Value Investing

Investment Secrets of Peter Lynch

If you are new to investing, you may not be familiar with Peter Lynch. He was one of the world’s greatest investors, but he retired before great investors became celebrities and fixtures on CNBC.

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  • His career began in the way many Wall Street careers began years ago. In 1966, Lynch was hired as an intern with Fidelity Investments partly because he had been caddying for Fidelity’s president, D. George Sullivan, at a local country club.

    He left Fidelity for a two year enlistment in the Army and was hired as a full time analyst by the company upon his release from the military in 1969. Five years later, Lynch was the direct of research for Fidelity and in 1977 he was named as the manager of Fidelity’s Magellan Fund.

    Magellan Fund Makes Lynch a Legend

    In 1977, Magellan Fund had $18 million in assets. By the time Lynch retired in 1990, the fund had grown to more than $14 billion in assets with more than 1,000 individual stock positions.

    From 1977 until 1990, the Magellan fund averaged a 29.2% return, an incredible sustained run for an investment manager.

    No investment manager can ever fully explain how they achieve the returns that they do. But, Lynch tried. He honestly believes that individual investors can outperform Wall Street investment managers and he is correct that individuals have some advantages.

    Individuals are not restricted by an investment policy statement, or IPS. An IPS describes what a manager can and, perhaps most importantly, what they cannot do. For example, an IPS may say an investment manager can not hold more than 2% of assets in cash and must invest in large cap value stocks.

    Well, right away we know this manager will remain fully invested in a bear market. In that case, the manager’s goal becomes losing less than the market, however the manager will almost assuredly suffer losses in line with the bear market. An individual will not face this restriction and can raise cash as they believe necessary.

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  • This hypothetical manager will also be restricted to large cap (which will most likely be defined quantitatively) even when they see an extraordinary opportunity in a mid cap or small cap stock. The manager will also be restricted to value, however that is defined in the IPS.

    Most definitions of value for large cap managers will divide the investment universe in half with half representing value and the other half being defined as growth. The IPS will require the manager to ignore opportunities in half of the market. Again, an individual has no such restriction.

    Lynch’s Book As a Roadmap To Success

    To help small investors, Lynch wrote a book called One Up on Wall Street, in which he detailed a few of the techniques he used to find winning stocks.

    To start with, he 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. For example, if he bought a stock at $2 he would want to see it rise to $20 to become a ten bagger.

    One of the stock-picking techniques he described was a strategy to find undervalued stocks with above average earnings growth, strong financials, and low institutional ownership. The specific criteria he defined were:

    • Value is measured with the price-to-earnings (P/E) ratio. Lynch wants to buy stocks with P/E ratios that are below its industry average and also below the stock’s own five-year average P/E ratio.
    • Growth is measured by the change in earnings per share (EPS). Lynch looks for companies whose EPS have increased faster than average over the past five years.
    • Financial strength is defined with the balance sheet. The ratio of liabilities to assets needs to be less than the industry average for a stock to be a buy.
    • Institutional ownership should be lower than average. This should allow for price gains when institutions discover the stock and crowd into it.

    Another technique he detailed was the use of the PEG ratio to find undervalued stocks. The PEG ratio can be used to assign a value to a growth stock and this technique bridges the line between value and growth.

    The PEG ratio considers both the P/E ratio and how fast earnings per share (EPS) are growing. This calculation (P/E ratio / EPS growth rate) recognizes that companies with rapidly growing earnings should have a higher P/E ratio than companies with slow earnings growth.

    For example, a tech company with EPS growth of 40% a year should be trading at a higher P/E ratio than a slow growth utility company with EPS growth of just 2% a year. That seems logical, but the PEG ratio quantifies that logic and allows us to find price targets for stocks.

    Before detailing the PEG ratio, we want to be sure you know that the calculation is available with the free stock screening tool available at FinViz.com. At this site, you could screen for a variety of fundamental factors, high levels of institutional ownership and bullish institutional transactions.

    Using the PEG Ratio

    Lynch suggested looking for stocks with low PEG ratios. Many analysts use a restrictive approach and want to buy stocks when the PEG ratio is less than 1. They define a stock as fairly valued when the P/E ratio is equal to the EPS growth rate and this is the case when the PEG ratio is equal to 1.

    Using FinViz.com to screen for stocks with a PEG ratio less than 1, we find Applied Optoelectronics, Inc. (Nasdaq: AAOI) on the list. This stock is currently priced at about $36 a share.

    There are 8 analysts that have published earnings estimates for AAOI for 2018. The average of their estimates is for EPS of $3.48. They expect earnings growth to average 18% a year.

    Remember that many analysts define a stock’s fair value as the price where the P/E ratio equals the EPS growth rate. For AAOI, that would be a P/E ratio of 18. Based on 2018 expected earnings, that provides a price target of about $62.64 per share which is 18 times the estimated earnings of $3.48 per share.

    This stock is potentially undervalued by more than 40%. This is a relatively small cap stock with a market cap of about $640 million and average daily trading volume of about $45 million. Large investment managers would move the price of the stock if they tried to buy or sell.

    AAOI is an example of what Lynch believes is the advantage of small investors. It’s a small stock that could rise sharply, and it’s available to individual investors who are willing to apply the investing secrets of Peter Lynch.