Peter Lynch and Earnings per Share

Peter Lynch is an american investor and mutual fund manager that manages the Magellan Fund at Fidelity. He is 75 years old and holds invaluable investing knowledge from his many years of experience. The Magellan fund averaged a 29.2% annual return from 1977 to 1990 and has the best 20 year return of any mutual fund ever.

In his book One Up on Wall Street Peter Lynch walks us through his method of investing. He lays out a few general guidelines that we will investigate:

1) Know the company

2) Buy small companies

3) Don't buy hot stocks

4) Find a niche company

5) Invest in a strong balance sheet

In addition to his general criteria, he focuses on 2 key stock fundamentals:

1) Growing Dividends

2) Growing Earnings per Share

Lynch's first example is Walmart.

We see Walmart experienced strong stock price growth as dividends and earnings skyrocket. Additionally, Lynch identified Walmart as an investment opportunity when Walmart was in single digit prices. He knew the Walmart business model and trusted the idea of a cost cutting store to win out in the market.

Another example is Ford.

By Analyzing the Ford Price vs Dividends vs EPS, we see the strong correlation between the 3 metrics. Lynch points out that dividend growth and EPS growth do not necessarily cause price growth, however, they are highly correlated. Investors like to see a company who is paying back investors in the form of dividends and earnings.

Another way to confirm Peter Lynch's strategy is to take a look at today's market pricing. We pulled the prices of all SnP600 Small Cap stocks to align with Lynch's 'small company' strategy. We then pulled the last 9 quarters of EPS from the financial statements of every company. Of the 9 quarters, we then counted the number of quarters the EPS grew.

The Average stock price of the SnP 600 at this time was $38 per share.

Interestingly, the average stock price of the top 50 stocks with the most quarters of a growing EPS was $52.

This simple EPS growth vs stock price analysis reveals the market pays a ~37% premium for stocks with growing EPS's. The goal then would be to find stocks with consecutive EPS growth, but are not reflecting their 37% premium in the stock price.

We completed the same analysis again, but this time looked Dividend growth. The top 50 Dividend Growth stocks averages a price of $56, nearly a 50% premium over the market average.

Dividends and Earnings growth are clear indicators of a healthy company. Only a company that is highly profitable is able to cover its expenses, invest in RnD, pay off its debt, and still have plenty left over to issue a bonus to stockholders while posting a positive bottom line.

However, these indicators are debatably lagged, and are actions companies take once they are already successful. There must be other fundamental metrics that could predict whether a company will post growing EPS and/or dividends before the growth actually happens. Our goal is to get in before everyone else to maximize our returns.

Check out our other research articles to learn more ways to identify quality stocks that will earn excess market returns.

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