How did this portfolio based on Peter Lynch's criteria perform?
Six months ago I trawled the market to find shares that meet Peter Lynch's investment criteria. But if you'd bought them, how would you have performed?
What Lynch looks for
Lynch uses an interesting rule of thumb to find cheap growth stocks: He takes the expected long-term growth rate, adds the dividend yield, and divides the total by the price/earnings ratio (P/E). This is basically the inverse of Jim Slater's PEG ratio, adjusted to account for dividend yield.
Using this 'Lynch ratio' as a guide, limiting the search to companies with a market capitalisation of at least £10m, and attempting to screen out companies recovering from dips rather than sustaining long-term growth, I generated a portfolio of 16 shares.
These were mainly at the smaller end of the spectrum, the exceptions being FTSE 100 member Old Mutual (LSE: OML), and mid-cap Brit Insurance (LSE: BRE).
Six-month results
As you can see from the table, it's a very mixed bag:
| Company | Lynch Ratio | Price then (p) | Price now (p) | Change (excl divi) | Change (incl divi) |
|---|
| Jetion Holdings (LSE: JHL) | 7.72 | 59.0 | 63.0 | 6.8% | 6.8% |
| GLOBO (LSE: GBO) | 5.87 | 9.5 | 11.0 | 15.8% | 15.8% |
| Velti (LSE:VEL ) | 4.12 | 146.5 | 196.0 | 33.8% | 33.8% |
| Brit Insurance (LSE: BRE) | 3.93 | 191.5 | 186.0 | -2.9% | 1.0% |
| RCG Holdings (LSE: RCG) | 3.82 | 77.5 | 84.5 | 9.0% | 9.0% |
| China Medical System (LSE: CMSH) | 3.56 | 164.0 | 432.0 | 163.4% | 167.1% |
| Eros International (LSE: EROS) | 3.43 | 108.5 | 135.0 | 24.4% | 24.4% |
| Hargreaves Services (LSE: HSP) | 2.82 | 490.0 | 681.0 | 39.0% | 40.6% |
| Aero Inventory (LSE: AI) | 2.73 | 187.0 | 0.0 | -100.0% | -100.0% |
| Formation Group (LSE: FRM) | 2.62 | 7.0 | 3.4 | -52.1% | -52.1% |
| Petmin (LSE: PTMN) | 2.45 | 15.3 | 14.2 | -7.5% | -7.5% |
| Old Mutual (LSE: OML) | 2.43 | 75.5 | 110.2 | 46.0% | 46.0% |
| OMG (LSE: OMG) | 2.37 | 26.3 | 17.5 | -33.5% | -33.5% |
| Amino Technologies (LSE: AMO) | 2.25 | 59.5 | 29.3 | -50.8% | -50.8% |
| Fiberweb (LSE: FWEB) | 2.08 | 63.5 | 57.5 | -9.4% | -6.8% |
| Alkane Energy (LSE: ALK) | 2.00 | 23.3 | 18.3 | -21.7% | -21.7% |
| PORTFOLIO | | | | 3.8% | 4.5% |
| FTSE All Share | | | | 18.4% | 20.3% |
| FTSE Small Cap | | | | 17.6% | 19.1% |
| FTSE Fledgling | | | | 17.8% | 19.5% |
If you had bought the whole group, you wouldn't have lost money, but you'd significantly under-performed all of the relevant benchmark indices.
About half of this under-performance was due to the crash of Aero Inventory, whose shares were suspended in October because of "issues regarding the valuation of a parcel of inventory". Further investigations revealed that the problems were wider than first thought, and eventually the administrators were called in.
It's noticeable that there is little correlation between the Lynch ratio and the subsequent performance, at least for this small sample of companies, and over this particular six-month time period.
Don't blame Lynch
It would be unfair to conclude from this small experiment that Lynch had got it wrong. The question of whether this indicator is likely to help us beat the market would require a much more comprehensive study.
Remember too that Lynch's focus is on long-term sustainable growth, and the two-year brokers' consensus figures that I was using are not necessarily a good proxy for that.
But most importantly, Lynch is not a mechanical investor -- he believes in understanding the companies in which he invests. A filter such as this is just a starting point, not a buy list.
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