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Here’s a trick question: Who has the best strategy for picking winning stocks, Warren Buffett or Peter Lynch?
It really doesn’t matter. Each man made billions of dollars with his stock-picking strategies. Both systems find companies that make profits for investors year after year. We would all, of course, like to replicate the success of Buffett and Lynch in our own investment portfolios.
In following either guru’s advice on things like which fundamentals to value and what qualities to seek, the theory goes, anyone can pick a money-making share. The problem with this approach is that it usually leads to an awfully long list of possible investments. In Buffett and Lynch world, whole teams of researchers spend a lot of time conducting due diligence—often at the companies themselves—to finalize the winning list of shares. Most individual investors don’t have the time, training or access for such work, so their chances of picking the wrong stocks are high.
YCharts, which charts historical company performance in dozens of ways, has found a way to shorten those starting lists considerably. Rather than quibble over which billionaire is more worthy of following, we looked for stocks both Buffett and Lynch can appreciate. The result: A list of 22 solid companies worthy of any value investors’ attention.
We created this Buffett and Lynch hybrid list by taking a key fundamental in each investor’s strategy and merging them into one stock-picking model.
Buffett is known to value earnings yield as an important indicator of a company’s potential. Adding up the earnings from the past four quarters and dividing them by the share price gives an indication of how much return an investor is getting for his money. With 10-year Treasury bills inching above 3.5%, a good earnings yield generally is considered somewhere north of 5.5%.
Lynch looks harder at historic earnings growth, emphasizing the price to earnings growth (PEG) ratio for stock picking. The lower the PEG, the more growth an investor can buy for his money.
Neither investors like companies with a lot of debt and both want to see healthy cash flow. Buffett prefers companies with market dominance; Lynch tends to pick smaller ones. Both men stress the importance of sticking with companies in businesses you actually understand. Importantly, both men invest for the long haul.
With apologies to Lynch, we limited the universe for the Buffett/Lynch Hybrid List to large-cap companies in order to add an element of stability. Searching all the U.S.-based large-caps for shares that have an earnings yield above 6% and a PEG of less than 1 produced a list of 33 solid possibilities in a variety of sectors. In deference to the debt and cash preferences of both investors, we kicked out companies with anything less than stellar numbers on current and debt-to-equity ratios; long-term average cash; and long-term debt compared to net income.
The resulting 22 stocks are not, of course, the only shares a Buffett or Lynch investor might consider. But for fans of these strategies, it narrows the possibilities to companies with respectable earnings growth and yields, decent share prices and strong balance sheets. It’s a safer place to start.
From the list of 22 stocks, here’s a look at five good prospects and one stock to avoid:
Northrop Grumman (NOC)
Defense company stocks have tanked in recent years as investors worried that the government will drastically cut the defense budget. Northrop gets about 90% of its business from the government. But as a generally rule, neither Buffett nor Lynch places a lot of significance on sector outlooks when evaluating a company. Both subscribe to the idea that good companies grow over time regardless of the general economic environment.
Defense company stocks have tanked in recent years as investors worried that the government will drastically cut the defense budget. Northrop gets about 90% of its business from the government. But as a generally rule, neither Buffett nor Lynch places a lot of significance on sector outlooks when evaluating a company. Both subscribe to the idea that good companies grow over time regardless of the general economic environment.
Northrop has managed to increase its revenues and generally produce steady earnings despite the gloominess of its sector.
With democracy in the messy stage of development around the world, massive cuts in the defense budget are less likely now than they were a few months ago. The diversity of Northrop’s goods and services—they range from making parts for fighter jets and space telescopes to training foreign militaries and building wireless networks—swill help the company maintain growth even if war spending drops.
Coca-Cola Co. (KO)
Buffett considers himself a life-long fan of Coca-Cola, largely because he believes the company is extremely well-managed. But there’s plenty here for Lynch to like too, despite its gargantuan size. The magic of Coca-Cola marketing continues to fuel respectable sales and earnings gains even as annual revenue tops $35 billion. A steady diet of acquisitions helps. The company projects this growth to continue well into the next decade. It’s PEG, one of the lowest on our list, would make Lynch happy too.
Buffett considers himself a life-long fan of Coca-Cola, largely because he believes the company is extremely well-managed. But there’s plenty here for Lynch to like too, despite its gargantuan size. The magic of Coca-Cola marketing continues to fuel respectable sales and earnings gains even as annual revenue tops $35 billion. A steady diet of acquisitions helps. The company projects this growth to continue well into the next decade. It’s PEG, one of the lowest on our list, would make Lynch happy too.
Bristol-Myers Squibb Co. (BMY)
As an international pharmaceuticals company, Bristol-Myers spends a lot of energy trying to pace the roll-out of new drugs to keep the bottom line growing. Not an easy task when your products are at the mercy of a years-long process for government approval.
As an international pharmaceuticals company, Bristol-Myers spends a lot of energy trying to pace the roll-out of new drugs to keep the bottom line growing. Not an easy task when your products are at the mercy of a years-long process for government approval.
Among pharma companies, Bristol-Myers is among the most threatened by patent expirations; its Plavix (a pricey blood thinner) brings in one third of revenue, and faces patent expiration this year. But good news in recent months about skin cancer treatments that are very close to going to market has perked up investor interest in the shares. But more important to our two long-term investment gurus would be Bristol-Myers’ business performance when the gods of industry are not looking down in its favor.
The company produces respectable earnings and a solid balance sheet even when there’s a dearth of new products to hawk. Thanks in part to price increases, revenues grew even in the past two years, even as investors were particularly worked up over worries that the company’s new product stream had stalled. Much of Bristol-Myers value to shareholders tends to come in the form of dividends, which the company has paid consistently, usually at yield well over 10-year Treasury bills.
Microsoft (MSFT)
While Buffett doesn’t care much for tech stocks, Lynch was never quite so sector-averse. Microsoft’s Bing search engine and a new controller for the popular Xbox game console have reinvigorated revenues at the company. They have also helped ramp up earnings per share growth to about 30% last year. That’s a level Peter Lynch would particularly like–high, but below the 50% mark he considered unsustainable.
While Buffett doesn’t care much for tech stocks, Lynch was never quite so sector-averse. Microsoft’s Bing search engine and a new controller for the popular Xbox game console have reinvigorated revenues at the company. They have also helped ramp up earnings per share growth to about 30% last year. That’s a level Peter Lynch would particularly like–high, but below the 50% mark he considered unsustainable.
Microsoft is not in the kind of boring business both investors claim to prefer. But as a grown-up tech company selling products for consumers, it’s a business that fits the definition of a company you can readily understand.
Corning (GLW)
On the surface, Corning has all the right numbers–high earnings yield, low PEG, low debt, growing earnings and lots of cash. But this is not a good fit for the Buffett/Lynch model. The company’s business is simply too complex to generate the steady, predictable share growth Buffett or Lynch value investors crave. Corning makes glass-based products like computer monitors, fiber optic cables and LCD television screens. It also is involved in a variety of joint ventures outside of those fields.
On the surface, Corning has all the right numbers–high earnings yield, low PEG, low debt, growing earnings and lots of cash. But this is not a good fit for the Buffett/Lynch model. The company’s business is simply too complex to generate the steady, predictable share growth Buffett or Lynch value investors crave. Corning makes glass-based products like computer monitors, fiber optic cables and LCD television screens. It also is involved in a variety of joint ventures outside of those fields.
The need to consistently produce new high tech products for its markets is partly responsible for big swings in earnings. The share price reflects the volatility too. While it would have been nice to own Corning shares for the ride up in the last couple of years, this is not a picture of the kind of value stock our mentors favor. It’s an example of how relying on the numbers alone can result in the wrong stock for the goal.
Becton, Dickinson & Co. (BDX)
Becton, Dickinson’s simplistic business among today’s diversified companies would thrill both Buffett and Lynch. Buffett, in fact, bought this company’s shares in 2009 and 2010.
Becton, Dickinson’s simplistic business among today’s diversified companies would thrill both Buffett and Lynch. Buffett, in fact, bought this company’s shares in 2009 and 2010.
BDX makes medical needles, syringes and other sharps that it sells to hospitals, clinics, doctors’ offices and pharmacies around the world. Sales figures have been muted recently, in part because people cut back on going to the doctor when they’re unemployed or worried about money. But Becton, Dickinson churned out profits anyway, thanks largely to a good hold on profit margins. Buffett likes companies whose profits are predictable years on out. It’s a safe bet that people will need shots for decades to come, recession or not.
Click on the slide show above for 22 Buffett/Lynch picks.
Source of all charts: YCharts Pro
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