Riding the Coattails of the Great Peter Lynch

 | Oct 23, 2013 | 5:59 PM EDT  | Comments
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esgr

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csco

Mutual fund managers are easy to come by. Thousands of mutual funds exist, each with a manager. Finding good fund managers? Well, that is much more difficult. Finding great ones is nearly impossible.

Peter Lynch vaulted into the ranks of the great when he ran Fidelity Investments' Magellan Fund between 1977 and 1990. At a time the S&P 500 rocketed up 15.8% a year, on average, Magellan produced an average annual return of 29.2%, nearly double that of the S&P 500.

Investors took note. At the start of his tenure in 1977, the fund had $20 million under management. When he retired in 1990 (at age 46), the fund managed $14 billion in assets.

Lynch not only created a great track record, but also wrote a great book on investing, the bestselling "One Up on Wall Street," notable for its simple and insightful investment advice.

He famously recommended that if you know something positive about a stock, such as your being a customer of the company or your liking the company's marketing, you can potentially buy into such companies at an early stage, when their stock prices are low, and beat professional investors whose radar screens do not yet include such companies. Of course, he insisted that before one invests, one study the company's financials and make sure it is truly a well-performing company.

Ten years ago I made a computer model of the strategy Lynch described in his book and it has been a star performer among all the computerized strategies I follow. This year it has been on fire. While the S&P 500 is up 23% for the year, my Lynch-based strategy is up a startling 64.3%. This is not a one-off anomaly. Since I started following the strategy in July 2003, it is up 193.6% vs. a 75.4% gain for the S&P 500 during the same time period.

The strategy's best-known variable is the P/E/G ratio, which is price-to-earnings relative to growth. It measures how much the investor is paying for growth. A P/E/G of 1.0 means the stock is priced at a point where each 1% increase in growth costs the investor $1, while a P/E/G of, say, 0.65 signifies the investor is paying 65 cents for every 1% of growth. The strategy sets an upper limit on the P/E/G of 1.0. If a stock is priced above this, the price is considered too high and the stock is not recommended. A P/E/G below 0.5 is considered particularly desirable.

Here are three stocks that currently earn high ratings from the Lynch strategy and which you might consider buying:

Bridgepoint Education (BPI) -- A higher-education corporation, Bridgepoint offers online courses and on ground courses at its campuses called Ashford University and University of the Rockies. The company's P/E/G is a very favorable 0.42.

Enstar Group (ESGR) -- Enstar acquires and manages insurance and reinsurance companies. Its P/E/G is a strong 0.46.

Cisco (CSCO) -- One of the world's major technology companies, Cisco is known for its enterprise-class networking equipment. Its yield-adjusted P/E/G is a perfectly acceptable 0.84.

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