When it Comes to Investing, Simpler is Often Better

The simpler it is, the better I like it.

Of the countless quotes attributed to mutual fund great Peter Lynch, this one really stands out as a reflection of his investment philosophy. When he took over as manager of Fidelity's Magellan Fund in 1977, fund holdings totaled approximately $20 million. During his tenure from 1977 to 1990, it generated returns averaging 29.2% per year compared to the S&P 500's 15.8%, making Lynch something of a legend. When he retired in 1990, the fund had grown to $14 billion, a 700-fold increase.

While this represents one of the most impressive track records of all time, Peter Lynch is also revered in the investing world for his no-nonsense, common sense investment approach-one that just about anyone can understand and implement. He shared this strategy in his best-selling book One Up on Wall Street (1989), which provided a road map of straightforward, easily-digestibleinvestment advicegeared toward the average investor.

Magellan was the first fund Lynch had ever managed, and his early report card reflected the difficult market environment during the 70s. But the rest, as they say, is investment history. If you were to ask Lynch for his secret sauce recipe, he might offer another of his famous quotes:

Invest in what you know.

Hardly a pithy inside tip, but very characteristic of the Lynch approach. He believed that if you had some knowledge about a stock-for example, you bought and liked the company's products, its marketing, brand, etc.-you could have a leg up as an investor before professional investors might get to it. That's not to say, however (and Lynch himself has clarified this) that if you like a product, you should run out and buy the company's stock. Rather, this should be considered a good starting point, a reason to take interest in a company and put it on your research list. Yet another example of his common-sense investment strategy.

Lynch broke stocks into different categories and applied a variety of fundamental quantitative tests depending on where a company fit. These categories were as follows:

1. Fast-growers: Companies that increased earnings at a rate of 20 percent or more per year while maintaining relatively low levels of debt;

2. Stalwarts: Large, prominent companies with annual sales in the multibillion dollar range that experienced 10 to 19 percent annual earnings growth;

The one metric he applied to every category, however, was the P/E/G ratio, which Lynch created himself. This ratio compares a company's price-earnings ratio to the growth in its earnings-per-share. He felt that the P/E ratio alone wasn't as helpful a gauge if not considered against the company's growth. High price-earnings ratios by themselves weren't necessarily bad as long as a company was growing at an appropriate pace. The P/E/G ratio was one of the key metrics Lynch used to identify growth stocks that were selling at a good price-if it was under 1.0, Lynch was interested. If it was under 0.50, he was very interested.

Since 2003, I've been tracking the Lynch approach through a model portfolio I run on Validea. Under the Lynch strategy, the optimal portfolio holds 20 stocks and is rebalanced monthly. The portfolio has an annualized return of 12.1% compared to 6.5% for the S&P 500 and from mid-2003 through the end of 2016, the portfolio outperformed in nine out of fourteen years, with the best year in 2009 (up 62.3%) and the worst year (33.6%) - in both of those years the performance was better than the overall market. But before you go thinking this is slam dunk, I should note the portfolio underperformed the broader market by a lot in 2014 and 2015, with 2015 being particularly difficult (the portfolio was down 13.8% vs. the market that was about flat for the year). It's important to understand that the types of environments where the portfolio may struggle, and given the model's all cap make-up there will be periods, like in 2015 when the leadership in the market narrows, thus making it difficult for the portfolio to produce good returns.

Historically, the portfolio has batted a 58.4% accuracy rating, meaning that 5.8 out of 10 positions (or 11.6 out of every 20 positions) have been winning positions and appreciate from when they are added to the portfolio.

The table below lists the 20 stocks currently held in the portfolio. As you can see, it's a diverse group of names. Some of the best positions were added last year, but have remained in the portfolio because the model still scores them highly. On the portfolios last rebalancing (April 7th, 2017) a handful of stocks were added, including Gain Capital ( GCAP ), Rudolph Technologies ( RTEC ) and Marcus & Millichap ( MMI ). For investors looking for a short list of companies with solid growth and reasonable valuations, this may be a good list to start from given that the pass Lynch's tests.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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