Peter Lynch, revered manager of Fidelity's Magellan fund from 1977 to 1990 and author of One Up on Wall Street, enjoyed huge market success using a common-sense approach, as illustrated by one of his many pearls of Wall Street Wisdom: "Go for a business that any idiot can run -- because sooner or later, any idiot is probably going to run it."
Not unlike Berkshire Hathaway CEO Warren Buffett, Lynch started with businesses he could understand. He subscribed to the notion that if you are familiar with a company's products (liking them is even better), you can have a leg up before professional investors get a whiff. This, however, should only be the first step: Lynch has always been a staunch advocate for evaluating a company's fundamentals to ascertain whether the underlying operation is strong.
In my book The Guru Investor, I describe in detail the quantitative measures used by Lynch and other legendary investors when evaluating stocks -- metrics that form the basis of my guru-inspired stock-screening models. Like many of the gurus, Lynch looked at different fundamentals depending on a company's size or performance, but there was one metric that he applied to every stock across the board -- and that he created -- called the price/earnings-to-growth (PEG) ratio, which is calculated by dividing a stock's price-earnings ratio (P/E) by its growth in earnings per share.
Here's the rationale: The faster a stock is growing earnings, the higher the price-to-earnings ratio an investor should tolerate. The lower the PEG ratio, the better, because it means you're getting more earnings growth bang for your buck. Lynch was comfortable if a company's P/E ratio was about even with or less than its EPS growth rate (i.e., P/E divided by EPS growth of 1.0 or lower), and was even more comfortable if the P/E ratio was half of or less than half of the EPS growth rate.
Lynch found that the PEG ratio was a great way to identify growth stocks that were still selling at a good price. In fact, the PEG ratio became the most important fundamental variable he considered when looking at a stock. This approach is an example of "GARP" investing -- Growth at a Reasonable Price -- which became a market buzz phrase in large part due to Lynch. In estimating the earnings growth rate, Lynch typically used historical earnings growth as the denominator. Lynch understood the difficulty of projecting earnings into the future, and therefore relied on the actual historical results in calculating the PEG ratio.
The PEG ratio, according to Lynch, was a more useful way to evaluate a stock's price than the price-earnings ratio alone. In his book One Up on Wall Street, he used Walmart to illustrate his argument by pointing out that Walmart's price-to-earnings ratio was rarely less than 20 during its three-decade rise, a ratio that was considered on the high side. Its EPS growth rate, however, was consistently in the 25% to 35% range, and the stock generated huge profits for shareholders. Even though the stock appeared pricey, it was still a sound and lucrative investment.
Using my Lynch-based stock screening model, I have identified the following high-scoring picks:
1. Waddell & Reed Financial (WDR)
Waddell & Reed is a mutual fund and asset-management company that provides advisory, product underwriting, distribution and shareholder services. Our Lynch-based stock screening model gives the company a perfect score considering its dividend yield of nearly 12% compared with the market average of 2.4%. The PEG ratio is considered best case at 0.32. The company also earns high marks from our Benjamin Graham-based investment strategy given its strong liquidity. (The current ratio of 3.8 vs. the minimum requirement of 2.0) and the modest leverage (net current assets well exceed long-term debt).