Peter Lynch Investment Criteria in the stock screener

In the book One Up on Wall Street, Peter Lynch, an American investor and fund manager, describes the rules of his investment strategy, which we will discuss in more detail in this article.

The investment strategy of Lynch is based on fundamental analysis and is a long term buy and hold strategy. It focusses on finding growing companies with reasonable to low valuation. So although it has some factors of growth investing, it leans more towards a value investing approach.

Pure growth investing strategies often have a technical analysis and market timing component, while Lynch advises to ignore the volatility of the market (and instead use it for opportunities) and build a diversified portfolio to hold for the long term. Lynch will also exclude companies which are growing too fast and does take into account valuation, health and profitability.

Does that work? Well ... it certainly worked for him:

As the manager of the Magellan Fund, Lynch managed to achieve an average yearly return of 29,2% in the period 1977 to 1990, doubling the average return of the S&P500.

Invest in what you know and understand

According to Lynch, many good investment ideas can come from things you use, like or buy in your everyday life. The company does not need to be active in the next hot or growing thing, but just provide goods or services which are appreciated in their specific field. Companies can perfectly be involved in relatively dull areas. In fact: often the more dull and understandable, the better.

Often, as a retail investor you can use your first hand experience to your advantage. Companies which have not been discovered by Wall Street yet and will often have low analyst coverage and institutional ownership, can often be very interesting. So when you notice a specific product, service or item turning up more and more, always check out the company which creates it.

The next step is to dig into the company. Long term investors can not run the stock screener and just buy the companies that come out. Before actually buying you need to do your homework and make sure you understand the business of the company. So the screener will just give you a list of companies to research.

After buying shares of a company, the next step is patience. Lynch stated that you can not make any sensible prediction on the price of the company or the market in the next 1 or 2 years, but over 10 or 20 years the price is more predictable. A portfolio of 10 to 30 well selected and diversified stocks should perform well over a period of 10 to 20 years.

Investment Rules and Stock Screener Criteria.

The Peter Lynch Screen is available in our trading ideas section. In this section we will go over the rules of the screen.

• EPS 5 year growth > 15% and < 30%: The Earnings per share should have grown by at least 15% on average over the past 5 years. This growth should not exceed 30% because that type of growth is not sustainable. In your research it will be important to understand how and why this growth was realized and you will also need to assess whether the same kind of growth can continue in the future.
• PEG<=1: The PEG Ratio should be below 1. The PEG ratio looks at the P/E ratio, but compensates for growth and evaluates the valuation of the company.
• Debt/Equity < 0.6: This makes sure the companies is funded more by equity than by debt. Actually Lynch would even tighten this a bit further and preferred a D/E ratio below 0.25.
• Current Ratio >= 1: Another health filter, making sure the company has enough current assets to meet the short term obligations.
• ROE > 15%: The Return On Equity should be at least 15%, ensuring healthy profitability.

In the screen, we also put the requirement of a minimum daily average trading volume of 100K shares to ensure liquidity. Note that you could leave this filter out as liquidity is less important when buying for a long term hold and could cause you to miss interesting companies which have really not been discovered yet.

Additional Checks by Peter Lynch

Additional things which are not included in the basic filters we provided in the example screen, but could be:

• Institutional Ownership: the lower, the beter. It is possible to filter directly.
• Insider buying: recent insider buying is a plus.
• Share Buyback program: Lynch preferred companies which buy back there own shares.
• Cash Available: Lynch preferred companies with a positive cash balance.

Additional Filter suggestions.

The screen provides a list of growing companies, which are healthy, profitably and trade at reasonable prices. Further digging, sorting and filtering could be done by:

• The Piotroski score: The Piotroski F-Score is a quick evaluation of more recent profitability, health and efficiency and also includes checks on outstanding shares. The higher the score the better.
• ROIC: the Return On Invested Capital provides information on how efficiently the companies is allocating its capital and could be checked next to the already included ROE. Again: the higher the better.