By John P. Reese
Who is the greatest mutual fund manager of all-time? John Templeton? Benjamin Graham? John Neff?
All of those investment gurus are no doubt legitimate choices. But the fund manager with the best long-term track record may well be the great Peter Lynch. During his tenure as the head of Fidelity Investments' Magellan Fund (1977-1990), Lynch produced a 29.2% average annual return -- nearly twice the 15.8% return that the S&P 500 posted during the same period. If you'd 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.
Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated with me, and with amateur and professional investors all over. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.
Lynch is known for his "buy-what-you-know" advice -- the idea that average investors can get turned on to new stock ideas by looking out for companies whose products they have used and liked. But that part of his approach was only a starting point. What his strategy really focused on was fundamentals, and the most important fundamental he looked at was one whose use he pioneered: the P/E-to-Growth ratio.
The "PEG", as it's known, divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its earnings. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.
To show how the PEG can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In 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% range, generating huge profits for shareholders despite the P/E ratio not being particularly low.
One Size Doesn't Fit All
Lynch's favorite types of investments were what he termed "fast-growers", companies growing earnings at a rate of 20% to 50% per year. (Lynch didn't want growth rates above 50%, because it was unlikely companies could sustain such high growth rates over the long term). But he also invested in "stalwarts" -- large, steady firms that have multi-billion-dollar sales and moderate growth rates (10% to 20%) -- and "slow-growers" (larger firms with single-digit growth). Stalwarts often offer protection in tough times, while slow-growers are desirable primarily for their high dividend yields. Lynch used the PEG to assess all of these types of stocks, but for stalwarts and slow-growers he added dividend yield to the company's growth rate when determining the PEG.
For fast-growers, stalwarts, and slow-growers alike, Lynch also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. For financial companies, however, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business. The equity/assets ratio should be at least 5%, while the ROA should be at least 1%.
The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35%, or a net cash/price ratio over 30%. (He defined net cash as cash and marketable securities minus long-term debt).
So far in 2013, my Lynch-based model has been a particularly strong performer, with a 10-stock portfolio picked with the model up 25.1%, more than doubling the S&P 500. Overall since I started tracking it in July 2003, the portfolio has averaged annualized returns of 8.4%, easily beating the S&P's 4.8% (performance figures are through June 20). My 20-stock Lynch-inspired portfolio has been one of my best performers, gaining 14.3% annualized over that period.
In my book, The Guru Investor: How to Beat the Market Using History's Best Investment Strategies, I walk step-by-step through the details of the Lynch-inspired strategy. While the Lynch chapter isn't a substitute for Lynch's own book, it is a way for individual investors to take Lynch's strategy to the next level in an easy-to-implement, unemotional, disciplined investment model.
And investing in a disciplined, unemotional way was key for Lynch. He 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 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: Stick with your 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. "The real key to making money in stocks," he once said, "is not to get scared out of them."
John P. Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. He is the author of “The Guru Investor: How to Beat the Market Using History's Best Investment Strategies” and runs The Guru Investor blog. John, a graduate of Harvard Business School and MIT, is considered an expert in the systematic investing strategies based on the methods and principles of Warren Buffett, Peter Lynch, Benjamin Graham and other investing greats.