Valuable Investing Tools From The Legendary Peter Lynch

Not too long ago, I had shared how investors can scout for stable growth stocks that are selling for reasonable prices using a simple set of criteria that the legendary investor Peter Lynch had used.

This time, I’d like to share more of Lynch’s investing wisdom on how shares can be segregated into different categories and analysed as such. There are six categories and they’re described in Lynch’s best-selling investing book One Up on Wall Street.

Here are three of those categories:

1) Fast Growers

Companies that belong to this category are generally those that are capable of growing their earnings by 20% to 50% a year. The firms that belong should also be able to grow organically without the use of excessive debt.

In addition, they would ideally have a price-to-earnings (PE) ratio that’s lower than their earnings growth rate; the relationship between the two metrics can be gleaned from the PEG (Price-to-Earnings-Growth) ratio and you can find out more about it here.

A local share which may belong to this category would be Starburst Holdings Ltd (SGX: 40D), a company which designs and engineers defense facilities.

As a share that got listed in the middle of 2014, Starburst’s historical financials only go back to 2011. But from 2011 to 2014, the company has managed to grow its net income at an annualised rate of 29.5%. At its current share price of S$0.56, Starburst would have a trailing PE ratio of 10.6 and this in turn gives rise to a PEG ratio of a mere 0.36 (10.6 divided by 29.5).

Coupled with a rock solid balance sheet (as of end-2014, Starburst had S$17.7 million in cash on hand and just S$1.56 million in total debt), it’s fair to say that all the figures do fall within Lynch’s definition of a Fast Grower.

2) Stalwarts

For this category, Lynch is looking for large corporations with moderate earnings growth of around 10% to 12% per year and which can provide investors with slow and steady returns over the long run.

Typically, these firms have businesses which are household brand names. Some other fundamentals to look out for include a debt-to-equity ratio of 33% or less and a low yield-adjusted PEG ratio. (The latter is calculated by dividing the PE ratio with the sum of a share’s earnings growth rate and dividend yield.)

In our local share market, Raffles Medical Group Ltd (SGX: R01), with its sizeable market capitalisation of S$2.2 billion and a track record of delivering consistent earnings growth, does have some qualities of a Stalwart.

From 2010 to 2014, the healthcare services provider has managed to grow its earnings per share at a compound annual growth rate of 8.7%; that’s not too far off from Lynch’s lower boundary of 10%. In addition, Raffles Medical also has a very strong balance sheet with a debt-to-equity ratio of just 1.2%.

The only snag is that the firm’s yield-adjusted PEG ratio is on the high side. At Raffles Medical’s current share price of S$3.91, it has a trailing PE ratio of 32.3 and a dividend yield of 1.41%. Together with its earnings growth rate of 8.7%, Raffles Medical’s yield-adjusted PEG ratio would be 3.2, a figure which might make Lynch uncomfortable.

3) Slow Growers

The Slow Growers, as their name suggests, are shares which would only be able to grow their earnings at low single-digit percentages.

That slow rate of growth often leads to lower valuations, which in turn gives rise to generous dividend yields. With their high yields, Slow Growers could be suitable for income-oriented investors.

In Singapore’s context, this category of shares may be made up of real estate investment trusts, utilities, and telecommunication services providers.

Foolish Conclusion

By knowing what category (or categories) a share belongs to, you can better manage your expectations with each investment you make.

Such knowledge can also help you spread out your capital into different categories of shares in order to build a diversified portfolio with shares of varying growth rates and valuations.

As a final note, investors should be aware that the points discussed above would serve to be just a starting point and that more work needs to be done beyond that.

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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.