AAII Stock Ideas: Lynch Screening Strategy

Today, I present the strategy used by the famous fund manager Peter Lynch. His approach capitalizes on the distinct advantage individual investors have over Wall Street and large money managers. Read on for how to identify stocks possessing the key characteristics Lynch looks for when selecting stocks and 13 current stock ideas from AAII’s Lynch screen.

Thirteen Tips and Stock Ideas From Legendary Stock-Picker Peter Lynch

Peter Lynch offered investors deep insight in his book “One Up On Wall Street.” Lynch was careful to warn his readers that it was important to first analyze oneself before spending any time analyzing companies. Lynch even provided in his bestselling book a list of the most important qualities it takes to succeed:

  • Patience
  • Self-reliance
  • Common sense
  • Tolerance for pain
  • Open-mindedness
  • Detachment
  • Persistence
  • Humility
  • Flexibility
  • Willingness to do independent research
  • Willingness to admit mistakes
  • Ability to ignore general panic
  • Discipline to resist your human nature and your gut feeling

You may be surprised that items such as humility, tolerance for pain and common sense are on Lynch’s personality checklist, but not intelligence. Lynch felt that the behavior of stocks is generally simple-minded and true geniuses get too “enamored of theoretical cogitations and are forever betrayed by the actual behavior of stocks.”

Lynch further noted that investors need to accept that they will have to make decisions without complete or perfect information. One is rarely certain when making investment decisions, and if one completely understands what is going on, it is already too late to profit.

Lynch gained his fame as the portfolio manager of the Fidelity Magellan mutual fund, which he took control of in 1977. During his 13-year tenure as portfolio manager, he grew its asset base from $20 million to $14 billion and beat the S&P 500 index in 11 out of 13 years, with a 29.2% average annual rate of return.

You would think that one of the top professional investors who earned his keep by managing other people’s money would try to dissuade individual investors from even trying to pick stocks. Instead, Lynch strongly believed that individuals could not only succeed at investing, but they also had a distinct advantage over Wall Street and professional money managers by being able to identify trends early, investing in what they know, having the flexibility to invest in a wide array of companies and not being evaluated on a short-term basis.

Short-Term Pain for Long-Term Success

Recent stock market volatility reminds us that long-term stock market success requires a certain detachment and tolerance for short-term pain. As Lynch pointed out, stocks will go up and down, and rather than panic when they go down, you must have detachment to stay the course. Peter Lynch warned investors “when you sell in desperation, you always sell cheap.”

AAII has developed a quantitative stock filter, or stock screen, with the goal of identifying stocks possessing the fundamental characteristics Lynch looks for when selecting stocks. Thirteen Lynch-inspired prospects are presented below.

Stocks Passing the Lynch Screen (Ranked by Dividend-Adjusted PEG Ratio)

Lynch was a bottom-up stock picker who looked for good companies selling at attractive prices. He did not focus on the direction of the market, the economy or interest rates. Lynch said, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” It wasn’t that he didn’t understand the importance of these big-picture elements, he just did not believe that it is possible to consistently forecast them in any bankable way. Instead he felt it was better to spend your time looking for superior companies, doing fundamental research and keeping a close eye on the fundamentals of your holdings.

Analysis is central to Lynch’s approach. In examining a company, he is seeking to understand the firm’s business and prospects, including any competitive advantages, and evaluate any potential pitfalls that may prevent the favorable “story” from occurring. Also, an investor cannot make a profit if the stock was purchased at a too-high price. For that reason, he also seeks to determine reasonable value. Here are some of the key numbers Lynch suggests investors examine:

Sustainable Earnings Growth

The growth rate of earnings should fit with the firm’s “story” — fast-growers should have higher growth rates than slow-growers. Extremely high levels of earnings growth rates are not sustainable but continued high growth may be factored into the price. A high level of growth for a company and industry will attract a great deal of attention from both investors, who bid up the stock price, and competitors, who provide a more difficult business environment.

Lynch prefers to invest in companies with earnings expanding at moderately fast rates (20% to 25%) in non-growth industries. To avoid companies whose earnings growth is not sustainable in the longer term, AAII’s Lynch-inspired strategy excludes companies whose average annual growth rate in earnings per share over the last five years is greater than 50%.

Price-Earnings Ratio

The earnings potential of a company is a primary determinant of company value. At times, the market may get ahead of itself and even overprice a stock with great prospects. The price-earnings ratio helps to keep your perspective in check. The ratio compares the current price to the most recently reported earnings. Stocks with good prospects should sell with higher price-earnings ratios than stocks with poor prospects.

By studying the pattern of price-earnings ratios over several years, you can develop a sense of the normal level for the company. This knowledge should help you avoid buying into a stock if the price gets ahead of the earnings or send you an early warning that it may be time to take some profits in a stock you own. If a company does everything well, you may not make any money on the stock if you paid too much for it.

The AAII Lynch approach specifies that the company’s current price-earnings ratio be lower than its own five-year average price-earnings ratio. Implicit in this filter is that a company must have five years of positive earnings and five years of price data.

Comparing a company’s price-earnings ratio to the industry may help reveal whether the company is a bargain. At a minimum, it leads to questions as to why the company is priced differently. Lynch’s ideal investment is a neglected niche company — one that controls a market segment in an unglamorous industry in which it would be difficult and time-consuming for another company to compete. The AAII Lynch screen requires that the company have a price-earnings ratio lower than the median for its respective industry.

Growth at a Reasonable Price

Companies with better prospects should sell with higher price-earnings ratios. A useful valuation technique is to compare the price-earnings ratio to the earnings growth, called the PEG ratio. A price-earnings ratio of half the level of historical earnings growth is considered attractive, while ratios above 2.0 are considered unattractive.

Lynch refines this measure by adding the dividend yield to earnings growth. This adjustment acknowledges the contribution that dividends make to an investor’s return. The ratio is calculated by dividing the price-earnings ratio by the sum of the earnings growth rate and the dividend yield. With this modified technique, ratios above 1.0 are considered poor, while ratios below 0.5 are considered attractive. The AAII Lynch screen uses this dividend-adjusted PEG ratio, with a ratio less than or equal to 0.5 specified as a cut-off.

Strong Balance Sheet

A strong balance sheet provides maneuvering room as the company expands or experiences trouble. Lynch is especially wary of bank debt, which can usually be called in by the bank on demand. Small-cap stocks have a more difficult time raising capital through the bond market than larger stocks and often turn to banks for capital. A close examination of the financial statements, especially in the notes to the financial statement, should help to reveal the use of bank debt.

The AAII Lynch approach makes sure that the company’s ratio of total liabilities to assets is below its industry norm. The screen uses total liabilities because it considers all forms of debt. It compares the company’s ratio against industry levels because acceptable levels vary from industry to industry. Normal debt levels are higher for industries with high capital requirements and relatively stable earnings such as utilities.

Also, the AAII Lynch screen excludes firms in the financial sector because their financial statements cannot be directly compared to other firms.

Institutional Ownership

Lynch feels that the bargains are located among the stocks neglected by Wall Street. The lower the percentage of shares held by institutions and the lower the number of analysts following the stock, the better. The AAII Lynch strategy requires a lower percentage of shares held by institutions than the median of all U.S.-listed stocks.

Portfolio Building and Monitoring

Lynch says investors should buy as many “exciting prospects” as they can uncover that pass all the tests of research. However, there is no point in diversifying just for the sake of diversifying. Lynch suggests investing in several categories of stocks as a way of spreading the downside risk.

Although Lynch is an advocate of maintaining a long-term commitment to the stock market, he says investors should review their holdings every few months, rechecking the company “story” to see if anything has changed either with the unfolding of the story or with the share price. The key to knowing when to sell, he says, is knowing “why you bought it in the first place.” Lynch says investors should sell if the story has played out as expected, and the price reflects this — for instance, the price of a stalwart has gone up as much as could be expected. Another reason to sell is if something in the story fails to unfold as expected, or the story changes, or fundamentals deteriorate — for instance, a cyclical’s inventories start to build, or a smaller firm enters a new growth stage.

For Lynch, a price drop is an opportunity to buy more of a good prospect at cheaper prices. It is much harder, he says, to stick with a winning stock once the price goes up, particularly with fast-growers where the tendency is to sell too soon rather than too late. With these firms, he suggests holding on until it is clear that the firm is entering a different growth stage.

Rather than simply selling a stock, Lynch suggests “rotation” — selling the company and replacing it with another company with a similar story, but better prospects. The rotation approach maintains the investor’s long-term commitment to the stock market and keeps the focus on fundamental value.

The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence

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