The Hang Seng Index posted a gain of nearly 26 percent in the Year of the 0Monkey (Feb. 11, 2016 to Jan. 17, 2017). Actual return was over 30 percent if dividend payments were included.
However, most individual investors failed to benefit from the rally, given that only around 30 percent of the listed stocks managed to beat the benchmark. By contrast, over 600 stocks underperformed.
This highlights the importance of picking the right stock.
As manager of the Magellan Fund at Fidelity Investments from 1977 to 1990, legendary stock investor Peter Lynch scored an average annual return of 29.2 percent.
Balancing value and growth considerations, Lynch was particularly fond of price/earnings to growth ratio, or PEG ratio, as a criteria for picking stocks.
The approach enabled him to pick many “tenbaggers”, stocks that gained tenfold.
Based on Lynch’s framework, we have set up this investment checklist:
1. The annual growth of earnings per share should be at least 15 percent but no higher than 30 percent.
2. The PEG ratio should be no more than 1.
3. Institutional investors should not hold more than 50 percent of the floating stocks of a particular counter.
4. Debt to equity ratio should not go above 25 percent.
5. Market cap should not exceed HK$16 billion.
6. Current operating profit margin is below 120 percent of the three-year average.
7. Current price earnings ratio is below the five-year average.
Cautioning against exceptionally high and therefore potentially unsustainable growth, Lynch prefers to drop companies with extremely high growth rates.
A stock that fulfills all seven criteria gets a maximum of seven points.
We have built a portfolio consisting of counters scoring at least six points and found through back testing that over the past 10 years, the portfolio returned significantly better than the Tracker Fund (02800.HK).
This article appeared in the Hong Kong Economic Journal on Feb. 9
Translation by Julie Zhu
[Chinese version 中文版]
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