error.” The simplest system on which an investor can focus is an individual company. Trying to understand something as complex as an economy in a way which outperforms the markets is not a wise use of time and is unlikely to happen.    

2. “The way you lose money in the stock market is to start off with an economic picture. I also spend fifteen minutes a year on where the stock market is going.” and “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.”  The media’s objective is to convince you that obsessively following the news cycle is necessary for an investor. In short, the media’s interest is to to convince you to watch their advertising. While you don’t want to be oblivious to the state of the economy, listening to talking head pundits and incessantly following the news cycle is actually counterproductive to profitable investing. Instead, focus on the companies  you chose to follow.

3. “The GNP six months out is just malarkey. How is the sneaker industry doing? That’s real economics.” The difference between the predictive power of microeconomics and macroeconomics is “night and day” since with the former vastly fewer assumptions are required and the systems involved are far less complex. The best investors make investing as simple as possible, but no simpler.  Lynch is saying he may pay attention to the economics of an industry, but only to understand the economics of the companies he chooses to follow. 

4. “To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets.” It is mathematically certain that you can’t beat the market if you *are* the market. You must find bets that are mispriced, be right about that mispricing and when you do find a mispriced bet, by definition, your view will be contrarian.  

5. “A share of a stock is not a lottery ticket. It’s part ownership of a business.” Many people love to gamble since it gives their brain a dopamine hit. They gamble even though it is a tax on people with poor math skills. The right thing for an investor to love is the process of investing, not the bet itself.  The right process for an investor is to understand the value generated by the underlying business.  

6. “Investing without research is like playing stud poker and never looking at the cards.” You can’t understand a business and its place in an industry without doing research. And in doing research you must find something that the market does not properly discount into the price of the stock or bond. If you spend more time picking out a refrigerator than researching a stock, you should instead be buying a low fee index fund.

7. “Owning stocks is like having children—don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies.” The time in any given day, week etc. is a zero sum game. If you work at a day job and you have a life, only so much time is left to follow stocks and bonds.  It is better to be a mile deep in understanding 8-12 companies than an inch deep on many more.

8. “Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.” Addition, subtraction, multiplication and division is all the math skill you need. Investors should ignore formulas with Greek letters in them.

9. “People seem more comfortable investing in something about which they are entirely ignorant.” Suspending disbelief about an investment is easier for many people for some reason when you know less rather than more, especially if the story is well crafted and told by the promoter.  When confronted with someone touting a stock, imagine them holding a megaphone at the circus and then think about what they are saying.  

10. “If you can’t convince yourself ‘When I’m down 25 percent, I’m a buyer’ and banish forever the fatal thought ‘When I’m down 25 percent, I’m a seller,’ then you’ll never make a decent profit in stocks.” and “Bargains are the holy grail of the true stock picker. We see the latest correction not as a disaster, but as an opportunity to acquire more shares at low prices. This is how great fortunes are made over time.” Who doesn’t like it when something like a hamburger is cheaper to buy? Stocks and bonds are no different.  Also, don’t put yourself in a position where you may need to sell at the wrong time.

11. “A market player has 50 percent of his portfolio in cash at the bottom of the market. When the market moves up, he can miss most of the move.” Markets over long period of time inevitably rise. They always have and always will. That is the good news. The bad news is that you can’t “time” when the rise in a market will happen. By trying to “time” the market you can miss a big move up and if you do, your returns will show it.   

12. “Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.” Nothing is worse than not being able to care for people you love. Don’t take that risk. And don’t put yourself in a position where you are likely to panic more than usual due to the pain of something normal and inevitable (e.g., a 20% correction in the stock market). Peter Lynch said once: “Small investors tend to be pessimistic and optimistic at precisely the wrong times.”

http://25iq.com/2013/07/28/a-dozen-things-ive-learned-about-investing-from-peter-lynch/

The Growth Stocks of Peter Lynch

Peter Lynch

From 1977 through his retirement in 1990, Peter Lynch steered the Fidelity Magellan Fund to a total return of 2,510%, or five times the approximate 500% return of the Standard & Poor's 500 index. In his 1989 book One Up on Wall Street, Lynch described a variety of strategies that individual investors can use to duplicate his success. These strategies divide attractive stocks into different categories, each characterized by different criteria. Among those most easy to identify using quantitative research are fast growers, slow growers and stalwarts, with special criteria applied to cyclical and financial stocks. (The latter, for example, should have strong equity-to-assets ratios as a measure of financial solvency.)

Peter Lynch's Company Categories:

Fast Growers

These companies have little debt, are growing earnings at 20% to 50% a year, and have a stock price-to-earnings ratio below the company's earnings growth rate.

Investing in these types of stocks makes sense for investors who want to find solidly financed, fast-growing companies at reasonable prices.

Slow Growers

Here Lynch is looking for companies with high dividend payouts, since dividends are the main reason for investing in slow-growth companies.

Among other things, he also requires that such companies have sales in excess of $1 billion, sales that generally are growing faster than inventories, a low yield-adjusted price/earnings-to-growth ratio, and a reasonable debt-to-equity ratio.

Investing in these types of stocks makes sense for income-oriented investors.

Stalwarts

Stalwarts have only moderate earnings growth but hold the potential for 30%-to-50% stock price gains over a two-year period if they can be purchased at attractive prices. 

Characteristics include positive earnings; a debt to equity ratio of .33 or less; sales rates that generally are increasing in line with, or ahead of, inventories; and a low yield-adjusted price/earnings-to-growth ratio. 

Investing in these types of stocks makes sense for investors who aren't willing to pay up for high-growth companies but still want the chance to enjoy significant capital gains.

Read more: http://www.nasdaq.com/investing/guru/guru-bios.aspx?guru=lynch#ixzz2fsOsMVsc

Invest Using Strategies of Wall Street Legends - Peter Lynch and Warren Buffett

Published on 26 Jan 2013
John Reese discusses his guru-based investing system and outlines the strategies of Warren Buffett, based on the book "Buffettology", and Peter Lynch, which is based on the book "One Up on Wall Street". Reese also discusses the Validea investing framework and how investors can be utilize systematic strategies like the ones outlined in the presentation.

http://www.youtube.com/user/valideavids/videos

http://www.validea.com/home/home.asp

How Peter Lynch Destroyed the Market

By Anand Chokkavelu, CFA 

May 21, 2010 

Peter Lynch didn't just beat the Street ... he absolutely destroyed it.

Reflect on his record for a second. Lynch ran Fidelity's Magellan Fund from 1977 to 1990, beating the S&P 500 in all but two of those years. He averaged annual returns of 29%. That's a mind-blowing figure. It means that $1 grew to more than $27; if you invested as little as $37,000 with him in 1977, you were a millionaire in 1990.

Fortunately for us, he's willing to share his secrets. To achieve his stunning track record, he clung to eight simple principles. Here they are.

1. Know what you own
Seems elementary, right? But as someone who talks to lots of investors, I can report that you'd be shocked at how few investors actually do their research. Scroll down to No. 7 for a good first step in getting ahead of the game.

2. It's futile to predict the economy and interest rates (so don't waste time trying)
After 2008's crash, I noticed a distinct increase in armchair economists. We financial types do enjoy water cooler talk about interest rates, trade deficits, debt levels, etc. But there's a danger in converting thought into action.

The U.S. economy is an extraordinarily complex system, with 300 million people acting in their own self-interest and responding to each others' actions, government incentives, and external shocks. And that's before we factor in our increasingly frequent interactions with the rest of the world.

Trying to time the market is futile. Set up a financial plan that allocates your assets based on your risk tolerance, so that you can sleep at night.

3. You have plenty of time to identify and recognize exceptional companies
Lynch mentions that Wal-Mart (NYSE: WMT  ) was a 10-bagger -- i.e. its stock rose to 10 times its initial price -- 10 years after it went public. Even if you had gotten in after waiting a decade, though, you'd be sitting on a 100-bagger.

Some would argue that it's still not too late to get in on Wal-Mart, decades after going public. While the company's no longer a monster growth story, it continues to crank out 20% returns on equity year after year. That type of consistent ROE is a huge positive indicator of management's ability to effectively allocate capital.

I could tell a similar tale about Microsoft's early growth years, right on down to its still-impressive current return on equity (42%).

And Amazon.com (Nasdaq: AMZN  ) , though only 13 years old as a public company, has seen its stock double since its 10th birthday. Of these three, it's the only company still trading at growth-stock valuations. Bulls are hitching their wagon to Amazon.com's ability to expand its role as the premier online retailer, and its upside in the cloud-computing space.

The lesson of Wal-Mart, Microsoft, and Amazon.com? You don't need to immediately jump into the hot stock you just heard about. There's plenty of time to do your research first. See No. 1.

4. Avoid long shots
Lynch claims he was 0-for-25 in investing in companies that had no revenue but a great story. Remember, the guy who averaged 29% returns went oh-fer on long shots. You and I are unlikely to do much better.

I've said it before, and I'll say it again. Use companies with proven track records as your baseline. ExxonMobil (NYSE: XOM  ) , IBM (NYSE: IBM  ) , and Procter & Gamble(NYSE: PG  ) are selling for 9, 11, and 16 times forward earnings, respectively. This is what the market is charging for solid, low-to-moderate-growth companies that dominate (or at least co-dominate) their spaces. Expect to pay more for higher-growth prospects, but make sure the risk-reward trade-off on an unproven company is worth it.

5. Good management is very important; good businesses matter more
The pithier Lynchism is: "Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it."

For a prototypical example of a so-easy-a-caveman-could-run-it company, think the aforementioned Procter & Gamble.

6. Be flexible and humble, and learn from mistakes
Lynch has said: "In this business, if you're good, you're right six times out of 10. You're never going to be right nine times out of 10."

You're going to be wrong. Diversification and the ability to honestly analyze your mistakes are your best tools to minimize the damage.

7. Before you make a purchase, you should be able to explain why you're buying
Specifically, you should be able to explain your thesis in three sentences or less. And in terms an 11-year-old could understand. Once this simply stated thesis starts breaking down, it's time to sell.

8. There's always something to worry about.
Lynch noted that investors made a killing in the 1950s despite the very new threat of nuclear war. There are plenty of fears to choose from right now, but we've survived a Great Depression, two world wars, an oil crisis, and double-digit inflation.

Always remember, if our worst fears come true, there'll be a heck of a lot more to worry about than some stock market losses. Lynch's parting shot is that investing is more about stomach than brains.

Peter's principles in action
So there you have it. These are the eight principles Peter Lynch used to bring the market to its knees. They seem simple, but trust me, sticking to them is harder than it sounds.

http://www.fool.com/investing/general/2010/05/21/how-peter-lynch-destroyed-the-market.aspx

The Overpriced Market: It's hard to find anything worth buying

1.  Stocks in the market had enjoyed a great rise to a year high and optimism abounded.
2.  In the festive atmosphere that surrounded a recent 300 points in three weeks, I was the most depressed person.
3.  I am always more depressed by an overpriced market in which many stocks are hitting new highs every day than by a beaten-down market in a recession.
4.  Recessions, I figure, will always end sooner or later.
5.  In a beaten-down market there are bargains everywhere you look.
6.  But in an overpriced market, it's hard to find anything worth buying.
7.  The devoted stockpicker is happier when the market drops 300 points than when it rises the same amount.
8.  Many of the larger stocks had risen in price to the point that they'd strayed far above their earning lines.  This was a bad sign.
9.  Stocks that are priced higher than their earnings lines have a regular habit of moving sideways (a.k.a. taking a breather) or falling in price until they are brought back to more reasonable valuations.
10.  A glance at these charts led me to suspect that the much-ballyhooed growth stocks this year would do nothing or go sideways in the next year, even in a good market.
11.  In a bad market, they could suffer 30% declines.  
12.  I was more worried about the growth stocks.
13.  There's no quicker way to tell if a large growth stock is overvalued, undervalued, or fairly priced than by looking at  a chart book.
14.  Buy shares when the stock price is at or below the earnings line, and not when the price line diverges into the danger zone, way above the earnings line.
15. The market overall had also reached very pricey levels relative to book value, earnings and other common measures, but many of the smaller stocks had not.
16.  Annual tax selling by disheartened investors at the end of the year drives the prices of smaller issues to pathetic lows.
17.  You could make a nice living buying stocks from the low list in November and December during the tax-selling period and then holding them through January, when the prices always seem to rebound.
18.  This January effect, is especially powerful with smaller companies., which over the last 60 years have risen 6.86% in price in that one month, while stocks in general have risen only 1.6%.
19.  Don't pick a new and different company just to give yourself another quote to look up.  You'll end up with too many stocks and you won't remember why you bought any of them.
20.  Getting involved with a manageable number of companies and confining your buying and selling to these is not a bad strategy.  
21.  Once you have bought a stock, presumably you have learned something about the industry and the company's place within it, how it behaves in recessions, what factors affect the earnings, etc.
22.  Inevitably, some gloomy scenario will cause a general retreat in the stock market, your old favourites will once again become bargains, and you can add to your investment.
23.  The more common practice of buying, selling, and forgetting a long string of companies is not likely to succeed.  Yet many investors continue to do this.
24.  They want to put their old stocks out of their minds, because an old stock evokes a painful memory.
25.  If they didn't lose money on it by selling too late, then they lost money on it by selling too soon.  Either way, it's something to forget.
26.  With a stock you once owned, especially one that's gone up since you sold it, it's human nature to avoid looking at the quote on the business page, the way you might sneak around the aisle to avoid meeting an old flame in a supermarket.
27.  I know people who read the stock tables with their fingers over their eyes, to protect themselves from the emotional shock of seeing that their sold stock has doubled since they sold it.
28.  People have to train themselves to overcome this phobia.
29.  I am forced to get involved with stocks I have owned before, because otherwise there'd be nothing left to buy.
30.  Along the way, I have also learned to think of investments not as disconnected events, but as continuing sagas, which need to be rechecked from time to time for new twists and turns in the plots.
31.  Unless a company goes bankrupt, the story is never over.
32.  A stock you might have owned 10 years ago, or 2 years ago, may be worth buying again.
33.  To keep up with the old favourites, I carry a notebook, in which I record important details from the quarterly and annual reports, plus the reasons that I bought or sold each stock the last time around.
34.  On the way to the office or at home late at night, I thumb through these notebooks, as other people thumb through love letters found in the attic.


Peter Lynch
Beating the Street

"Gentlemen who prefer bonds don't know what they've missing."

Theoretically, it makes no sense to put any money into bonds, even if you do need income.

Take the case of a asset allocation of 50 percent of the money invested in stocks that grow at 8% and 50 percent in bonds that don't appreciate at all, the combined portfolio had a growth rate of 4 percent - barely enough to keep up with inflation.

What would happen if we adjusted the mix?

By owning more stocks and fewer bonds, you would sacrifice some current income in the first few years.  But this short-term sacrifice would be more than made up for by the long-term increase in the value of the stocks, as well as by the increases in dividends from those stocks.  

Since dividends continue to grow, eventually a portfolio of stocks will produce more income than a fixed yield from a portfolio of bonds. 


Peter Lynch



Additional notes:

1.  Once and for all, we have put to rest the last remaining justification for preferring bonds to stocks - that you can't afford the loss in income.
2.  But here again, the fear factor comes into play.
3.  Stock prices do not go up in orderly fashion, 8 percent a year.  Many years, they even go down.
4.  The person who uses stocks as substitute for bonds not only must ride out the periodic corrections, but also must be prepared to sell shares, sometimes at depressed prices, when he or she dips into capital to supplement the dividend.
5.  This is especially difficult in the early stages, when a setback for stocks could cause the value of the portfolio to drop below the price you paid for it.
6.  People continue to worry that the minute they commit to stocks, another BIG ONE will wipe out their capital, which they can't afford to lose.
7.  This is the worry that will keep you in bonds, even after you've studied and are convinced of the long-range wisdom of committing 100% of your money to stocks.


Let's assume, that the day after you've bought all your stocks, the market has a major correction and your portfolio loses 25% of its value overnight.
1.  You berate yourself for gambling away the family nest egg, but as long as you don't sell, you're still better off than if you had bought a bond.
2.  Computer run simulation shows that 20 years later, your portfolio will be worth $185,350 or nearly double the value of your erstwhile $100,000 bond.

Or, let's imagine an even worse case:  a severe recession that lasts 20 years, when instead of dividends and stock prices increasing at the normal 8 percent rate, they do only half that well.
1.  This would be the most prolonged disaster in modern finance.
2.  But, if you stuck with the all-stock portfolio, taking out your $7,000 a year, in the end you'd have $100,000.  This still equals owning a $100,000 bond.

Ref:  Pg 55 Beating the Street, by Peter Lynch.


FOR YOUR IMMEDIATE ACTION!!!

1.  TALK YOURSELF OUT OF OWNING ANY BONDS.
2.  AT LEAST, YOU SHOULD DECIDE TO INCREASE THE PERCENTAGE OF ASSETS INVESTED IN STOCKS, WHICH IS A STEP IN THE RIGHT DIRECTION.

Buy Stocks!

Millions of people are devoted to collecting interest, which may or may not keep them slightly ahead of inflation, when they could be enjoying a 5 - 6 percent boost in their real net worth, above and beyond inflation, for years to come through investing in stocks for the long-term.

Of course, that assumes that you go about your stock-picking or fund-picking in an intelligent manner, and that you don't get scared out of your stocks during corrections.

Don't give up on the rewarding pastime of stock-picking.  An amateur who devotes a small amount of study to companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun in doing it.

Peter Lynch

Peter Lynch's strategy for all seasons

More than 80% of investment managers don't beat the market. Peter Lynch did it consistently over 13 years with Magellan. His secret: PEG ratios, and staying power.

20 September 07, John Reese

It stands to reason that professional mutual fund managers should be considerably more successful at picking stocks than the average investor. After all, people who have degrees in finance and years of practical experience in the market -- and who are willing to take your money in exchange for their expertise -- should be very good at what they do, right?

Unfortunately, many times that is not the case. In fact, my own research has shown that 80 to 90 percent of active fund managers fail to beat the market in the long term.

But there are, of course, fund managers who have proved you can beat the market over the long haul, and if you're looking for inspiration there's probably no better example than Peter Lynch. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch guided the fund to a 29.2 percent average yearly 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. Looked at another way, if you had 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.

How did Lynch achieve such success where so many other professional investors failed? 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 if 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.

Investing in what you know is really just a starting point for Lynch, however. His strategy also has many quantitative aspects, and I was so impressed by it that it became the basis for one of my "Guru Strategies", computer models each of which mimics the approach of a different investing great. Here's a look at how my Lynch-based strategy works, and some examples of companies that fit the bill.

Different criteria on one PEG

An important aspect of Lynch's strategy is that he didn't apply the same rules to all stocks. He classified companies by their size and growth rate (and sometimes by the nature of their business), and used different sets of criteria to analyze these different groups.

His favorite type of investment was "fast-growers" -- companies whose earnings have been increasing at a rate of 20 to 50 percent per year. Other groups he focuses on in his book are large "stalwarts", which grow at a more moderate pace, and "slow-growers", which have single-digit growth rates but are attractive for their high dividend payouts.

Before I examine what Lynch looks for in each of these categories of stocks, however, I should note that there is one variable that Lynch considers crucial no matter what the stock's classification: the P/E/Growth ratio.

While the price/earnings ratio (which compares a company's per-share price to its per-share earnings) may be the best-known stock market variable, Lynch found that looking at the P/E ratio by itself was less useful than looking at it in comparison to a company's growth. The rationale was that higher P/E ratios are okay, provided that the firm is growing at an appropriate pace. If a company's P/E ratio was about even with or less than its growth rate (i.e. P/E divided by growth rate equals 1.0 or less), Lynch saw that as acceptable

Lynch found that this P/E/Growth ratio -- or "PEG" -- was a great way to identify growth stocks that were still selling at good prices. In fact, the P/E/G ratio became the most important variable he considered when looking at a stock, and his reliance on it is one of the things he is most known for in the investing world.

To show how the P/E/G can be more useful than the P/E ratio, Lynch 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 you have plenty of time to identify and invest in exceptional growth companies, even after they have exhibited years, or even a decade, of rapid growth and have become quite large.

An example of a company with a very strong P/E/G ratio is energy giant Exxon Mobil (NYSE:XOM), which has a P/E of 12.15. When we divide that by its growth rate of 31.69 percent (based on the average of its three-, four-, and five-year earnings per share growth figures), we get a P/E/G ratio of 0.38. This not only betters my Lynch-based model's 1.0 maximum; it also falls into the strategy's best-case category (0.5 or below).

Fast-growers

Now let's take a look at those three categories I mentioned earlier, beginning with fast-growers. Exxon Mobil is an example of one such stock, because of its 31.69 percent growth rate.

For fast-growers, Lynch looks not only at the P/E/G, but also at the P/E ratio by itself. For large companies -- which my model views as those with annual sales greater than $1 billion -- he likes to see P/E ratios below 40, because he found that larger companies have trouble maintaining high enough growth to support P/Es over that threshold. (Smaller firms can have very high P/E ratios during their growth years, however).

Another quality Lynch looks for in fast-growers is manageable debt. He likes companies that are conservatively financed, and my Lynch-based model calls for debt to be no greater than 80 percent of equity. Exxon again makes the grade, with a debt/equity ratio of 7.56 percent.

An even better example of a fast-grower that meets this criterion is computer software power Microsoft (NASD:MSFT). Microsoft has no long-term debt, which my model considers exceptional. (Its 0.89 P/E/G ratio is another reason it passes my Lynch-based method.)

Lynch also made an astute observation about inventory, which can be applied not only to fast-growers but to other firms as well. He viewed it as a red flag when inventory increased more quickly than 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 percent if all other financials are in order. Exxon's inventory/sales ratio increased by just 0.32 percent this year while Microsoft's dropped by 1.13 percent, so each passes the test.

One caveat about "fast-growers": to Lynch, there is such a thing as too much growth. When a firm's historic growth rate is greater than 50 percent, he avoids it. Growth that high is unlikely to be maintained over the long run, and an investor shouldn’t pay for a stock on the basis of the assumption that a growth rate this high or higher will be maintained for long.

Stalwarts

Because of their large size (sales in the multi-billion-dollar range) and moderate earnings growth rate (10 to 19 percent per year), Lynch always keeps a few stalwarts in his portfolio, as they offer protection during recessions or hard times. An example of a stalwart that my Lynch-based model likes is credit card giant American Express (NYSE:AXP), which has a growth rate of 18.1 percent (again based on the average of the three-, four-, and five-year EPS growth rate figures) and annual sales of $29.8 billion.

One of the main differences between stalwarts and fast-growers is that dividends are often important for stalwarts, so Lynch adjusted the earnings portion of their P/E/G calculations for dividend yield. (He makes this adjustment by adding the yield, 1.01%, to the growth rate in the P/E/G formulathe yield supplements the EPS growth.) American Express's yield-adjusted P/E/G is 0.93, which comes in under my model's 1.0 upper limit.

Lynch also looked at debt for stalwarts, and my model again calls for debt to be no greater than 80 percent of equity.

When it comes to financial companies like American Express, however, 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 with 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. At 8 percent and 3.18 percent, respectively, American Express passes both tests. (Note that while American Express is a stalwart, the equity/assets and return on assets figures are used for fast-growing and slow-growing financials as well.)

Slow-growers

Lynch was less keen on slow-growers and their single-digit growth than he was on fast-growers or stalwarts. But they can have high dividend yields, so they may be a good option if you're investing for income.

Lynch liked slow-growers to be large companies, so the model I base on his writings requires their sales to be greater than $1 billion. Just as with stalwarts, the P/E/G ratio for slow-growers is adjusted for dividend yield, and the debt-equity ratio should be below 80 percent (unless the firm is a financial).

One key difference when it comes to slow-growers: Because by definition they don't post big earnings increases, their dividend yields must be greater than 3 percent or greater than the yield of the S&P 500, whichever is larger.

Few slow-growers currently pass my Lynch-based model, but one that does is the US financial firm Comerica (NYSE: CMA), a Texas-based company that offers banking and financial management services in the US, Canada, and Mexico. Comerica's growth rate (7.34 percent, based on the average of the three-, four-, and five-year EPS figures) and high sales ($3.6 billion) make it a slow-grower, and its yield of 4.78 percent (which more than doubles the S&P's current 2.09 percent yield) is one reason my Lynch strategy considers it a good slow-grower. In addition, Comerica's yield-adjusted P/E/G is an acceptable 0.91, its equity/assets ratio is a healthy 9 percent, and its ROA is a strong 1.32 percent.

Be ready for all weathers

There is another critical aspect of Lynch's approach not specifically included in my quantitative model. It's simple in theory, but in practice it is one of the hardest things for an investor: Stay in the market.

Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."

Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.

That, of course, means resisting the temptation to bail when the market takes some short-term hits, no easy task. But as Lynch once said, "The real key to making money in stocks is not to get scared out of them." If you have the fortitude to follow that advice -- and the discipline to follow Lynch's quantitative blueprints -- your portfolio should be much the better for it.

http://www.globes.co.il/serveen/globes/docview.asp?did=1000256306&fid=3011

Published by Globes [online], Israel business news - www.globes.co.il - on September 20, 2007

One up on Wall Street by Peter Lynch (Summary)

Here is a summary of One up on Wall Street by Peter Lynch – this is one of the best books you could ever lay your hands on.

Peter Lynch argues how jokers like you and me could find hidden gems in the stock market much before the bigger jokers of Wall Street can if we keep our eyes open. He suggests that everyday information can be used to find spectacular growth stocks.

Peter used his skills at Fidelity to rake in huge profits from stocks that the market discovered much later than he did. Following are some of the gists taken from the book. Note the type of stocks he thinks we should be looking out for.

Summary of One up on Wall Street by Peter Lynch – types of companies

SLOW GROWERS

• Since you buy these for dividends (why else would you own them?), you want to check to see if dividends have always been paid and whether they are routinely raised.

• When possible, find out what percentage of the earnings are being paid out as dividends. If it’s a low percentage, then the company has a cushion in hard times. It can earn less money and still retain the dividend. If it’s a high %, then the dividend is riskier.

 

STALWARTS

 • These are big companies that aren’t likely to go out of business. The key issue is price and the P/E ratio will tell you whether you are paying too much.

• Check for possible di-worseifications that may reduce future earnings.

• Check the companies long-term growth rate and whether it has kept the same momentum in recent years.

• If you plan to hold the stock forever, see how the company has fazed during previous recessions and market drops.

 

FAST GROWERS

 • Investigate whether the product that’s supposed to enrich the company is a major part of the company’s business.

• What the growth rate in earnings has been in recent years (20-25% is great)

• That the company has duplicated its successes in more than one city/town, to prove that expansion will work.

• That the company has room to grow.

• Whether the stock is selling at a P/E ratio at or near the growth rate.

• Whether the expansion is speeding up (3 new motels last year and 5 this) or slowing down.

• That few institutions own the stock and only a handful of analysts ever heard of it. With fast growers on the rise, this is a big plus.

 

CYCLICAL

 • Keep a close watch on inventories, and the supply demand relationship. Watch for new entrants into the market, which is usually a dangerous development.

• Anticipate a shrinking P/E multiple over time as business recovers and investors look ahead to the end of the cycle, when peak earnings are achieved.

• If you know your cyclical, you have an advantage in figuring out the cycles. Its easier to predict an upturn in a cyclical industry than it is to predict a downturn.

 

TURNAROUNDS

 • Most important, can the company survive a raid by its creditors ? How much cash and debt does it have ? What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt ?

• If it’s bankrupt already, what’s left for the shareholders ?

• How is the company supposed to be turning around ? Has it rid itself of unprofitable divisions ? This can make a big difference in earnings.

• Is business coming back ?

• Are costs being cut ? If so, what will the effect be.

 

ASSET-PLAYS

 • What’s the value of the assets ? Are there any hidden assets ?

• How much debt is there to detract from these assets (Creditors are first in line)

• Is the company taking on new debt, making the assets less valuable ?

• Is there a raider in the wings to help shareholders reap the beneficiaries of the assets ?

Summary of One up on Wall Street by Peter Lynch – learnings

• Understand the nature of the company you hold and the specific reason for holding the stock.

• By putting your stock in categories, you’ll have a better idea of what to expect from them.

• Big companies have small moves, small companies have big moves.

• Consider the size of the company, if you expect it to profit from a specific product.

• Look for small companies that are already profitable and have proven that their concept can be replicated.

• Be suspicious of companies with growth rate of 50 to 100% a year.

• Avoid hot stocks in hot industries.

• Distrust diversification, which usually turn out to be diworseifications.

• Long shots almost never pay off.

• It’s better to miss the first move in a stock and wait to see if a company’s plan are working out.

• People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years.

• Separate all stock tips from the tipper, even if the tipper is very smart, very rich and his or her last tip went up.

• Some stock tips, esp from an expert in the field, may turn out to be valuable

• Invest in simple companies that appear dull, mundane, out of favour and haven’t caught the fancies of Wall Street.

• Moderately fast growers (20-25%) in non growth industries are ideal investments.

• Look for companies with niches.

• When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt.

• Companies that have no debt can’t go bankrupt.

• Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the CEO’s resume or speaking ability.

• A lot of money can be made when a troubled company is turning around.

• Carefully consider the P/E ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money.

• Find a story line to follow as a way of monitoring a company’s progress.

• Look for companies that consistently buy back their own shares.

• Study the dividend record of a company over the years and also how its earnings have fared in past recessions.

• Look for companies with little or no institutional ownership.

• All else being equal, favour companies in which management has a significant personal investment over companies run by people who benefit only from their salaries.

• Insider buying is a positive sign, esp when several individuals are buying at once.

• Devote at least an hour a week on investment research. Adding up your dividends and figuring out your gains and losses doesn’t count.

• Be patient. Watched stock never boils.

• Buying stocks on stated book value alone is dangerous and illusory. It’s real value that counts

• When in doubt, tune in later.

• Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.

• Is the P/E ratio high or low in general as compared to the other companies in the same industry.

• Lower the % of Institutional Ownership, the better.

• If insiders are buying and if company is buying back its own shares, both are positive.

• The earnings growth to date should be consistent, not sporadic (exception for asset play where earning growth is not important).

• Company should have a strong balance sheet (debt to equity ratio) – how is it rated for financial strength.

- See more at: http://www.thewealthwisher.com/2010/06/08/one-up-on-wall-stree-peter-lynch/#sthash.IK780zbb.dpuf