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All-Star Stock Strategy: Peter Lynch

Peter Lynch, former manager of the Fidelity Magellan mutual fund, is, perhaps, one of the most popular investment "All-Stars." Not only did he achieve a stellar long-term performance track record, key aspects of his strategy have considerable emotional appeal to many investors many of who see Lynch-style investing as just plain fun.

Backyard investing

Peter Lynch is primarily associated with the notion of investing based on what you learn during the course of your day-to-day life. If you discover a new clothing store or restaurant, for example, and you are impressed by how well it seems to be doing, that is a cause for additional research. Perhaps you have spotted an emerging young company and can avail yourself of an opportunity to get on board early.

That, unfortunately, is the Lynch notion that is least amenable to rule-based investment models and the one most dependent on Lynch's personal business assessment talent. It also does not appear to be the cornerstone of his work. It seems to be presented in an opportunistic context, rather than as the central idea of a day-in and day-out investment program.

It should be cold but it's really hot

Fortunately, the core of Lynch's work lends itself magnificently to rules-based modeling; companies that, based on a surface examination, might seem to be dogs but which are in fact, gems.

Some such stocks are simply undiscovered. In other words, anyone who examines them would be impressed, but few investors have stumbled upon them. Other such opportunities come into being simply because of Wall Street's tendency to paint with a broad brush. Once major institutional investors turn sour on or apathetic toward a particular industry, all or almost all such stocks seem to suffer, even those oddball companies that are doing quite well.

The PEG Ratio

Lynch is also widely associated with the PEG (PE-to-Growth)ratio. For our context, this poses some difficulties. The growth rate we use for PEG should reflect assumptions about the future. When Lynch invested, presumably these were his own expectations and/or those of analysts who worked with him at Fidelity. For us, because we are often seeing obscure stocks, many will not have analyst coverage and, therefore, no growth expectations that can be plugged into a PEG ratio.

Where PEG is available to us, we look closely at it (in the context of our Lynch ranking system) but we believe it would not be productive to establish an iron-clad PEG test every stock must pass in order to be considered. Our Lynch model therefore uses other valuation metrics consistent with the data we have.

Other Fundamentals

There is discussion in One Up On Wall Street about a variety of other fundamentals but for the most part, these idea are not distinctive relative to what can be found in many other sources, especially the ideas of other all-star investors. It cannot be assumed that each such idea was an iron-clad rule to Lynch that every stock had to pass since we don't know that Lynch ever used any sort of computer application like a screener.

The tone of his book suggests Lynch had many ideas about the ideal stock, but had some leeway in his practice to allow some stocks to shine in some respects and other stocks to stand out under other sets of criteria. Accordingly, we have taken a moderate approach to fundamentals, picking and choosing among various notions in order to support the primary Lynch-inspired theme of our model; a quest for stocks that should be cold but aren't.

So don't be surprised if you read through Lynch's book and come across concepts not reflected in our model. Since we, unlike Lynch, need a one-size-fits-all approach, we have to be careful about throwing too much into a single model lest we drive our result set too close to zero.

One notion calls for special note. Lynch was averse to exceptionally high growth rates believing such companies pose unusually high risk (of adverse stock reaction when deceleration occurs). This is important. Moderate growth could, indeed, serve as the basis for a separate Lynch model. But for better or worse, Wall Street likes hyper-growth so addressing it here, on top of a model that already pulls us far afield of the things Wall Street likes short term, would pile too much baggage atop a single strategy. So this particular Lynch model does not contain a ceiling on growth.

The Portfolio123 Lynch model

This model reflects the general principles used by Portfolio123 for its All-Star screens (stand-on-their-own models inspired by key elements of the All-Stars' approaches), which can be seen here.

The Portfolio123 Peter Lynch model is built around this concept. It seeks gems that are apt to be mistaken for dogs and sprinkles in some valuation and stability criteria (both of which were also important to Peter Lynch). were Here are the details:

The screen uses the following rules:

Liquidity filter: Universe(foliofn), which means the stock must be tradable in the Folio Investing.com window system; for backtesting purposes, substitute a rule that bars OTC stocks. (Click here for more information)

Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek

Omit Utilities, Communication Services firms and ADRs with market capitalizations above $1 billion

The PE ratio (based on trailing 12 month EPS) must rank in the bottom 25% relative to the industry or relative to all stocks, or the trailing 12 month Price/Sales ratio must be in the bottom 25% relative to the industry or to all stocks

The five-year rate of EPS growth should be greater than or equal to 15%

The percent of institutional share ownership must rank in the bottom 50% relative to the industry or relative to all stocks

Among the companies that pass the above screen, we select the top 15 based on the Lynch ranking system, which uses the following factors:

Valuation - 20% of total
PE based on trailing 12 month EPS (20% of this category)

The historical relative P/E ratio (20% of this category)

PEG ratio (P/E based on the estimate of current-year EPS) and growth based on the projected 3- to 5-year EPS growth rate (60% of this category)
Prominence - 20% of total
Institutional % ownership, sorted relative to industry peers, lower is better (50% of this category)

Number of analysts publishing current-year EPS estimates, sorted relative to industry peers, lower is better (50% of this category)
Balance Sheet - 10% of total
Liabilities to assets ratio, lower is better (100% of this category)
Company Stature Relative to Industry - 50% of total
Industry Average EPS growth rate, 5 years, lower is better (20% of this category)

Industry Average 26-week share price % change, lower is better (20% of this category)

Company EPS growth rate, 5 years, higher is better (15% of this category)

Five-year average company return on equity, higher is better (15% of this category)

Company five-year rate of EPS growth minus industry average, higher is better (15% of this category)

Stocks 20 day exponentially-weighted moving average divided by the 200-day average, higher is better (15% of this category)

Portfolio123 users who would like to examine the details or copy the models for their own use, may do so:

Click here for the Peter Lynch screen

Click here for the Peter Lynch ranking system

Backtest results

Figure 1 and Table 1 show the results of a five-year backtest that ran through 1/12/10 which assumes rebalancing every four weeks and selection of the top 15 stocks as per the screen sorted on the basis of the Peter Lynch ranking system.

Figure 1

Click here for more information on Portfolio123.

The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of Portfolio123.com, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.

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