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Monday June 11, 2012
10 stocks for a Peter Lynch strategy
by John Reese, editor Validea  Choosing the greatest fund manager of all-time is a tough task. But, if you were to rank Peter Lynch at the top of the list, you'd probably find few would disagree with you. If you'd invested $10,000 in Fidelity Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later. Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. The most important fundamental he looked at was one whose use he pioneered: the "PEG" ratio, divides a stock's p/e by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain. In addition to "fast-growers" Lynch looked for "stalwarts" and "slow-growers", which tend to offer strong dividend yields; as such, Lynch adjusted their PEG calculations to include yield. He also looked at the inventory/sales ratio and the debt/equity ratio. The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. For most of the time since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has been one of my better performers. It has averaged annualized returns of 5.3%, easily beating the 3.1% annualized return for the S&P 500. The portfolio's performance numbers have been hurt by a poor 2011 and a sub-par first part of 2012 (down 1.5%), but given its long-term track record, I expect the recent troubles are short-term and wouldn't be surprised to see the portfolio post some strong bounce-back gains before the year is over. Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio: Ternium S.A. (TX) OmniVision Technologies (OVTI) Kulicke and Soffa Industries (KLIC) NACCO Industries (NC) Crexus Investment (CXS) AsiaInfo-Linkage (ASIA) Humana (HUM) GT Advanced Technologies (GTAT) FXCM (FXCM) Apollo Group (APOL) While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success, and it's one that is particularly relevant given the portfolio's rough recent run: Don't bail when things get bad. Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them. That, of course, is particularly hard to do when the market gets volatile. But Lynch said it's critical to stay disciplined: "The real key to making money in stocks," he once said, "is not to get scared out of them." Learn more about this financial newsletter at John Reese's Validea. Related articles: 
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