John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Peter Lynch's remarkable run as manager of Fidelity's Magellan fund throughout the 1980s made him a household name, and he was often called on to talk to investment groups and the public about his secret to picking stocks. In his 1993 book Beating the Street, he wrote down a list of maxims, which can be summarized along three broad themes: Do your homework, invest for the long term and only buy what you understand.
Mr. Lynch was big on doing research before investing, and he emphasized keeping a clear head about it. He developed a way to measure the value of stocks by dividing a stock's price-to-earnings ratio by its long-term growth rate. When a company generates healthy growth, an investor should be willing to pay a little bit more for it. With slow-growing stocks, he also looked at some other measures, including sales against inventory and debt over equity. He also examined free cash flow as it related to the stock price, with anything over 35 per cent being a buying opportunity.
In Mr. Lynch's world, there are different types of stocks. Famously at Magellan, he homed in on fast-growing companies where the shares were ready to run up, what he called his "fast growers." But he also recognized that a portfolio needs a little yin for its yang, so he also invested in "slow growers," or stocks of companies that were growing at 10 per cent a year or less.
What made these stocks attractive was their dividend, or income generated for shareholders. Ideally for Mr. Lynch, these stocks would have dividends that were higher than the market average and more than 3 per cent. These often turn out to be stocks of large established companies (banks, utilities, big corporations) that could grow earnings predictably and steadily enough to return some of that capital to shareholders. These stocks tended to get overlooked for the flashier, high-growth stocks, too, so often there were bargains to be found.
But Mr. Lynch knew another thing: Investing is a long-term game that requires patience and a fair amount of courage. Readers of children's stories will remember Aesop's classic fable of The Tortoise and the Hare. The latter gets way ahead of his competitor in a race and decides to take it easy, and later wakes up to find the tortoise has passed him by on his way to the finish. In investing, too, it is easy to get overconfident. People who owned any type of stock in 2007 found this out quickly over the next year and a half. But the investors who didn't panic when the great financial crisis arrived and held on to their shares even as markets dropped to alarming levels ended up recovering their money and even making a profit depending on how many years they held the shares and when and if they sold any.
But probably the maxim that stuck with him the most was to buy shares of companies you understand, that make products you buy or have brands you value. Mr. Lynch's view was that individuals as consumers had a good vantage point from which to evaluate a company's prospects. Another successful investor, Warren Buffett, also uses the "buy what you understand" philosophy, and it seems to have served him, and Berkshire Hathaway shareholders, well.
Now for the twist: That list of maxims we summarized above was presented to Mr. Lynch in 1991 by a group of Grade 7 students who had been learning about the stock market. The lesson is that it doesn't take years of experience to develop a set of principles that makes sense for most investors.
Here are three top picks tracked by our portfolio that is modelled on Mr. Lynch's investment philosophy.
Taro Pharmaceutical: The maker of Warfarin, hydrocortisone cream and other prescription and over-the-counter products falls in to the "fast grower" category, and its price-to-earnings of 7.9 compares favourably to its 46-per-cent growth.
Gamestop: This manufacturer of video-game consoles and components is a "slow grower" by Mr. Lynch's definition. But it has a nice dividend yield. While the S&P 500 average is currently around 2.3 per cent, Gamestop's yield is 6.1 per cent.
Amtrust Financial: A provider of workers' compensation and other insurance products for small businesses, Amtrust has five-year average earnings per share growth of 27.4 per cent, well within the range Mr. Lynch set for sustainable growth.