by Archie M. Richards, Jr., CFP^®
April 25, 2005

Peter Lynch gained fame as a highly successful manager of Fidelity's Magellan Fund from 1977 to 1990. If you favor buying individual stocks, I recommend his style, as described in Lynch's books, "One Up on Wall Street" and "Beating the Street."

The American Association of Individual Investors (AAII) has developed a screening system based on Lynch's system. AAII does the work for you.

AAII membership costs $29 a year, for which you receive 10 issues of AAII's excellent magazine. Membership also gives you access to the Association's website, www.aaii.com, which keeps you up to date monthly with changes in the portfolio. (Access to weekly changes costs more.)

A key element in any stock selection is the price-earnings ratio (PE). Let's say a company's earnings for the last 4 quarters add up to $1 a share. If the stock's price is $15, this is 15 times the earnings, and the PE is 15. The price-earnings ratio is the best way to measure a stock's value. As a general rule, the lower the better.

Companies included in AAII's list must meet all of the following requirements:

• The company must not be in finance or real estate. The financial statements of companies in those industries are not directly comparable with those of other industries.

• The price-earnings ratio must be less than the median price-earnings ratio of the industry. For example, if the company's PE is 19 and the industry median PE is 20, the company passes the test. ("Median" means that half of the scores are above the median and half are below.)

• The PE ratio must be lower than the company's average PE for the last 5 years. If the average is 17 and the current PE is 15, the standard is met.

• Growing companies generally have higher PEs. To prevent overpaying, Lynch annualizes the company's earnings growth rate for the last five years and adds the current dividend yield. If the sum is at least twice the stock's price-earnings ratio, the company qualifies. For example, say a company has grown at 15 percent a year for the last five years and the current dividend yield is 1 percent. The sum is 16 percent. If the current PE ratio is 8 or less, the standard is met.

• Companies that have grown exceedingly fast run the risk of faltering. Those whose annual earnings from continuing operations have grown by 50 percent or more over the last five years are excluded.

• Bargains are best found among stocks that Wall Street neglects. To be included in AAII's list, the percentage of shares held by institutions must be lower than that of the median of all companies.

• Finally, the company must have relatively low debts, enabling it to navigate troubled waters. A company meets the standard if the ratio of its liabilities to assets for the latest quarter is lower than that of the industry's median ratio.

The result, as of March 4, 2005, is a list of 18 stocks, 12 of them foreign. (This fits nicely with my predictions that foreign stocks will outperform U.S. stocks.)

AAII cautions that any mechanical filter of stocks requires further analysis. It mentions that one of the companies on the list (MedQuist) faces investigation for potential violation of federal laws.

I disagree with the need for further analysis. A mechanical approach is sufficient. During the week before this writing, about 10,000 shares of MedQuist traded at approximately $13 a share. This means that buyers plunked down $130,000 on the assumption that the stock will not fall. Who's to say they're wrong? After all, the stock is cheap.

Buy all 18 stocks. If this is too costly, arrange them alphabetically and acquire every other one. You're not buying the stocks; you're buying Lynch's system.

Between January 1998 and the end of February 2005, AAII's Peter Lynch selections appreciated by almost 310 percent. During the same period, the S&P 500 gained by only 24 percent. Since 1998, the portfolio has had only one losing year - the horrendous 2002 - when it lost 7.2 percent. During that year, the S&P lost a whopping 23.4 percent.

Stock-picking mechanics that produce such an outstanding record are fine with me.