Investing Through the Lens of the Legendary Peter Lynch

Peter Lynch is a bona fide investing legend. In 1977, he took over the helm of Fidelity’s Magellan Fund in the U.S. He retired in 1990, just 13 years later.

But during that span of time, he led the Magellan Fund to annualised returns of 29.2%, nearly double the S&P 500’s (a broad U.S. market barometer akin to the Straits Times Index (SGX: ^STI) we have in Singapore) 15.8% annual returns over the same period. For some perspective on Lynch’s achievement, every $10,000 entrusted to him in 1977 would have become nearly $280,000 by 1990.

While running Magellan, Lynch had his own set of investing criteria which he employed to help assess if a company may be worthy of a deeper study or an investment.

I’d be using Serial Systems Ltd (SGX: S69) as an example of how Lynch’s criteria would work in a local context.

1. The Price to Earnings/Growth (PEG) ratio

The Price to Earnings, or PE, ratio is likely well-known. But a related ratio, called the PEG (Price to Earnings/Growth), is less heard of.

As one of the pioneers to really work the PEG ratio hard, Lynch used it to find promising companies that have both earnings growth and reasonable valuations.

The logic behind the PEG ratio is this: When a company’s earnings is growing at a faster clip than the market’s “expectations” (where the PE ratio is used as a proxy), good things may happen. Mathematically, this is represented by a PEG ratio of less than 1.

Also, generally speaking, a low PEG ratio would be preferred to a high one.

With Serial Systems’ PE ratio of 7.2 (at its current share price of S$0.171) and a 51% spike in earnings per share in 2014, the firm would have a trailing PEG ratio of just 0.14 (7.2 divided by 51).

2. The Debt/Equity ratio

Lynch likes his companies to be in a robust financial position with little or no debt on their books. This makes sense as a strong balance sheet could signify two things: 1) the company’s ability to tide over rough times; and 2) a prudent management team which does not take unnecessary risks.

At end-2014, Serial Systems had total borrowings of US$178 million and total equity of US$122 million. This would give the company a debt/equity ratio of 146%; such a high figure might turn Lynch off.

Serial Systems' debt to equity ratio

Source: S&P Capital IQ

It’s also worth noting that Serial Systems’ debt/equity ratio has been increasing in nearly each calendar year since at least 2010. This can be seen in the table above.

3. The Inventory/Sales ratio

For manufacturers of physical goods, one of the early tell-tale signs that its products are not selling well would be a consistent build-up of excess inventory.

On that note, a quick way to assess if a firm’s demand is waning is to monitor how the inventory-to-sales ratio has changed over the years; a ratio that is consistently on the rise without any valid explanations might be a yellow flag.

Serial Systems' inventory to sales ratio

Source: S&P Capital IQ; author’s calculations

The table above shows how Serial Systems’ inventory/sales ratio has changed since 2010. As you can see, the ratio has fallen by a fair bit since then.

4. The presence of free cash flow

The presence of free cash flow means that a firm has extra cash to be deployed after reinvesting what it needs to maintain its businesses in their current state.

That extra cash can be used to grow the business or distributed as dividends for shareholders. It thus follows that it’s a good thing for shareholders of a company if the firm has the ability to produce copious amounts of free cash flow.

Serial Systems' cash flows

Source: S&P Capital IQ

This area is where Serial Systems would have work to do. There have been three calendar years since 2010 where the firm has not been able to even produce operating cash flow (free cash flow is defined as operating cash flow minus capital expenditures).

Foolish Summary

These four criteria can help provide a simple framework which investors can use to scout for stable growth stocks that are selling at reasonable prices.

It should be noted though that the criteria are meant to help narrow the field and isn’t meant for picking investments. More homework still needs to be done on any company even if it manages to ace Lynch’s list.

For more lessons from investing masters, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.