Financial Planning

I found this interesting article by Harry Domash which I like to share with you. Harry did a very good study on Peter Lynch investment style.

The white-haired guru, now retired, made his mark by pursuing fast-growing companies that trade out of the limelight. This screen lets you emulate his legendary strategy.

By Harry Domash

When talk turns to market gurus, Peter Lynchs name usually pops up, and for good reason. His Fidelity Magellan fund (FMAGX) returned 29% on average, annually, during Lynchs 13 years at the helm.

Lynchs stock-picking success didnt rely on secret formulas or magic indicators. He didnt buy stocks simply because they fit his mathematical criteria. Instead, he considered passing stocks as grist for further research.

Once he identified a candidate, Lynch diligently learned as much as possible about its business, industry and future prospects. Lynch avoided hot, fast-growth industries, preferring instead to find an overlooked stock in a humdrum sector. Much like Warren Buffett, Lynch avoided industries that he didnt understand.

Lynch revealed his stock-picking strategies in his book, One Up on Wall Street, published in 1989, shortly before he retired. That book became an instant best seller and is still in print. In 1993, Lynch followed up with a second book, Beating the Street.

If youre going to read just one to glean his best ideas, choose One Up on Wall Street, because its stuffed with the specific rules that Lynch employed to qualify prospective stock candidates. “Beating the Street” is more anecdotal, discussing stocks that Lynch bought or should have bought. The only exception is the chapter on stocks in the savings and loan sector, one that Lynch didnt cover in his first book. There he gives specific guidelines for analyzing S&Ls, which these days, have morphed into regional banks.

Lynch loves aggressive companies, big baggers
In his books, Lynch divides stocks into six different categories including turnaround plays, cyclical stocks and asset plays. But he makes it clear that his favorite is a category he calls the fast growers. These are small, aggressive enterprises that grow (earnings) 20% to 25% a year.

Lynchs definition of fast growth is at the low end of the 20% to 40% numbers that you hear from most growth-stock mavens these days.

Nevertheless, Lynch says that “if you choose wisely, this is the land of 10- to 40-baggers and even the 200-baggers. If you havent heard the expression before, a 10-bagger is a stock that increases 10 times in value.

Out of the limelight and no red flags
Heres a link to a screen I used to find stocks that Peter Lynch might like, based on my interpretation of his fast-grower strategy. It looks for consistently profitable, out-of-the-limelight, low-debt, reasonably priced stocks meeting his earnings growth requirements. The screen also checks for an inventory red flag that Lynch relied on to avoid risky bets.

Since Lynch felt that earnings growth was a primary driver of stock prices, Ill start there.

Fast . . . but not too fast. Although Lynch favors companies with a track record of fast earnings growth, he thinks that you can have too much of a good thing.

Lynch’s view: stocks growing earnings faster than 30% annually are risky bets. For starters, those high growth rates aren’t sustainable, and worse, such companies attract hordes of competitors wanting to get in on the action.

Companies showing historical average annual earnings growth in the 20% to 25% range are the best bets, and anything above 30% is verboten, under the Lynch strategy.

I set my minimum allowable five-year average annual earnings growth at 20% and the maximum at 30%. I used 30% instead of 25% to increase the number of stocks turned up by the screen. Reduce the maximum to 25% if you want to stick to Lynchs ideal earnings growth range.