Criteria Rules – Lesson 7

Fund manager Peter Lynch in his two best-selling investment books entitled One up on Wall Street (1989) and Beating the Street (1993) has outlined several strategic rules of thumb or criteria that should be evaluated when considering a particular security investment:

Market cap

Market capitalization less than $5 billion – Lynch generally avoids large, well-known companies in favor of small-cap stocks that still contain significant upside potential. Most fund managers define small-caps as companies with market capitalizations under $1 billion. Institutional investors often use market one investment criterion, requiring, for example, that a company have a market capitalization of $100 million or more to qualify as an investment. Analysts look at market capitalization in relation to book value for an indication of how investors value a company’s future prospects.

PEG ratio < 1.2

PEG ratio below 1.2 – The PEG ratio is a valuation metric that compares a company’s price-earnings ratio with its projected growth rate. Small, high-growth stocks generally trade at higher PEGs compared to the big-caps. If the PEG ratio is around 1, the company is considered fairly valued. A PEG ratio that is much higher than 1 indicates an overvalued company, and a PEG below 1 indicates an undervalued company. While the PEG ratio can effectively provide insight in certain evaluations, it is limited by its overriding focus on earnings growth. Revenue growth, cash flow, dividends, debt, and numerous other factors are also critical in determining value. Additionally, while PEG is useful for smaller companies it may be misleading for big-caps, since sustained growth is less important to their total returns. PEG is most useful when supplementing a thorough discounted cash flow analysis or relative valuation.

Earnings growth 15–30%

Five-year earnings growth between 15% and 30% per year – In investments, earnings growth refers to the annual rate of growth of earnings, or the amount of profit a company produces during a specific period, usually defined as a quarter (three calendar months) or year. Earnings typically refer to after-tax net income.. When the dividend payout ratio is same, the dividend growth rate is equal to the earnings growth rate. Earnings growth rate is a key value that is needed when the DCF model, or the Gordon’s model as used for stock valuation. Companies that exceed a 30 percent earnings growth rate are confronted with two fundamental problems:

(1) sustaining a high growth-rate over the long term is extremely difficult.

(2) stocks growing that rapidly are usually already being actively covered by Wall Street analysts, and Lynch prefers less well-known names and avoiding competition.

Debt ratio < 35%

Debt-to-Equity (D/E) ratio below 35 percent – If a companies debt levels are excessive, it often proves extremely difficult for managers to raise sufficient cash to finance continued expansion. Without expansion into new markets, corporate growth eventually slows down. Companies with lower debt often have better prospects for future expansion. Additionally, in the event of an economic slowdown, these firms should be in better shape to weather any storms. Regarding debt-equity ratios, Lynch cites 0.33 (25% debt compared to 75% equity) as normal for a corporation. Additionally, he believes a debt-equity ratio of 4 reflects a weak balance sheet. Buffett echoed Lynch’s avoidance of companies that have significant debt. He argued that debt is “the weak link that snaps you.” A good business “will produce quite satisfactory economic results with no aid from leverage” while a company with significant debt will be vulnerable during economic slowdowns.

Institutional ownership 5–65%

Institutional ownership ranging between 5% and 65% – Institutional investors are organizations that trade large volumes of securities. Percentage institutional ownership is the percentage of outstanding shares that are owned by mutual funds, pension plans and other institutional investors. Most well-known stocks have at least 40 percent institutional ownership. Typically, upwards of 70 percent of the daily trading on the New York Stock Exchange is on behalf of institutional investors. Peter Lynch uses the degree of institutional ownership to gauge market interest. His contention is that stocks with a relatively small level of institutional sponsorship offer the best return potential. When ‘Wall Street’ analysts identify a stock and institutional money begins flowing in, price growth can be dramatic.

Dividend yields

When yields on long-term government bonds exceed the dividend yield (annual percentage of return earned by an investor on a common or preferred stock) on the S&P 500 Index by 6 percent or more, Lynch recommends selling stocks and purchasing bonds. He recommends this as a type of value-contrarian-safety strategy, claiming that when this situation occurs investors should enjoy the “risk-free” investment of bonds, they are either yielding exceptionally well or the stock market is over-valued. Either way bonds make more sense than stocks at that time. This is the only exception to Lynch’s assertion that stocks are always better investments compared to bonds.

Cyclical stocks

For cyclical stocks it is recommended to purchase when the P/E ratio is low, and sell them when the P/E ratio is high (i.e. when earnings are peaking). Cyclical stocks tend to rise quickly when the economy turns up and fall quickly when the economy turns down. Examples are housing, automobiles and paper.

Cyclicals can be a rewarding investments if purchased at their bottom price, so it helps to seek opportunity in depressed stocks, rather than analyzing potential reasons why a cyclical will take losses. When cyclical stocks are crushed by a weak economy and it appears things could not possibly worsen, cyclicals usually hit their bottom.

Lynch goes on to explain the PE ratios for cyclicals, advising the time to buy is when their PE hits a historic high, because ‘Wall Street’ has caught on to cyclicals and often begins discounting them before the overall market tops-out (i.e., ends a period of rising prices and is expected to stay on a plateau or decline). When a cyclical stock is at a low PE ratio, alongside record-high profits that have grown for several years, the market is anticipating a downturn. When a cyclical reaches a high PE on very low earnings, the price may be ready for an upturn because earnings will be at or near their nadir.