After 68% Gain in ’13, Lynch Model Likes These 10 Stocks

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Peter Lynch-inspired strategy, which has averaged annual returns of 10.0% since its July 2003 inception vs. 6.0% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Lynch-based investment strategy.

Taken from the March 28, 2014 issue of The Validea Hot List

Guru Spotlight: Peter Lynch

Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff — a number of investors have put up the types of long-term track records that make it difficult to pick just one who was “The Greatest”.

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Beat The Market With Peter Lynch’s Help

In his latest column for’s Money & Markets blog, Validea CEO John Reese looks at how investors can use the wisdom of mutual fund legend Peter Lynch to beat the market.

“Lynch is known for his ‘buy-what-you-know’ advice — the idea that average investors can get turned on to new stock ideas by looking out for companies whose products they have used and liked,” Reese writes. “But that part of his approach was only a starting point. 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-to-Growth ratio.”

Reese looks at how Lynch used the PEG ratio and several other variables to choose stocks. He also talks about how critical discipline was to Lynch, and talks about his Lynch-inspired Guru Strategy. A 10-stock portfolio picked using the model is up 8.9% since its July 15, 2003 inception vs. 5.1% for the S&P 500.

Why Apple Isn’t Rotting

In his latest column for, Validea CEO John Reese says that, despite the pounding Apple’s shares have taken in recent months, investors shouldn’t give up on the tech titan. 

“Slowing sales growth, two straight quarters of declining earnings, and questions about the company’s post-Steve Jobs leadership have all sent investors heading for the hills, thinking that Apple’s best days are behind it,” Reese writes. “I think they’re probably right — and I’m still bullish on Apple.”

Reese says that, while it would be nearly impossible for Apple to duplicate the run it’s had over the past decade, that shouldn’t be a surprise. “The next company that posts phenomenal growth with a pristine balance sheet and never has a hiccup or slowdown will be the first,” he says. “Frankly, that’s just not how things work. Good companies go through short-term problems. Sometimes, they get so big that they just can’t keep growing at the same pace — Warren Buffett has told Berkshire Hathaway shareholders not to expect the same kind of returns from Berkshire going forward, simply because of its sheer size.”

Reese says that Apple may be transitioning from a fast-growing firm to what mutual fund grade Peter Lynch called a stalwart — a big, moderate growth firm with attractively valued shares. Lynch said that many fast growers end up making such a transition. “Because investors tend to be so myopic, they often don’t acknowledge that natural transition,” Reese says. “They see slowing or declining growth as a sign that a company is headed for doom, and they sell shares in what may still be very good businesses — even if they are attractively priced. I think that’s what’s going on with Apple right now.”

Reese uses his Guru Strategies, each of which is based on the approach of a different investing great, to analyze Apple, as well as four other firms that have made the transition from fast-growing dynamo to steady stalwart. To read the full article, click here.





Lynch And Buffett Form Winning Team North Of Border

Warren Buffett and Peter Lynch are two of history’s most successful investors. And in a Number Cruncher column for Canada’s Globe and Mail, John Heinzl says combining their strategies has led to some big returns.

Using data from Validea Canada, Globe and Mail last year set up a portfolio of stocks that met both Validea’s Lynch-inspired investment model’s criteria and its Buffett-based model’s criteria. “From the portfolio’s inception date on Jan. 18, 2012, through March 20, 2013, eight of the nine stocks rose, with several producing substantial double-digit gains,” Heinzl writes. “As was the case in our last update in January, convenience store operator Alimentation Couche-Tard led the pack, up 75.8 per cent, followed by quick-service restaurant franchisor MTY Food Group, ahead by 65.5 per cent. Over all, the portfolio posted an advance of 23.6 per cent, excluding dividends. That trounced the S&P/TSX composite index, which rose 4 per cent over the same period, also excluding dividends.”

Globe and Mail recently performed the screen again, Heinzl says. This time it found just three stocks that pass both the Lynch- and Buffett-inspired models. Among them: Home Capital Group. To see the others, click here.

The Lynch Approach: Growth, at a Reasonable Price

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Peter Lynch-inspired strategy, which has averaged annual returns of 6.6% since its July 2003 inception vs. 4.1% for the S&P 500 (through Jan. 3). Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Lynch-based investment strategy.

Taken from the January 4, 2013 issue of The Validea Hot List

Guru Spotlight: Peter Lynch

Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff — a number of investors have put up the types of long-term track records that make it difficult to pick just one who was “The Greatest”.

If you were to rank Peter Lynch at the top of the list, however, you’d probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments’ Magellan Fund, Lynch produced a 29.2 percent average annual return — nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron’s, over the last five years of Lynch’s tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren’t impressive enough, try this one: If you’d invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch’s book One Up On Wall Street was a big part of what put me on the right track. Lynch didn’t use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch’s approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.

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. In fact, one of the things that led him to one of his most successful investments — undergarment manufacturer Hanes — was his wife’s affinity for the company’s new pantyhose years ago.

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 — that’s why I was able to computerize it — 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/earnings ratio 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.

To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America’s largest retailer. In his book “One Up On Wall Street”, he notes that Wal-Mart’s P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch’s tenets: that a good company can grow for decades before earnings level off.

The PEG wasn’t the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of “GARP” — Growth At A Reasonable Price — investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were “fast-growers” — those growing earnings per share at an annual rate of at least 20 percent — his use of PEG as a way to make sure he wasn’t paying too much for growth really makes him a hybrid growth-value investor.

One Size Doesn’t Fit All

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 percent per year. (Lynch didn’t want growth rates above 50 percent, 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 multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well — Wal-Mart and IBM are current examples of “stalwarts” based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.

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

One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you’d divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.

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 percent.

Beyond The PEG

The PEG wasn’t the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)

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. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn’t hurt a stock, however, since these are only bonus criteria.

A Market-Beater

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. Since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has averaged annualized returns of 6.2%, easily beating the 3.6% annualized return for the S&P 500 (all performance figures are through Dec. 30). The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 13.0% annualized over that period.

Here’s a look at the stocks that currently make up my 10-stock Lynch-based portfolio:

Capella Education Company (CPLA)

Bridgepoint Education Inc. (BPI)

HomeStreet Inc. (HMST)

Finish Line Inc. (FINL)

AutoNavi Holdings Limited (AMAP)

Crexus Investment Corp. (CXS)

Lexmark International Inc. (LXK)

Enstar Group Ltd. (ESGR)

AsiaInfo-Linkage, Inc. (ASIA)

Humana Inc. (HUM)

The Stomach’s The Key

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. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like “just like betting on red or black at the casino. … What the market’s going to do in one or two years, you don’t know.”

Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. 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.”

Large-Caps Lynch and O’Shaughnessy Might Like

In his latest RealMoney column, Validea CEO John Reese looks at a trio of large-cap stocks that look attractive as 2012 winds down.

“Year to date, we’ve seen a robust 13% rise in the large-cap index S&P 500,” Reese writes. “I am not a soothsayer, and I do not profess to know how well large-caps will do in the coming year, but at this point I see no signs of a slowdown anytime soon.”

Reese looks at three large-caps (those with more than $10 billion in market capitalization) that get high marks from his Guru Strategies — investment models based on the approaches of some of history’s best investors. Among the large-cap picks: Bed Bath & Beyond, which gets strong interest from his Peter Lynch-inspired model.


Lynch & Buffett Strategies Winning North of the Border

This year hasn’t been a great one for Canadian stocks, but Peter Lynch and Warren Buffett have been having quite a bit of success north of the border — at least, their strategies have.

In his Number Cruncher column, John Heinzl of Canada’s Globe and Mail has been tracking a 9-stock portfolio of stocks that got high marks from Validea Canada CEO John Reese’s Buffett- and Lynch-based models, and the result has been some strong market outperformance. “From the inception date on Jan. 18 through Oct. 2, seven of the nine stocks rose, led by a 48.5-per-cent gain in Alimentation Couche-Tard,” Heinzl writes.

Overall, the portfolio has gained 11.6%, excluding dividends. “That crushed the S&P/TSX composite index, which rose about 0.5 per cent, excluding dividends, over the same period,” Heinzl says. To see the full portfolio, click here.

The Benefits of Turnaround Firms

If you are looking for places to invest as the current bull market ages, try turnaround stocks, says The Wall Street Journal’s Jack Hough.

Hough says that several turnaround firms — those that have had big problems and are now trading on the cheap — have had big years in 2012. Among them are several homebuilders, as well as Gap and Sprint Nextel. Hough says that turnarounds are attractive not only because they can produce big returns if they get their act together, but also because they provide diversification. “As famed Fidelity stock-picker Peter Lynch explained in his 1989 book ‘One Up on Wall Street,’ ups and downs for turnaround stocks are less tied to broad market movements,” Hough writes. “That is a perk for investors who expect the 3 1/2-year stock rally to slow or stall.”

Among those top stock-pickers who’ve been betting on turnarounds lately is Oakmark’s Bill Nygren, whose fund bought shares of much-maligned American International Group earlier this year, notes Hough. Hough offers some tips for how to find good turnaround candidates, as well as some broader advice: “Investors who buy turnaround stocks shouldn’t fall in love with them,” he says. “If the valuation rebounds to average market levels, or if signs mount that efforts to improve aren’t working, it is time to sell. Also, fund investors should expect a bumpy ride from turnaround-heavy portfolios. … That sort of turbulence will keep most investors away. But to ones who like shopping for turnarounds, that is the whole point.”