Peter Lynch Background
Want a sure-fire way to get rich?
Double the annual return of the S&P 500 for over a decade and you won’t go far wrong.
Sounds great, but impossible, surely? Nobody can consistently outperform the market by that much, right?
Try telling that to Peter Lynch.
Best known as a portfolio manager for the Fidelity Magellan Fund between 1977-1990, Lynch averaged an annual return of 29% – more than double the S&P 500 over the same period. This record made Magellan the best performing mutual fund in the world, with assets growing from $20 million to $14 billion under Lynch’s reign.
How did he achieve these phenomenal returns, I hear you ask?
Well, lucky for us, Lynch outlines his investing secrets in ‘One Up on Wall Street’ – a holy grail for anyone looking to invest their own money seriously. There aren’t many books guaranteed to be on most investors’ shelves, but this is certainly one of them.
What’s more, Lynch’s investment approach is one of, if not, the most accessible to the beginner that I’ve come across. Thinking like an amateur is literally a key pillar of his process (more on this below).
“In other words, I try to think like an amateur as much as possible”
By doing so, he simplifies investing into a framework that’s intuitive and easy to implement.
Even better, it’s a framework that can be captured by a stock screener.
This means that YOU can seamlessly generate investment ideas that Peter Lynch himself would be proud of.
If you want to find out how, then keep reading.
Peter Lynch Screen
Peter Lynch groups stocks into 5 different buckets; each with distinct characteristics. These are:
- Slow Growers
- Fast Growers
- Stalwarts
- Turnarounds
- Asset Plays
The reason he does this is because he has a tailored stock picking approach for each group.
However, in this article I want to specifically focus on his investment approach for “Fast Growers”. This growth stock screener criteria article gives a useful primer about some of the metrics we’re about to use.
Fast Growers
Fast Growers are Lynch’s favourite investments – small, aggressive new enterprises that grow at 20-25% a year. This is the land of the 10- to 40-baggers if you choose wisely. Lynch is wary of companies that grow much faster than this (30%+) as this is usually unsustainable.
These companies don’t need to be in a fast-growing industry; in fact Lynch prefers if they aren’t. Companies stealing market share in slow-growing industries are the perfect candidates. These upstarts learn how to succeed in one place, and then duplicate the winning formula over and over.
Growth at Reasonable Price (GARP)
A key pillar of Lynch’s investment process was making sure he wasn’t overpaying for strong earnings growth. The reason being that expensive, high-growth stocks risk a massive derating when they eventually run out of steam and/or fail to meet the high expectations of Wall Street.
He could therefore be described as a GARP investor, similar to Martin Zweig. Read here for a more detailed look at a Martin Zweig stock screener strategy.
Low Price Earnings (P/E) Ratio
Lynch deems a stock ‘fairly priced’ if its price earnings ratio is less than or equal to its earnings growth rate. This is encapsulated by the well-known PEG ratio, which divides a stock’s P/E ratio by its earnings growth rate.
Lynch’s definition of ‘fairly priced’ means that he generally looks for companies with a PEG ratio less than or equal to 1.
I prefer to widen that threshold slightly to 1.5. This accounts for the higher valuations we see in markets today and gives a broader list of stocks to conduct further research on. Also, the fact that Lynch held as many as 1400 stocks at a given time means he certainly didn’t follow this strict constraint himself.
Strong Balance Sheet
Another core feature of any Peter Lynch screen is balance sheet strength. This helped him avoid those overzealous and under-financed companies that face the risk of extinction.
Lynch likes a debt/equity ratio of less than 25%. The focus is on long-term debt if the company has enough current assets (cash, inventories, receivables) to cover short-term debt. Again, I widen the leverage ratio slightly to 50% to account for higher corporate debt levels today and to obtain a larger list of stocks to research.
To ensure the healthy short-term liquidity that Lynch looks for, I also screen for companies with a current ratio greater than 1.
Healthy Net Cash Position
It was an added bonus if a company had a healthy net cash position. Net cash per share constitutes a floor for the stock price, and big piles of cash can also be used for buybacks. Therefore, cash acts a safety buffer for a company’s share price.
I don’t include this as part of the screening criteria, but certainly favour those companies with net cash when eyeballing the screening results.
Lynch defines net cash as (cash & equiv. + marketable securities) – (long-term debt). If this is positive the company has net cash, if it’s negative the company has net debt. As above, we only consider long-term debt if current assets cover short-term debt.
Other Bonus Conditions
As with net cash, I don’t include the following conditions into my Peter Lynch stock screener criteria. Even though Lynch liked these attributes in a stock, including them makes the criteria too restrictive.
- Low Percentage of Institutional Ownership: This is something Lynch refers to as “Street Lag”, which means you are early to an investment.
- Insiders are Buying: Management are bullish on company’s prospects.
- Company is Buying Back its Own Shares: Increases earnings per share (EPS) and reduces odds of a company “diworseifying”: a term Lynch coined for companies blowing cash on foolish acquisitions that are overpriced and beyond their realm of understanding.
William O’Neil is another investment guru who likes companies with a low percentage of institutional ownership that are buying back their own shares. Read more about it in this CANSLIM stock screener article.
Peter Lynch Stock Screener Criteria
In summary, the following conditions comprise my Peter Lynch stock screen.
ChartMill is a stock screener that lets you input most of this criteria, as you can see in the image below. They also have their own Peter Lynch screen that you can run at a click of a button.
Now, while I exclude the “extra criteria” as strict constraints in my screen, I believe they should still be taken into consideration.
The best way to do this is to create a “Custom Table View”, which lets you display the metrics you want as a data columns alongside the stock screener results.
For example, the first 4 columns in the image below are the “hard” criteria for a Lynch screen, whereas the last 2 are the “soft” criteria, which we can eyeball at our own discretion.
As you can see, Workday looks quite interesting in the list above. It has a relatively low institutional ownership share below 70%, and insiders have been buying stock over the last 6 months.
Unfortunately, net cash and buybacks aren’t available as metrics, but you can look these up on further research.
Beating ‘The Street’ Using What You Already Know
So far, we’ve established the quantitative criteria involved in a Peter Lynch screen.
However, as you know, this is just the beginning of the stock selection process. We now need to drill down into each company’s prospects with some qualitative analysis.
As such, the rest of this article will delve into Peter Lynch’s investing philosophy and the traits he looks for in stocks at a qualitative level.
The first thing to understand about Peter Lynch’s investing philosophy, is his belief that individual investors have numerous built-in advantages that, if exploited, can result in them outperforming the experts. He even goes so far as to call “professional investing” an oxymoron.
One advantage amateur investors have is being regularly exposed to interesting companies and products years before Wall Street. You could be a customer, employee, supplier, accountant, lawyer, building contractor, or even a cleaner for some promising company.
The point is that you are constantly acquiring first-hand knowledge of potential investment opportunities in your day-to-day life. Knowledge a professional analyst would love to attain yet can’t from their city office.
This gives you what Lynch calls, an edge.
“If you like the store, chances are you’ll love the stock”
The above quote is self-explanatory, but it’s logic can be extended. If you like a company’s product as a consumer, see their orders exploding as a supplier, or are a builder on one of their many new store sites, then you should see if you can invest in that company.
Peter Lynch on Using Your ‘Edge’
The best way to illustrate this line of thinking is to apply it to some real-world examples.
Netflix
Netflix is a company that I will never forgive myself for missing. I should have known it was going to be a huge success when everybody around me at university was subscribing. This was years before it was a household name. My edge was being in an environment where word-of-mouth is so powerful – giving me an early insight into new demand trends.
Costco, TJX, JD Sports
And how many of you have loved shopping in Costco, TJX (TK Maxx in UK) or JD Sports (Finish Line in US) over the years, not realising that you could have made an enormous amount of money as an investor in them?
JD Sports only started gaining recognition from Wall Street in late 2019/20, after it went from £0.07 in 2013 to £1.60 in 2019, adjusted for stock splits (a twenty-three bagger in Lynch parlance!).
Intuit
Any small business owner that’s used QuickBooks will have known that Intuit is the company behind this accounting software. The share price has been a multi-bagger over time.
On this point, Lynch recommends that if you are buying a company for a certain product, make sure it contributes to a significant portion of sales and profits. If it is only 2% of sales for example, then it is unlikely to have a meaningful impact on the share price, regardless of how well it performs.
In the case of Intuit, QuickBooks represents about half of its overall sales so you can be confident that its performance will be reflected in Intuit’s share price.
Rightmove
Rightmove is another company where countless of you (including myself) will go straight to its platform whenever you’re looking to move house or rent somewhere. How many estate agents will have seen this trend play out in real time? This company IPO’d at £0.25 in 2008 and is trading at £6.20 in 2022 – a twenty-five bagger.
Games Workshop
Games Workshop is best known for its Warhammer tabletop games and miniatures, which have long been an obscure hobby for a small, but loyal customer base. This is the type of unsexy business model that turns Wall Street off, but one look at the share price tells you that has been a mistake.
Any fan of Warhammer would have known the value of its intellectual property, and therefore been able to predict the explosion in royalty income as the company started licensing its IP to video games developers, comics, and movie producers.
This type of brand niche is what we call a franchise and something that Lynch is always on the look-out for.
Getting ‘One Up on Wall Street’ Like Peter Lynch
So, why do professional investors tend to overlook these lucrative, high-growth businesses?
Well, Lynch believes there is a natural tendency to avoid career risk on Wall Street. There is a famous saying that “you will never get fired buying IBM”. If IBM performs poorly, then it’s IBM’s fault, but if a new company that nobody has ever heard of performs poorly, it’s your fault.
Essentially, a stock isn’t deemed attractive until a large number of institutions have recognised its suitability and an equal number of respected analysts have put it on their recommended lists. This is almost always after the fast-growth phase and the share price has appreciated significantly (see JD Sports, Games Workshop).
“Look for opportunities that haven’t yet been discovered and certified by Wall Street – companies that are off the ‘radar scope’”
Street Lag
Lynch refers to the time it takes for Wall Street to finally catch on to a successful company as “Street lag”. In between this time is your window to get ahead of the professionals by using your edge.
So, whilst Wall Street is looking for reasons not to buy exciting growth companies, you should be taking advantage of what you already know and looking to buy these very stocks.
“The stocks I try to buy are the very stocks that traditional fund managers try to overlook”
Timing the Stock Market
The last thing to understand about Lynch’s general approach to investing, is that he does not try to time the stock market, nor try to predict where the economy is going. He believes these are futile endeavours that add little value. He is fundamentally a bottom-up stock-picker.
“Invest in companies, not the stock market”
Now we have laid out Lynch’s general approach to investing, it’s time to get into the really interesting stuff.
In particular, what characteristics does Lynch look for in a stock?
The Perfect Peter Lynch Stock
Although you will never find the perfect stock, Lynch argues that if you can imagine it, you will know how to recognise favourable attributes. Lynch believes the most important thirteen attributes are as follows.
The Duller, The Better
“The perfect stock would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name”
1. It sounds dull – or, even better, ridiculous: Automatic Data Processing (ADP) fits that bill – and what an investment it’s been.
2. It does something dull: Think Assa Abloy (door locks), or Shimano (bicycle components) – both fantastic companies.
3. It does something disagreeable: e.g. Waste Management (look at that share price!).
4. The rumours abound: it’s involved with toxic waste and/or the mafia: Maybe a little outdated this one, but again think waste management or hotels/casinos back in the day.
5. There’s something depressing about it: e.g. Service Corporation (boring name), which owns funeral parlours, cemeteries, and flower shops.
6. It’s a no growth industry: High growth industries attract talented people who look to disrupt the competition. This isn’t such a problem in boring industries, which allows companies to grow market share under the radar.
As you can see, Lynch likes dull-sounding companies with simple, unexciting business models in low-growth industries. Whilst this sounds counter-intuitive, the logic is that it reduces competitive threats and makes Wall Street less likely to recommend it (Street lag). In addition, the simpler the business model, the less likely management will run into trouble.
“If it’s a choice between owning a stock in a fine company with excellent management in a highly competitive and complex industry, or a humdrum company with mediocre management in a simpleminded industry with no competition, I’d take the latter … “Any idiot can run this business” is one characteristic of the perfect company, the kind of stock I dream about”.
Ideal Product
7. It’s got a niche: Once you’ve got an exclusive franchise in anything, you can raise prices. Regional newspapers have niches, drug companies with patents have niches, brand names are niches. Niches create barriers to entry, or what Warren Buffett calls, an ‘economic moat’.
8. People have to keep buying it: Software, drugs, soft drinks, razor blades, cigarettes etc.
Efficiency
9. It’s a spinoff: Once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve earnings.
10. It’s a user of technology: Instead of investing in technology companies that struggle to survive in endless price wars, why not invest in a company that benefits from the price war e.g. ADP?
Confidence Signals
11. The insiders are buyers: When management is buying its own stock, this is a sign of confidence in the company. Insider selling shouldn’t be viewed as negatively according to Lynch, as there are all hosts of reasons for insiders to sell, e.g. to fund living expenses.
12. The company is buying back shares: Again, a sign of confidence in company that also increases earnings per share (EPS). It also prevents companies from “diworseifying”.
13. The institutions don’t own it, and the analysts don’t follow it: This increases the probability that you are early to an investment.