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

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Prospecting for Good Quality Stocks at the Right Price at any given time.

There are about 16,000 publicly owned companies in the U.S. for you to select from.  There are also about 3 times this number (48,000) of publicly owned companies in the other countries for you to select from too.

With so many companies, of course, some are much better candidates for your consideration than others.

Of these companies, fewer than 2% are likely to make the cut so far as your quality standards are concerned.

And perhaps, only 5% of THOSE might be available at the right price at any given time- and even this could be an overestimate.


Illustration:

1000 stocks

Only 20 are quality stocks (20/1000 = 2%)

Of these 20 quality stocks, only 1 is available at the right price at any given time, if at all. (1/20 = 5%)

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

It pays to be eclectic

Markets change and conditions change.
One style of manager or one kind of fund will not succeed in all seasons.
You just never know where the next great performances will be, so it pays to be eclectic.


Some problems to look out for:
1.  Stuck in a situation where the managers have lost their touch.
2.  The stocks in the fund have gone out of favour:

• A value fund can be a wonderful performer for 3 years and awful for the next 6 years.
• Growth funds lost their advantage in certain years and then led the markets in certain years.

Definition

eclectic

adj

1. (Fine Arts & Visual Arts / Art Terms) (in art, philosophy, etc.) selecting what seems best from various styles, doctrines, ideas, methods, etc.

2. composed of elements drawn from a variety of sources, styles, etc.

Some basic approach to finding stocks:

1.  Capital appreciation stocks:  Buy any and all kinds of stocks that can give capital appreciation.

2.  Value stocks:  Invest in companies whose assets, not their current earnings, are the main attraction.  

3.  Quality growth stocks:  Invest in medium-sized and large companies that are well established, expanding at a respectable and steady rate, and increasing their earnings 15% a year or better.  [This cuts out the cyclicals, the slower-growing blue chips, and the utilities.]

4.   Emerging growth stocks:  Invest mostly in small companies.  

5.  Special situation stocks:  Invest in stocks of companies that have nothing in particular in common except that something unique has occurred to change their prospects.

"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

A luxury that few people can afford.

If you are lucky to have been rewarded in life , there comes a point at which you have to decide:

- whether to become a slave to your net worth by devoting the rest of your life to increasing it

- or to let what you have accumulated begin to serve you.

The End Of The American Dream - USA

The Middle class is defined as a set of people with these aspirations:

I want to own my own house
I want to live in a safe neighbourhood with good schools
I want to be able to put a bit of money away for taking a modest vacation every year.
I want a health insurance.
I want to be able to save a little for retirement.
I want to be able to send my kids to college.

These make up the "Middle class basket."


Big Question:  Are you doing the things that are most important in your life?

Who owns the Federal Reserve

Someone once asked Warren Buffett how to become a better investor.

Someone once asked Warren Buffett how to become a better investor. 

He pointed to a stack of annual reports and industry trade journals. 

"Read 500 pages like this every day," he said. "That's how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it." 

That last sentence is the most important.

World Collapse Explained in 3 Minutes

Money As Debt - Full Length Documentary

How Do Banks Create Money from Nothing? The Basics of the Economic Crisis



Uploaded on 3 Oct 2009
The economic crisis is the result of flawed banking rules. In 5 minutes, learn the basics of how banks operate and why the rules must change.

The rules of banking allow banks to lend out 90% or more of the money of depositors under a system known as "fractional reserve banking". This leads to the majority of all deposits in checking and savings accounts to be backed only by the promises of borrowers to pay back the loans on schedule and with interest. If the borrows are unwilling or unable to keep up their payments, the banks enter a state of crisis, and the deposits of all the savers are at risk.

In 5 minutes, review the basics of how banks "create" money from "nothing" by lending out money based on promises of future repayment. If the borrowers fail to repay, and if the collatoral backing the promises is insufficient, then crisis results. This is a key component of the current economic crisis, which led to bailouts, financial crisis, tightened lending standards, job losses, and a recession that some believe will continue indefinitely.

(Note: This is a 5-minute revision of a 10-minute video covering the same concepts. The 10-minute video goes through each step in more detail, bringing in more basics, and created with a school-aged audience in mind.)

Chin Peng

An intriguing enigma to the end

BY CHEAH BOON KHENG

Chin Peng, flanked by C.D. Abdullah and Tan Sri Rahim Noor, during the signing of the Peace Accord in Haadyai in 1989.

Chin Peng’s legacy after his death in a Bangkok hospital remains a hot dispute in Malaysia today.

GOVERNMENT ministers, including Home Minister Datuk Seri Dr Ahmad Zahid Hamid, were quick to denounce Chin Peng as a criminal, while DAP leader Lim Kit Siang and website bloggers have come out to acknowledge the role and struggle of the clandestine Communist Party of Malaya (CPM), which Chin Peng led against British rule, saying it hastened the achievement of Malaya’s national independence in 1957.

Even before his death, while the Government had banned films on the CPM and his return to Malaysia from exile, his role had been grudgingly accepted by even those who once fiercely opposed him.

Since 1989, public controversy has swirled over the party’s role and its real contribution to the achievement of Malaya’s independence in 1957. Some people have argued that while the party’s struggle for independence was valid up to 1957, its continuation thereafter against the popularly elected governments of Malaya and Singapore has been difficult to justify.

Nevertheless, first Prime Minister Tunku Abdul Rahman in his memoirs, Lest We Forget (1983), acknowledged the communists’ role in the struggle for independence: “Just as Indonesia was fighting a bloody battle, so were the communists of Malaya, who, too, fought for independence.”

Chin Peng’s application to return to Malaysia to launch his memoirs in September 2003 was rejected by the Home Ministry. He finally lost his appeal against this ban in the Federal Court in 2009.

PAS leaders, including Mat Sabu, and its party organ Harakah have recognised the role played by the CPM’s Malay leaders, Rashid Maidin and C.D. Abdullah, in the CPM’s armed struggle in achieving Malaya’s independence. Even former Inspector-General of Police Tan Sri Rahim Noor has echoed this recognition.

Former Prime Minister Tun Dr Mahathir Mohamad, who played a crucial role in initiating the negotiations to end the CPM’s armed struggle, half-heartedly recognised the role of Rashid Maidin and other Malay communists in Malaya’s independence up to 1957, in a foreword he wrote in a book on the CPM.

Ong Boon Hua, alias Chin Peng, was the CPM’s secretary-general for 42 years. Until his memoirs, Alias Chin Peng: My Side of History, was published in 2003, much of his life and leadership of the party remained shrouded in secrecy and he is best known for his wartime (1942–45) exploits as a guerilla leader.

At the end of World War II, Chin Peng’s heroic role as an anti-Japanese resistance leader was highlighted in Spencer Chapman’s account, The Jungle Is Neutral(1952), in which he is portrayed as the key link between the resistance movement in Malaya and the British armed forces based in Kandy, Sri Lanka.

Post-war Malayan newspapers called him “Britain’s most trusted man”. For his wartime services he was awarded two military medals and an Order of the British Empire (OBE), which was revoked when the CPM took up arms against British rule in June 1948.

Born in Kampong Koh, in Sitiawan, Perak, on Oct 21, 1924, Chin Peng became a communist at 15. He adopted the alias “Chin Peng” because all secret cell members were required to conceal their true identities from the police.

In the interwar period it took great intellectual and moral courage to join the banned CPM as once its members’ identities became known, the British police hunted them down.

Chin Peng found the communist ideology attractive as it stood for social justice, the elimination of poverty, a new classless world order and the end of imperialism.

His father from Fujian province, emigrated to Singapore where he met and married Chin Peng’s mother. They moved to Sitiawan where they ran a bicycle business.

The second of 11 children, Chin Peng studied at the Hua Chiao (Overseas Chinese) Primary School in Sitiawan, and later briefly attended a secondary school, the Anglo-Chinese Continuation School.

While there, the police discovered his communist activities and he disappeared underground to evade arrest.

Within the movement, he worked ρrst in 1940 as a probationary member, in charge of members in the Sitiawan district, then transferred to Ipoh to do propaganda work, and was subsequently appointed the party’s state secretary in 1942, the year he married a party comrade, Lee Khoon Wah, who was from Penang. They had three children.

In 1941, during the Japanese occupation, the British administration, accepted the CPM’s offer of volunteers to ρght the Japanese behind enemy lines.

Wanted man: The bounty on Chin Peng's head is equivalent to millions of ringgit today.

In Perak, Chin Peng was responsible for establishing communication and supplies lines between the urban areas and the guerrilla forces in the jungle camps. He was the liaison ofρcer between the British special operations group, Force 136, and top party ofρcials in the Blantan highlands in 1943 and 1945, to discuss the airdrop of money and arms to the guerilla groups.

At the end of the war, in recognition of his wartime services, Chin Peng was awarded a military medal in Singapore and later in London he received a second medal.

In 1947, the party’s central committee purged its secretary-general, Lai Tek, after Chin Peng and another committee member, Yeung Kuo, exposed him as a British agent.

Chin Peng was elected to replace him and the party began to adopt a “militant” line against the British administration.

After British intelligence uncovered information that the party was planning an insurrection, the colonial government decided to seize the psychological advantage by declaring an emergency in Malaya in June 1948.

This was in the wake of widespread labour unrest, including the murder of white planters on rubber estates, which it blamed on the CPM.

The British put up a reward of 250,000 Straits dollars on Chin Peng’s head. This offer was given wide publicity in the local and foreign press.

The Malayan Emergency lasted from 1948 to 1960, in the midst of which, Malaya secured independence on Aug 31, 1957.

In December 1955, Chin Peng and two CPM leaders, Rashid Maidin and Chen Tien, attended “peace talks” in Baling, Kedah, with Tunku Abdul Rahman, who was then Malaya’s chief minister, David Marshall, Singapore’s chief minister, and Tun Tan Cheng Lock, the MCA leader.

At the Baling talks, Chin Peng rejected the offer of amnesty when he failed to secure legal recognition for the CPM, and refused to accept the condition that the police screen his guerillas when they laid down their arms.

However, he made the surprising offer that the party would cease hostilities and lay down its arms if the Tunku secured the powers of internal security and defence in his talks on Malaya’s independence with the British Government in London.

It strengthened the Tunku’s bargaining position in the talks, which allowed him to win Malaya’s independence.

“Tunku capitalised on my pledge and gained considerably by this,” claims Chin Peng in his memoirs. In 1960, the Tunku’s Alliance government ended the Malayan Emergency. An ailing Chin Peng left for Beijing to recuperate and reorganise the party’s struggle.

He remained in Beijing for 29 years and did not return until 1989 to bring the CPM’s armed struggle to a close after negotiating a peace agreement with the Malaysian and the Thai Governments in Haadyai.

Chin Peng, in his book, described himself as a nationalist and freedom ρghter.

He took responsibility for the thousands of lives lost and sacriρced in the cause of the communist struggle. “This was inevitable,” he said, in an interview with me in Canberra in 1998. “It was a war for national independence.

> Cheah Boon Kheng was Professor of History at Universiti Sains Malaysia until his retirement in 1994. He was a visiting fellow in Singapore, Canberra and at USM. He is the author of several books, including The Masked Comrades (1979) and Red Star Over Malaya (1983).

http://www.thestar.com.my/News/Nation/2013/09/17/An-intriguing-enigma-to-the-end.aspx

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