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Published: November 4, 2004

(Note: In each biweekly issue of his premium Market Advisor newsletter, editor Paul Tracy uses proprietary software and screening methods to develop a list of investment opportunities that might be worth examining further. Below you’ll find an excerpt from our most recent Market Advisor issue.)

If there were an investing Hall of Fame, then fund manager Peter Lynch would be a shoo-in. Lynch took over the helm of the Fidelity Magellan Fund in 1977 and retired as the fund’s chief manager in 1990. Over that period he racked up average annualized gains of close to +30%; nearly double the S&P 500’s +17.5% annualized performance over the same time period. Not surprisingly, the Magellan Fund grew from a few hundred million in assets back in 1977 to well over $13 billion by the time Lynch retired — making Magellan the largest mutual fund of its day.

Those performance statistics are impressive in their own right, but Lynch has also gained notoriety thanks to his two best-selling investment books — One up on Wall Street and Beating the Street. Over the years, his down-to-earth buy what you know approach to the market has won countless praise and has captured the interest of millions of investors.

Although it is downright impossible to come up with a screen that exactly replicates his investing strategy, in today’s scan we attempted to incorporate many of Peter Lynch’s strict investing criteria. After all, many of Lynch’s criteria are very well defined in his books. In the analysis below my staff and I discuss a few features Lynch looks for in a good investment and we devise a screen to help us identify a few names that fit Lynch’s criteria.

Easily Understood

Lynch, like Warren Buffett, advocates buying stocks that he thoroughly understands. With this in mind, Peter Lynch wasn’t a big investor in technology or biotech stocks. Instead, he tended to focus on companies in easy-to-understand sectors like retail, consumer products and regional banks. In fact, Lynch actively tried to avoid the hot� fast-growing industries, focusing instead on finding unloved gems in more mundane groups.

Peter Lynch also believed in a very hands-on approach to the market. For example, he was well known for taking frequent trips to his local mall to find out where consumers were shopping. Lynch was also a big proponent of talking directly to the managers of the firms in which he planned to invest. Only after he understood a company fully would he delve into the numbers — carefully studying the financial statements and other important documents for all potential new investments.

Another manifestation of this buy what you know� philosophy is Lynch’s definition of growth. He likes to buy stocks that are growing, but are not growing at unsustainable rates. As a rule of thumb he generally looks for earnings growth of between +15% and +30%.

Companies that are growing faster than +30% have two main problems. First, it’s extremely difficult to sustain that type of growth rate over the long term. And second, stocks that grow too fast are usually already actively covered by Wall Street analysts — Lynch prefers to look for less well-known names. Many stocks growing over +30% are also involved in the tech or biotech fields. These stocks certainly wouldn’t fit his buy what you know� philosophy.

Institutional Sponsorship

Lynch believes that large, well-established companies can’t offer truly superior returns for investors. Instead, he prefers to look for what he calls ten-baggers — stocks that have the potential to rise in price by +1,000% (10 times) within five years or so. Large-cap companies rarely move that far, that fast. As such, in most cases Lynch focuses on small or mid-cap names. That means looking for companies with market capitalizations of less than $2 billion or so.

Lynch also honed in on another key aspect of the market — institutional buying and selling. The really big money in the market is controlled by institutions, not individual investors. In fact, most large-cap stocks are owned mainly by mutual and pension funds. An important statistic to watch here is institutional ownership. Institutional ownership measures the percentage of a firm’s total outstanding shares that are held by institutional players. For example, a quick glance at the components of the Dow Jones Industrial Average reveals institutional sponsorship ranges between 80% and 95% — most outstanding shares are owned by institutions.

The key question here is this — if the institutions have already piled into a given stock, then who is left to buy? After all, heavy buying interest is needed in order to fuel a sustained rise in share prices. With this in mind, Lynch prefers to look for companies that are under owned by the pros and relatively undiscovered by Wall Street. In that way, when large investment firms start to buy one of his stocks, he can post tremendous gains as the big institutional money starts to flow into the shares.

Debt and Balance Sheet Strength

Warren Buffett and Peter Lynch both agree on the importance of debt. In Beating the Street. Lynch stated he’d always flag a company that showed a debt-to-equity (D/E) ratio in excess of 25%. The D/E ratio is calculated as follows:

Debt-to-Equity = Total Debt / Total Equity

Remember that one of Lynch’s favorite sectors was retail. In the retail business companies must have the financial flexibility to expand into new markets and open new stores. This is why he focused so acutely on a stock’s debt burden.

Retailers that expand too quickly often take on way too much debt. At the first sign of a slowdown these high-fliers are often vulnerable to a cash crunch, and in some cases even possible bankruptcy. Financial history is littered with examples of this phenomenon. Consider Boston Market, a popular restaurant chain that went on a debt-financed expansion spree in the mid-1990s. The chain expanded too rapidly, and as a result, Boston Market eventually ended up filing for Chapter 11 Bankruptcy protection.

If debt levels are too high, then it often proves extremely difficult for managers to raise enough cash to keep expanding. Without expansion into new markets, corporate growth eventually slows.

What To Look For

With all of the above factors in mind, my staff and I recently combed through the investment landscape in search of stocks that met each of the following Peter-Lynch-like criteria:

Market Capitalization < $5 billion

Lynch generally avoids big, well-known companies in favor of small-cap stocks that still have room to grow. Most fund managers define small-caps as companies with market capitalizations under $1 billion. We decided to ease this requirement slightly to allow slightly larger, fast-growing mid-cap names into the mix.

Earnings Growth >15% and Earnings Growth <30%

This is at the low end of what some managers consider growth stocks. But remember, we’re trying to exclude well-known, high-growth momentum names from this screen, as these do not fit with Peter Lynch’s investing philosophy.

We required that both 5-year trailing growth and projected long-term growth were in the +15% to +30% percent range. Looking at past growth rates proves that the companies are established performers — they’ve actually been delivering strong growth in recent years. In addition, we want to make sure that all of these companies are expected to see continued growth without much of a slowdown in the coming years.

Debt-to-Equity < 35%

As we explained above, stocks with a relatively small level of institutional sponsorship offer the best return potential. When Wall Street catches onto a stock and institutional money starts flowing, price gains can be dramatic.

Below you’ll find a summary of all criteria we incorporated into today’s Peter Lynch screen:

— PEG ratio below 1.2

— Debt/Equity ratio below 35%

— Market cap less than $5 billion

— Average daily trading volume of more than 100,000 shares

— Five-year trailing earnings growth of between +15% and +30% per year

— Projected future earnings growth of between +15% and +30% per year

After running the above criteria through StreetAuthority’s advanced screening software, we came up with the following list of companies.