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Lynch’s ideal investment is a neglected niche company-one that controls a market segment in an unglamorous industry in which it would be difficult and time-consuming for another company to compete. At a minimum, it leads to questions as to why the company is priced differently. Implicit in this filter is that a company must have five years of positive earnings and five years of price data.Ĭomparing a company’s price-earnings ratio to the industry may help reveal whether the company is a bargain. The AAII Lynch approach specifies that the company’s current price-earnings ratio be lower than its own five-year average price-earnings ratio. If a company does everything well, you may not make any money on the stock if you paid too much for it. This knowledge should help you avoid buying into a stock if the price gets ahead of the earnings or send you an early warning that it may be time to take some profits in a stock you own. Stocks with good prospects should sell with higher price-earnings ratios than stocks with poor prospects.īy studying the pattern of price-earnings ratios over several years, you can develop a sense of the normal level for the company. The ratio compares the current price to the most recently reported earnings. The price-earnings ratio helps to keep your perspective in check. At times, the market may get ahead of itself and even overprice a stock with great prospects. The earnings potential of a company is a primary determinant of company value. To avoid companies whose earnings growth is not sustainable in the longer term, AAII’s Lynch-inspired strategy excludes companies whose average annual growth rate in earnings per share over the last five years is greater than 50%. Lynch prefers to invest in companies with earnings expanding at moderately fast rates (20% to 25%) in non-growth industries. A high level of growth for a company and industry will attract a great deal of attention from both investors, who bid up the stock price, and competitors, who provide a more difficult business environment. Extremely high levels of earnings growth rates are not sustainable but continued high growth may be factored into the price. The growth rate of earnings should fit with the firm’s “story”-fast-growers should have higher growth rates than slow-growers. Here are some of the key numbers Lynch suggests investors examine: For that reason, he also seeks to determine reasonable value. Also, an investor cannot make a profit if the stock was purchased at a too-high price. In examining a company, he is seeking to understand the firm’s business and prospects, including any competitive advantages, and evaluate any potential pitfalls that may prevent the favorable “story” from occurring. Instead, he felt it was better to spend your time looking for superior companies, doing fundamental research and keeping a close eye on the fundamentals of your holdings.Īnalysis is central to Lynch’s approach. Lynch said, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” It wasn’t that he didn’t understand the importance of these big-picture elements, he just did not believe that it is possible to consistently forecast them in any bankable way. He did not focus on the direction of the market, the economy or interest rates.
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Lynch was a bottom-up stock-picker who looked for good companies selling at attractive prices. Stocks Passing the Lynch Screen (Ranked by Dividend-Adjusted PEG Ratio)Īmerican Association of Individual Investors Our model has shown impressive long-term performance, with an average annual gain since 1998 of 7.9%, versus 6.5% for the S&P 500 index in the same period. Fifteen Lynch-inspired prospects are presented below. Lynch warned investors “when you sell in desperation, you always sell cheap.”ĪAII has developed a quantitative stock filter, or stock screen, with the goal of identifying stocks possessing the fundamental characteristics Lynch looks for when selecting stocks. As Lynch pointed out, stocks will go up and down, and rather than panic when they go down, you must have detachment to stay the course. Stock market volatility reminds us that long-term stock market success requires a certain detachment and tolerance for short-term pain.
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Lynch strongly believes that individuals could not only succeed at investing, but they also had a distinct advantage over Wall Street and professional money managers by being able to identify trends early, investing in what they know, having the flexibility to invest in a wide array of companies and not being evaluated on a short-term basis.