Peter Lynch Would Love These 5 Stocks

Monday, July 11, 2011 - 11:00am

by Lisa Springer

When one thinks of legendary investors, Peter Lynch stands out as arguably the most successful mutual-fund manager of all time. His track record as manager of Fidelity's Magellan (Nasdaq: FMAGX) fund is extraordinary. Lynch took control of the Magellan fund in 1977 and grew it into the world's largest mutual fund. During the 13 years he managed Magellan, the fund delivered average annual returns of 29.2% and outperformed the S&P 500 by more than 13 percentage points a year. If you'd invested $10,000 in Magellan when Lynch took over, then you would have had $280,000 when he retired 13 years later.

Peter Lynch no longer manages other people's money, but the good news for us is that his investing strategy is well-documented and fairly easy to replicate. Lynch begins by segmenting stocks into three categories: fast growers (greater than 20% annual earnings growth for the past three years), stalwarts (10% to 20% annual growth) and slow growers (less than 10% growth). During tough economic times, Lynch often increased the weighting of stalwart stocks in his portfolio, because these type companies are lower-risk and less affected by recessions.

Valuing "stalwart" stocks
To value stocks, Lynch used the PEG (price/earnings/growth) ratio, which is the price-to-earnings ratio (P/E) divided by the earnings-growth rate. He preferred a PEG ratio below 1.0, with 0.5 or less considered best. For valuing stalwart stocks, Lynch used a yield-adjusted PEG ratio, which is the company's P/E ratio divided by the sum of its multi-year EPS (earnings per share) growth and current dividend yield. Stalwart stocks purchased for his portfolio generally had modest debt levels and a yield-adjusted PEG ratio of less than 1.0, with earnings growing between 10% and 20% a year.

Many stalwart stocks are former fast growers that have matured beyond the rapid expansion stage and generate slower, but more reliable growth. This is because many stalwart companies produce boring but necessary products that customers always buy -- even in tough economic times. Such companies generally have solid fundamentals and generate billions of dollars in sales. Stalwarts no longer produce the impressive returns of fast-growers, but deliver steady gains at much less risk. Many pay dividends that provide a secure income stream. 

Given the uncertain outlook for the economy right now, this seems like a great time to re-visit Lynch's strategy and uncover stalwart stocks he might own today...

1. Intel Corp. (Nasdaq: INTC)
The P/E ratio for this integrated circuit manufacturer is a low 10.4. Its dividend yield is also  an impressive 3.7%.

Consensus analyst estimates look for Intel to deliver 11% annual earnings growth during the next five years. Intel has a yield-adjusted PEG ratio well within Lynch's comfort zone at 0.71. The company's debt is also exceedingly modest at just 5% of equity. With a market capitalization exceeding $120 billion, Intel has the size, stability and solid fundamentals Lynch looks for in a stalwart.

2. Applied Industrial Technologies (NYSE: AIT)
Despite a $1.6 billion market capitalization, Applied Industrial Technologies is not exactly a household name. The company is an industrial parts distributor, carrying 4 million-plus parts used by customers in many different industries.

Applied Industrial has a P/E ratio of 16.2 and an above-average 2.1% yield. Analysts forecast for long-term earnings exceeding 18% a year. Applied Industrial easily fits Lynch's parameters for a stalwart, based on a yield-adjusted PEG ratio of 0.81. Even better, the company has no debt and strong cash flow of $184 million last year. 

3. Ashland Inc. (NYSE: ASH)
Ashland makes specialty chemicals used in paper manufacturing, construction, metal casting and packaging. The stock carries an unusually low P/E ratio of just 8.0 and yields 1.1%.

Consensus estimates for Ashland target 12% annual earnings growth. The company also meets Lynch's criteria, with a yield-adjusted PEG ratio of only 0.61 and a conservative debt level of just 20% of equity. Although not well-known among retail investors, Ashland is a solid stalwart. The 93-year old company generates $9 billion in annual sales and has a $5.2 billion market capitalization.

4. Illinois Tool Works (NYSE: ITW)
Illinois Tool Works often appears on lists of stocks Peter Lynch would like -- and for good reason. The company has a large number of businesses, one less glamorous than the next, ranging from screws and fasteners to laminate floor coverings. Illinois Tool Works has been in business for close to 100 years and produces almost $16 billion in annual sales. Analysts think this company's long-term earnings will grow 14% a year. The stock has a P/E ratio of 16, a dividend yield of 2.4% and a yield-adjusted PEG ratio of 0.98. Debt is a bit high for a stalwart, but still reasonable at less than one-third of equity.

5. Corning Inc. (NYSE: GLW)
Corning is a familiar name to many of us because of its cookware products, but the company also makes glass substrates for LCD computer and television screens, optical fiber and cable and ceramic filters for emission control systems. The company has been around since 1851 and has a market value of greater than $28 billion. Corning has one of the lowest P/E ratios of the stocks I've mentioned (at just 8.0) and has a 1.1% dividend yield. The company's ratio of debt-to-equity is an appealingly modest 11%. With earnings growth forecast at 12% a year and a yield- adjusted PEG ratio of 0.61, Corning appears bargain-priced.

Action to take--> Any of the five stocks mentioned above score well based on Lynch's formula. My top picks from this group of stalwart stocks are Intel and Applied Industrial Technologies because of their generous dividends and minimal debt levels.

P.S. -- We've just identified six surprising events that could break your portfolio wide open in 2011. Knowing these pivot points in advance lets you focus your investing strategy like a beam of light in the dark... and make a lot of money in a hurry. Get them free by simply watching this video presentation.

Lisa Springer does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.