Risk & Return: Peter Lynch

Peter Lynch

  • Believes individual investors have an advantage over Wall Street due to less bureaucracy and short-term performance pressure.
  • Developed his investment philosophy at Fidelity Management & Research, managing the Magellan Fund from 1977-1990.
  • Employs a bottom-up approach, focusing on individual stock analysis rather than macroeconomic factors.
  • Uses fundamental analysis, emphasizing valuation, prospects, and competition.
  • Stresses understanding a company's plans for increasing earnings, reducing costs, raising prices, expanding markets, or innovating.
  • Categorizes stocks into six types:
    • Slow Growers: Large, slow-growing companies with dividends.
    • Stalwarts: Large companies with 10-12% annual growth (e.g., Coca-Cola, P&G).
    • Fast Growers: Small, aggressive firms with 20-25% annual earnings growth.
    • Cyclicals: Companies affected by economic cycles (e.g., auto, airlines).
    • Turnarounds: Battered companies with potential for recovery (e.g., Chrysler).
    • Asset Opportunities: Companies with overlooked assets.
  • Selection Criteria:
    • Year-by-year earnings stability and upward trend.
    • P/E ratio lower than historical and industry averages.
    • A P/E ratio above 2.0 is unattractive.
    • Low debt-equity ratio.
    • High net cash per share.
    • Low payout ratio and long records of regularly raising dividends.
    • Inventories should not pile up faster than sales (for cyclicals).
  • Looks for companies with boring names or in disagreeable industries.
  • Favors spin-off companies and niche firms controlling a market segment.
  • Avoids hot stocks in hot industries and companies with unproven plans.
  • Monitors holdings every few months, rechecking the company story.
  • Sells if the story has played out, fundamentals deteriorate, or something in the story fails to unfold as expected.
  • Views price drops as buying opportunities for good prospects.

Price-to-Earnings Ratio (P/E)

  • Used to estimate if a stock is undervalued or overvalued.
  • Intrinsic Value = Benchmark P/E × Earnings per Share (EPS)

Dividend Yield

  • Measures annual dividend income relative to the stock's current price.
  • Dividend Yield = (Dividend per Share / Price per Share) × 100

Benjamin Graham's Equity Valuation Principles

  • The main idea is that intrinsic value of a stock is its true worth based on financial and economic analysis.
  • Margin of Safety: buy stocks when their market price is significantly below their estimated intrinsic value.
  • Strict investment criteria to identify undervalued stocks, including:
    • P/E Ratio: Below a certain threshold (often below 15)
    • Debt-to-Equity Ratio: Should be below 1
    • Current Ratio: Greater than 2

Peter Lynch’s Valuation Formula

  • {\text{P/E Ratio}} = {\frac{{\text{Future growth of EPS + DY}}}{\text{%}}}

Warren Buffett

  • Believes the intrinsic value of a stock is the discounted value of all future cash flows.
  • Focuses on companies with:
    • Consistent earnings growth.
    • High Return on Equity (ROE).
    • Durable competitive advantage (economic moats).
    • Reasonable price.
  • Buys stocks with a margin of safety below their intrinsic value.
  • Seeks companies with economic moats, such as brand strength, network effects, cost advantages, regulatory protection, and intangible assets.
  • Simplified Formula:
    • Intrinsic Value = {Earnings \over r}
    • Where:
      • Earnings: Current annual earnings or expected future annual earnings.
      • r: Required rate of return (usually between 8% and 10% for Buffett).