Peter Lynch investment style

What if Peter Lynch would use Uncle Stock? How would he use it? Most of you know Peter Lynch as the successful funds manager at Fidelity Management with at his maximum a 14 billion dollar asset base under his management. Or you might know him as the writer of some great books such as “One Up on Wall Street” or “Beating the Street” to convince the retail or young investor that he can beat the institutional professional. He argues that buying what you know combined with the right financial checks, might lead to the discovery of so called “ten- baggers”, investments that lead to profits over 1000 percent. A ten bagger is mostly a stock that is already growing and will continue his growth to the sky. This growth in the past is important, as this indicates a good company. His “buy what you know strategy” can be taken very literally: if your wife loves a famous new designer brand and she tells you that all her friends love it too, you have a potential stock investment. The word new is important, indicating that you could be one step ahead of the institutional investor.  Lynch is also convinced that your investment attitude is crucial for beating the market, even more than the most advanced quantitative metrics. Of course, you should also check the financials as you do not want to pay too much for your great discovery.

Based on his story, I do not think Peter lynch would simply combine a set of financial criteria to make a screen and buy the eight stocks that come out on top. He prefers to work in the other direction, use your personal edge to find upcoming companies and then check the financials. However, there is a way to reproduce this strategy to a certain degree. Uncle Stock has a built- in Peter Lynch screen that combines his view on investing with the financial criteria that he finds important. On top of that screen we should select companies about which we know a lot. That second step is crucial and is not a built- in functionality, as this is different for every individual. For example if you have worked for 10 years at a mobile phone store. Try to screen for companies in that business, so that can use that knowledge there. But you should not be experienced in a professional way, I you are 22 years old and spend two weeks of your summer on finding the best price/quality phone you might also be able to use that knowledge. Every market can be profitable, but only for someone with specific knowledge.

Screening

Limited Institutional ownership

To stay in line with Lynch view on investing, institutional ownership in a company we consider should be small. Peter Lynch thinks a retail investor should be able to beat Wall Street, but it is difficult to do this if Wall Street already owns the companies that you are considering. That is why my Peter Lynch screen filters on stocks that only have less than 50 percent of their shares held by institutions.

Small market cap

A second indicator of a company not being explored by wall street is market cap. A company can be known by Wall Street, but they can chose not to own it because it is a bad company. This is why our screen contains a filter that market cap should be under 2 billion euros, as all the stocks above this level are certainly known by the famous institutions.

PEGY ratio < 1

Third, Lynch is looking for good companies that can become ten baggers. To be a ten bagger, a company needs to grow strongly and we do not want to pay too much for it. To check this, Lynch popularized a ratio that we all know very well: the PEG ratio (price earnings to growth). In “One up on wall street” he states that “The P/E ratio of any company that’s fairly priced will equal its growth rate”. In my screen, I added the PEGY ratio. The PEGY ratio is a variant of the PEG ratio and takes into account dividends. We state that this ratio should be smaller than one.

Decent growth of earnings per share

As growth is so important for Lynch, we add a second indicator to measure this. We for a compound annual growth rate of earnings per share from over 15 percent. The companies that have the best chance of becoming successful one day, are the ones that had a good start. They need to have a strong growth in the beginning and already be able to produce more value for the shareholder. This is why growth in earnings per share is so important.

Low dept to equity

Lynch also states that we should look at the debt ratio, as we are lending a firm our money. And if the debt ratio is high, we are less likely to get our money back when things go wrong. That is why we also add a final filter that selects companies with a debt to equity ratio under 50 percent.

Sort on Lynch intrinsic value

I will sort the results on the intrinsic value calculation based on price earnings and growth. On Uncle Stock this IV is defined as: “The value of a security which is fair (intrinsic) to or contained in the security itself, based on Peter Lynch’s famous rule of thumb: He is willing to buy a growth company at a P/E multiple that is equal to its growth rate. Based on this, we can derive an intrinsic value formula that goes as follows: “IV = EPS rCAGR * Net income”. For example if a company grows for 16 percent a year, I would be willing to pay for a price earnings ratio under 16.

Screening results

These five filter conditions already excludes most of the companies. From the 50 000+ stocks in the Uncle Stock database, only 162 stocks match all the criteria. Every screen need a sort function, but I do not think Lynch would really use this function. As he would state that from the stocks that match your criteria, an investor should now look at the companies, sectors or markets that he knows. That is why he would probably use the sectors and industries filter, the markets filter or even the business summary filter in addition to the five previous criteria.

Backtest

When backtesting this screen, we get an annual return of 9 percent over the past 10 years. It is interesting to see that the S&P500 almost exactly had the same return. But we see on the Peter Lynch screen very large beta values and we also see that the yearly returns fluctuate a lot. So if we would blindly buy stocks coming out of the Peter Lynch screen, we would not beat the market. We would have the same return with more risk, which is not a good result. But Lynch would not see this backtesting result as a problem, he would consider this screen just as a first step.

Conclusion

Lynch would consider stock screening as a first step to find possible ten-baggers that are not known by Wall Street and have a lot of potential. This potential goes upward and downward, if one just blindly picks stocks from this list. But this first step is crucial, there is no use in finding a great company if it is already famous on Wall Street and heavily overvalued. The second step would be to take this list of 162 stocks and use your specific local domain knowledge to separate the winners from the losers. There is no backtest that can prove this second part of his strategy, except for this own track record. As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index and making it the best performing mutual fund in the world.

As a conclusion, I think Peter Lynch would use Uncle Stock by doing a screen as described in the article, but he would complete this quantitively analysis with specific business knowledge.

You can reproduce the screen from this article by using the following link:
unclestock.com/top/Peter-Lynch-Screen-Sort-on-Lynch-IV