10 stocks for a Peter Lynch strategy

These stocks meet the growth and value criteria of the legendary manager of Fidelity Magellan.

By TheStockAdvisors Jun 12, 2012 1:17PM
By John Reese, Validea

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. If you'd invested $10,000 in Fidelity Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

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.

The most important fundamental he looked at was one whose use he pioneered: the "PEG" ratio, divides a stock's price/earnings 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.

In addition to "fast-growers" Lynch looked for "stalwarts" and "slow-growers," which tend to offer strong dividend yields; as such, Lynch adjusted their PEG calculations to include yield. He also looked at the inventory/sales ratio and the debt/equity ratio.

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%.

For most of the time since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has been one of my better performers. It has averaged annualized returns of 5.3%, easily beating the 3.1% annualized return for the S&P 500.

The portfolio's performance numbers have been hurt by a poor 2011 and a sub-par first part of 2012 (down 1.5%), but given its long-term track record, I expect the recent troubles are short-term and wouldn't be surprised to see the portfolio post some strong bounce-back gains before the year is over.

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

Ternium S.A. (TX)
OmniVision Technologies (OVTI)
Kulicke and Soffa Industries (KLIC)
NACCO Industries (NC)
Crexus Investment (CXS)
AsiaInfo-Linkage (ASIA)
Humana (HUM)
GT Advanced Technologies (GTAT)
FXCM (FXCM)
Apollo Group (APOL)

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."

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