(07/08/13) A Portfolio of Peter Lynch PEG Plays

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, observes John Reese of Validea.

During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Peter Lynch produced a 29.2% average annual return. These gains were nearly twice the 15.8% return that the S&P 500 posted during the same period.

Lynch didn't use complicated schemes. 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.

But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals, and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.

The P/E/Growth ratio, or "PEG," divides a stock's price-to-earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company is 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.

One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables.

His favorite category, as I noted, was "fast-growers." These companies were growing earnings at a rate of 20% to 50% per year. (Lynch didn't want growth rates above 50%, because it was unlikely companies could sustain such high growth rates over the long term.)

The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers." Stalwarts are large, steady firms that have multibillion-dollar sales and moderate growth rates (between 10% and 20%).

"Slow-growers," meanwhile, are firms with higher sales growing EPS at an annual rate below 10%. These are the types of stocks you invest in primarily for their high dividend yields.

Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3%.

For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory-to-sales ratio, which my Lynch-based model wants to be declining, and the debt-to-equity ratio, which should be below 80%.

The final part of the Lynch strategy includes two bonus categories: free cash flow-to-price ratio and net cash-to-price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35%, or a net cash/price ratio over 30%.

Over the long term, my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. This year it's been a particularly strong performer, with my ten-stock Lynch-based portfolio gaining 27.9% to nearly double the S&P 500.

Here are five stocks that currently earn a place in my Lynch-based portfolio:

Bridgepoint Education (BPI)
HCI Group (HCI)
Volterra Semiconductor (VLTR)
East West Bancorp (EWBC)
Humana (HUM)

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."