Peter Lynch's Investing Strategy: Built with the Little Guy in Mind

What makes Peter Lynch's investing advice so beguiling to so many is his insistence that the little guy can beat the pros on Wall Street. Go to the mall, he says. See what people are buying -- and where. Pay attention to what your kids buy and use.  Look at what's going on in your community. Often, you can see a business in action before the pros do, and that's the time to look to get into a stock.

Sounds easy, but that's only the starting point for someone wanting to invest like Peter Lynch. There's more research to be done. A stock still must pass statistical muster. But the time spent on the research and understanding what it means should pay off if you're patient enough.

Lynch may well be the greatest mutual fund manager ever, at least according to John Reese, whose Validea Capital Management is built on running money according to the thinking of what he calls investing gurus.

Lynch's creds are built on the 13 years (1977-1990) he spent managing the Fidelity Magellan fund (FMAGX). The fund averaged a 29 percent annual return during his tenure; assets grew from $18 million to $14 billion. When he spoke, people most definitely listened, in part because he regularly appeared on "Wall Street with Louis Rukeyser." He also participated in Barrons' annual market outlook conference.

People read Lynch, too. His books "One Up on Wall Street" and "Beating the Street" have been big best sellers and are considered investing classics.

Better yet, they are specific about what he wants to see in a stocks. So specific in fact that Reese's site Validea.com maintains two portfolios based on Lynch's investing principals. The American Association of Individual Investors has a stock screener built on Lynch principals. All three have outperformed the Standard & Poor's 500 Index.

Lynch's books, written with John Rothschild, are witty, chatty, full of good anecdotes. They also contain specific things investors should do, starting with keeping your eyes open and, more importantly, doing the homework. "Investing without research is like playing stud poker without looking at the cards," he writes in "One Up on Wall Street."

You don't have to be a math whiz, he says. "All the math you need in the stock market  . . . you get in the fourth grade."

Sounds easy, doesn't it? There's a lot of truth about the required math prowess. And much of it you can do with the aid of a good spreadsheet.

But the homework is the hard part because it requires that you find the numbers and understand them. It requires that you can articulate why you own a particular stocks. An investor should be able to track Sales, sales growth, earnings per share, earnings per share growth, not to mention assets, liabilities, equity and debt. And, if appropriate, inventories.

Plus, you must pay close attention to price/earnings ratios and PEG ratios. The latter two are key guides to understanding the value of a company and they help signal "buy," "sell" and "stay the heck away." PEG divides a stock's price/earnings ratio by its historical growth rate.  In Lynch's world-view, when price growth is lower than earnings growth, that makes a stock cheap and possibly worth pursuing.

Don't forget the news. If sales miss Wall Street estimates or simply fell, then you need to find out why. A number of sites offer transcriptions of a company's earnings call. Analysts may have some insights.

All that said, remember that Lynch is a bottoms up investor, not a pure growth or pure value investor. He buys stocks, not the market. Predicting the market in the short term is futile, he will tell you.

It's appropriate to sell a stock when its story changes. In the 1990s, he was a big supporter of Fannie Mae (FNMA), the giant supplier of mortgage capital, because he expected a booming housing market. One would expect his enthusiasm would have cooled when housing peaked in 2005 and 2006.

In his books, Lynch sees stocks in six categories:

·         Slow growers. Electric utilities are in this group. You buy them for their dividends.

·         Stalwarts. Big companies but capable of boosting earnings per share 10 percent to 12 percent a year. The list includes Coca-Cola KO, Colgate-Palmolive CL and Procter & Gamble PG.

·         Cyclicals. Think airlines, autos and housing. The stocks move up and down with the economic cycle.

·         Asset plays. Real estate companies or railroads, which have tremendous land holdings.

·         Turnarounds. For Lynch, these are "no growers." They're usually situations like bail-outs, spin-offs, and restructurings. Today's General Motors GM would fit the bill.

·         Fast Growers. Preferably smaller companies on a fast growth track.

While Lynch would consider stocks in the first five groups, fast growers -- companies able to grow earnings 20 percent to 50 percent a year -- are what Lynch loves.  The company doesn't have to be in a fast-growing industry, though that helps. It just has to have room to grow in a slow-growing industry. In the 1980s, Lynch liked Wal-Mart Stores WMT, Anheuser-Busch, now part of Anheuser Busch InBev BUD. Apple AAPL became a favorite because his family liked their Macintosh computer that he had to buy a second.

But one of his truly favorite picks, as he noted in "One Up on Wall Street," was La Quinta Inns and Suites. La Quinta's strategy was to cater to business travelers who want a place to sleep, do paperwork. So, La Quinta offered room to work, a light breakfast and maybe a swimming pool.

The Magellan fund made a ton of money on the stock after Lynch started to buy it in the early 1980s. Everything aligned perfectly. The company had perfected its strategy. It had gone public in 1975 and built up a track record that made its competitors envious. And few analysts were bothering with it, always a plus for Lynch, who prefers smaller companies because they have the most growth potential.

La Quinta is now owned by private-equity firm Blackstone (BX), which is looking to bring it public again this year.

How does a Lynch decide a stock is a viable pick? Some of the specific elements he considers include:

·         Is the value right? Lynch looks a price/earnings ratios and whether earnings are growing faster than earnings. The preferred stock has a P/E ratio below the industry average and also below the stock's own five-year P/E.

·         Growth can't be understated. Lynch prefers to see earnings per share rise for five straight years before considering it. The company has to be financially able to withstand recessions and worse. That means debt-to-equity ratio must be low.

·         Institutional ownership must be low. Institutions usually have come to a stock late and can leave in a hurry.

·         Insiders are buying. That's a clear sign of confidence.

Lynch is wary of very not stocks because their growth rates probably can't be sustained. So, if you were to ask him what he likes now, he probably would be wary of a Netflix NFLX or a Twitter TWTR.  

In his books, Lynch admits his picks weren't always winners, and he missed some good buys. If all was going well, he thought 60% of his picks would pan out.

Computerized portfolios built using Lynch's methodology, which includes quarterly rebalancing, have done very well. Validea's 10-stock portfolio is up 204.5% since 2003, compared with 81.8% for the S&P 500.  Its 20-stock portfolio is up 300%.

Validea's 10-stock portfolio features the top-ranked stocks using the Lynch methodology. It includes HCI Group HCI, HSBC Holdings (HBI) and Cisco Systems (CSCO). Validea's 20-stock portfolio includes the 10-stock portfolio plus such stocks as Russian oil company Lukoil (LUKOY), Chinese oil company CNOOC (CEO), French-based insurance giant AXA (AXAHY) and data-storage-maker NetApp (NTAP).

Right now, Validea.com lists 375 stocks that meet the criteria of the Lynch methodology. It includes Apple, Fossil Group FOSL, Panera Bread PNRA,Xerox XRX, Community Bank Shares of Indiana CBIN, Berkshire Hathaway (BRK.A), Tyson Foods TSN, Intel INTC and Jabil Circuit JBL.

Reese says the picks are generated by applying Lynch's criteria to a database of stocks. He doesn't substitute his own judgment for some of the picks. The reason: He can't outperform what the Lynch methodology serves up by itself.