In investment circles, ex-Fidelity mutual fund manager Peter Lynch is widely regarded to be among the very best. Not only did his 13-year management of Fidelity’s Magellan fund produce peerless results up until his retirement in 1990, but his subsequent influence on private investors has been vast. An early proponent of the celebrated investor tool, the price earnings growth factor – or the PEG, he also produced a now renowned book that encouraged investors to “buy what you know” and offered a way of chasing growth and dividends in the search for the next stock success.
Lynch published One Up on Wall Street in 1989 and offered an update in 2000 at the height of the dot com boom. What is surprising – given his self-confessed love of companies and the numbers behind them – is how little time he actually commits in the text to explaining his formula. Whilst understanding the nature of companies and their value is essential, the main thrust of One Up on Wall Street is that private investors can outperform institutions by applying what they see around them – what your wife is buying in the local shop could be more important than you think.
As a starting point, Lynch divides companies into one of six categories: slow growers, stalwarts, fast growers, cyclicals, asset plays and turnarounds. Among his favourites are the fast growers, which he describes as “the land of the 10- to 40-baggers”, although he insists that fast growth shouldn’t be confused with ‘hot’ companies and sectors. Meanwhile, the slow growers are large and aging companies – think utilities – where investors swap the upside potential of fast growth for the certainty of dividends. Stalwarts are slightly different, albeit he describes them as multi-billion dollar hulks that are not exactly agile but are nevertheless faster than the slow growers. He points to the stalwarts as ideal protection during recession and hard times.
Lynch and the PEGY
Lynch’s relationship with the PEG was cemented during his days at Fidelity when, he says, the ratio was used all the time when picking stocks. We recently assessed how another famous investor, Jim Slater, developed a version of the PEG that puts extra emphasis on future earnings forecasts. In essence, Slater divides the forward PE of a share by the estimated future growth rate in EPS to arrive at the PEG. By contrast, Lynch prefers to measure a company based on its historical, rather than forecast, earnings performance versus its PE. This reduces the reliance on broker forecasts which are notoriously inaccurate - the theory is that if you find a company that is valued at a PE less than its historical EPS growth rate then you may have found yourself a bargain.
While the PEG has been to be a useful tool in selecting potentially fast growth companies (assuming you make your exit at the right moment), it falls down when you apply it to larger, more mature companies where the factors driving growth are more opaque. To get around this, Lynch took the formula a step further (and explains it in about eight lines in his book!) by taking dividends into account. By adding together the long term growth rate and the dividend yield and dividing it by the PE, you get his PEGY ratio.
It is worth noting a point of possible confusion here as more recently, analysts have tended to invert this equation (instead dividing the PE by the GY) so that anything with a PEGY of less than 1 is the ideal target. That’s the approach we have mirrored using the Stockopedia PRO data-set.
In market conditions where growth investors may be feeling war weary, we have used Lynch’s PEGY approach to find larger companies with interesting growth prospects that are also paying dividends. To standardise the comparisons, our PE and EPS growth figures are ‘rolling’ 12 month values, which weights this current year and next year’s earnings forecasts depending on how far a company is through in its fiscal year. So, hands up, we are also blending in some Slater-esque techniques here, but we suggest that this gives a fairer representation for each company.
Stockopedia PRO users can see the full list of stocks arrived at here. The first name that stands out on the list is Beazley (LON:BEZ), the specialist insurer. This is actually the third of several insurance companies that make up some of the top stocks on the list. The others are Catlin (LON:CGL) and Hiscox (LON:HSX). With a PE of 5.17, EPS growth of 68.2 and a forecast dividend yield of 6.27, Beazley scores an impressive PEGY of 0.17. Despite increasing competition the company performed well in 2010, delivering a pre-tax profit of US$250.8 million. Total dividends paid for the year increased to 10.0p from 7.0p in 2009. You should note however that Lynch avoids financial firms directly and treats financial intermediaries with slightly different criteria to normal investment prospects. Instead of scrutinising debt levels in a business, with an insurance company he would assess the asset/equity ratio as a measure of health. This means dividing total assets by shareholder equity, with any ratio greater than 5.0 passing the test. In this case, Beazley scrapes through with a ratio of 5.33.
Moving on, Hargreaves Services (LON:HSP) looks on paper to be a fairly ideal Lynch stock, with a diversified business model that spans coal production and waste services such as tyre recycling. Pre-tax profits at Hargreaves were up 20.2% at £36.9 million last year, driving the dividend up by 14.8% to 15.5p. With a PE of 12.4, EPS growth of 28.7 and a dividend yield of 1.74, Hargreaves scores a PEGY of 0.34.
Building supplies group Wolseley (LON:WOS) is another contender on a Lynch-style PEGY screen. Like many others, Wolseley has seen the economic conditions make a big impact on its customers but has focused on cutting debt (now at a 10 year low) and tweaking its operations to focus on larger, more attractive markets. With a PE of 13.5, EPS growth of 15.9 and a dividend yield of 3.01 (paying 45p in 2010), Wolseley scores a PEGY of 0.68. Its peers on the PEGY list include Travis Perkins (LON:TPK).
Security group G4S (LON:GFS) attracted criticism earlier this year when it launched, and later aborted, a bid to buy Danish cleaning company ISS. Shareholder concerns largely centred on the frothy proposed price and the risk that G4S might be diversifying too far from a model that has delivered strong growth in recent years. Lynch calls this type of strategy “diworsification” – so good news that the deal failed. Underlying growth and dividends have been growing for six years at G4S and with a PE of 14.2, EPS growth of 11.6 and a dividend yield of 3.93, it scores a respectable PEGY of 0.69.
Finally, retailers are a notable presence on this PEGY screen, with Kingfisher (LON:KGF), Sports Direct (LON:SPD), Next (LON:NXT) and Majestic Wine (LON:MJW) among the front runners. The only supermarket chain is Morrisons (LON:MRW) which has enjoyed rising sales despite the effects of tortuous economic conditions on households. Morrisons has been a relative later-comer to e-commerce but last year it moved to fix that with the notable acquisition of kiddicare.com and investment in FreshDirect. Could that be what Lynch calls a “kicker” to additional growth in coming years? It is an unknown, and in the hugely competitive and increasingly sophisticated grocery retail market, Morrisons will have its work cut out. All said, with a PE of 13.4, EPS growth of 14.0 and a dividend yield of 3.81, Morrisons scores a PEGY of 0.71.
As with last week’s Slater review, it does remain to be seen how a PEGY growth-focused screen may fare in the difficult times we all face at present but it’s worth remembering that Lynch himself invested using this metric through multiple cycles. By his own admission, stalwart companies in Lynch’s portfolio are frequently changed. While soaring stock values are unlikely at this end of the market, PE ratios can run away and that can dent the attractiveness of PEGY stocks. Apart from regular reviews of portfolio companies as matter of good house keeping, he urges investors to watch for whether their companies are failing to launch successful new products, whether directors are buying the shares and whether the growth rate is slowing.
Finally, it should be stressed that, while the companies identified above enjoy strong positions according to their PEGY numbers, any screen should just be a starting point for further research. Additional scrutiny is always required, using your own judgement and perhaps by covering a range of extra criteria discussed by Lynch in One Up on Wall Street and a generous dose of the “buy what you know” advice that underpins his whole approach. For those that are interested, you can see an even more onerous Lynch screen here on PRO, the performance of which we will be tracking the performance closely in the coming months.