Peter Lynch is one of the most successful investment managers of all time. But, he retired many years ago and many new investors are unfamiliar with him. That is unfortunate since there is much to learn from studying Lynch’s record.
Lynch’s record is among the most remarkable in market history. He managed the Fidelity Magellan Fund, and grew it into the largest mutual fund in the world by the time he retired. From 1977 until his retirement in 1990, Lynch delivered average annual gains of 29.2% to investors in his fund.
Lynch’s gains were more than double the average annual return for the S&P 500. While he certainly had a talent for stock picking, he did share many techniques in his books, including One Up on Wall Street. Lynch explained that his goal was to find stocks that would become “ten-baggers” or stocks that he believed could be held for years before they would be sold for at least 10 times the amount he paid for them.
One of the stock-picking techniques he described was a strategy to find undervalued stocks that was based on an indicator known as the PEG ratio. This metric compares the stock’s price to earnings (P/E) ratio to the company’s reported earnings per share (EPS) growth rate.
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The PEG ratio recognizes that investors are willing to pay a premium for growth. In fact, companies growing earnings at 30% a year, for example, should have a higher P/E ratio than a company that is growing earnings at 3% a year.
The PEG ratio recognizes this fact. The ratio is found by dividing the P/E ratio by the EPS growth rate. A ratio of 1.0 indicates a stock is fairly valued. PEG ratios less than 1 highlight stocks that are undervalued no matter what their P/E ratio is. PEG ratios greater than 1 show a stock is potentially overvalued.
Low P/E stocks with slow growth can still be overvalued and high PEG ratios will warn investors of the overvaluation. This is a simple but powerful concept.
To turn this idea from a concept into an investing strategy, we created a screen that can be used at the free web site FinViz.com. We searched for stocks that have a PEG ratio of less than 1. We also required the stock to have a P/E ratio greater than 1 for both last year and this year.
The requirement for a positive P/E ratio serves two purposes. It eliminates companies without earnings over the past twelve months. It also eliminates companies without analyst coverage since an estimate is needed for the current year. Analyst coverage can help a stock deliver gains with increased visibility.
We also looked for stocks priced under $7. The screen we used is shown below.
As a final step in our screening process, we sorted the list by market cap and limited our potential buys to stocks with a market cap of at least $1 billion. We did this to identify stocks with higher than average liquidity.
Six stocks passed our screening process:
- AEGON N.V. (NYSE: AEG) provides life insurance, pensions, and asset management services. It offers life and protection products, such as traditional and universal life insurance products, as well as employer, endowment, term, and whole life insurance products; and supplemental health, accidental death and dismemberment insurance, critical illness, cancer treatment, credit/disability, income protection, travel, and long-term care insurance products. In addition, the company also provides investment and retirement products and services, such as variable and fixed annuities, retirement plans, mutual funds, and stable value solutions; individual and group pensions sponsored by or obtained through an employer; and mortgages, as well as banking products, including saving deposits. In addition, it offers general insurance products consisting of automotive, liability, disability, household insurance, and fire protection.
- Semiconductor Manufacturing International Corporation (NYSE: SMI) is an investment holding company. The company engages in the computer-aided design, manufacture, testing, packaging, and trading of integrated circuits and other semiconductor services. It also designs and manufactures semiconductor masks; and manufactures and trades in solar cell related semiconductor products. In addition, the company is involved in the bumping and circuit probe testing, as well as marketing related activities. It operates in the United States, Europe, and the Asia Pacific.
- AK Steel Holding Corporation (NYSE: AKS) produces flat-rolled carbon, stainless, and electrical steels and tubular products. The company also buys and sells steel and steel products, and other materials; and produces metallurgical coal from reserves in Pennsylvania. It sells its flat-rolled carbon steel products primarily to automotive manufacturers and to customers in the infrastructure and manufacturing markets. The company also sells its stainless steel products to manufacturers and their suppliers. AK Steel’s 2016 revenues reached approximately $5.88 billion. The company was named “Steel Producer of the Year” by American Metal Market in 2010 and is recognized by Toyota for quality performance and supplier diversity achievement.
- United Microelectronics Corporation (NYSE: UMC) provides semiconductor wafer foundry solutions. It provides circuit design, mask tooling, wafer fabrication, and assembly and testing services. The company also engages in the research, development, and manufacture of products in the solar energy and LED industries. It primarily serves fabless design companies and integrated device manufacturers.
- AU Optronics Corp. (NYSE: AUO) researches, develops, produces, and sells thin film transistor liquid crystal displays and other flat panel displays. The company operates through two segments, Display and Solar. The Display segment designs, develops, manufactures, assembles, and markets flat panel displays for use in televisions, TV sets, and other related products. The Solar segment manufactures and sells solar materials, including ingots, solar wafers, and solar modules, as well as provides technical engineering and maintenance services for solar system projects. The company also engages in the renewable energy power generation; repairing of TFT-LCD modules; injecting and stamping parts; manufacture and sale of molds, light guide plates, backlight modules, and related parts, as well as precision plastic and metal parts; and IP related business.
- Gold Fields Limited (NYSE: GFI) produces gold and holds gold reserves in South Africa, Ghana, Australia, and Peru. The company engages in underground and surface gold and surface copper mining and related activities, including exploration, extraction, processing, and smelting. The company holds interests in eight operating mines with an annual gold-equivalent production of approximately 2.2 million ounces, as well as mineral reserves of approximately 48 million ounces and mineral resources of approximately 101 million ounces. It also holds attributable copper mineral reserves totaling 454 million pounds and mineral resources totaling 5,813 million pounds.
This is simply a list of stocks that passed our quantitative screen. This could be considered as a list of potential investments. If it is used that way, the screen needs to be maintained by adding a set of sell rules. In that way, there will be a strategy for taking profits and stopping losses.
As an example of sell rules that could be used, the list could be rerun every three months. Stocks that are no longer on the list would be sold and replaced with those that do pass the screening criteria. This could be combined with a stop, for example selling whenever a stock declines by 20% or more.
While we have focused on the buy rules, it is important to consider the sell rules. Lynch would hold stocks for years, allowing them to deliver large gains. He could do this because he had a highly diversified portfolio, often consisting of more than 1,000 stocks.
Individual investors will not have the millions of dollars required to hold a large portfolio like Lynch did. We need to make decisions about selling and ideally, the sell rules should be defined before a buy is made. That way, profits will be taken when they are available and losses will be recognized before they grow too much.