Peter Lynch's Secret to Finding Value Is Coming Up Empty in the S&P 500

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Peter Lynch
Photographer: Michael Springer/Bloomberg

For Peter Lynch, the legendary Fidelity Investments fund manager who returned almost 30 percent a year in the 1980s, the key to success in stocks was buying growth at a reasonable price.

Right now, you can’t find much of either.

A look at the Standard & Poor’s 500 Index shows price-earnings multiples are about 1.7 times higher than the rate at which analysts expect profits to grow over the next five years, according to data compiled by Yardeni Research Inc. That difference, a version of something known as the PEG ratio that Lynch favored, is the widest since at least 1995.

Comparing prices to growth is one way of showing how conventional valuation models may obscure risks after stocks tripled amid one of the weakest economic recoveries since World War II. Extreme readings in the PEG are being driven by above-average valuations and earnings pessimism that could worsen once the Federal Reserve raises interest rates.

“Higher prices need to come from higher earnings and it’s just unlikely that we’re going to get the magnitude of earnings acceleration we need,” said Rich Weiss, the senior portfolio manager at American Century Investment, which oversees $150 billion in Mountain View, California. “We’re much less sanguine about equities than we were five years ago or one year ago.”

Earnings Prospects

While the PEG ratio highlights poor prospects for income expansion, its record as a tool for market timing is mixed, especially as a signal to sell. Its message at the moment -- that shares are unmoored from earnings expectations -- would change if either stocks decline or expectations improve.

Right now, they’re not. Analysts are cutting projections for S&P 500 profit growth at the fastest rate in six years, predicting earnings will rise 1.4 percent in 2015, according to data compiled by Bloomberg. That’s down from an average of 15 percent a year since 2009.

The S&P 500 rose 0.2 percent at 4 p.m. in New York.

The earnings machine that powered the bull market for 2,275 days is decelerating after U.S. gross domestic product contracted in the first quarter and corporate revenue is tempered by a stronger dollar and sinking oil.

That’s not good news for investors at a time when valuations have resisted expansion. At about 17 times forecast earnings, the index’s P/E is 15 percent above its average in the past two decades, data compiled by Bloomberg and Yardeni show.

Fair Value

“Arguably the past few years have seen prices rising far beyond what growth would justify,” Sam Stewart, Salt Lake City, Utah-based chairman at Wasatch Advisors Inc., said by phone. The firm oversees $19 billion. “Does it scare me? No. But it gives me a cause of concern.”

In his 1989 book “One Up on Wall Street,” Lynch wrote that a stock is fairly valued when its PEG ratio equals 1. He produced average annual returns of 29 percent managing Fidelity’s Magellan Fund from 1977 to 1990, almost double the gain in the S&P 500 over the same period.

Today, 204 companies, including DirecTV, Netflix Inc. and ConocoPhillips, have a PEG ratio above 2. That’s 43 percent of the S&P 500 members whose data are available on Bloomberg. A year ago, 26 percent of the stocks were that high.

Predictive Use

Valuation metrics such as the PEG ratio do a poor job in identifying market turns and fail to account for things like monetary policies and business cycles, according to Steven Einhorn, vice chairman of New York-based Omega Advisors Inc., which oversees more than $9 billion.

“These absolute measures of value, P/E-to-growth and the like, overstate valuations of the market because they don’t incorporate the discount rate, which is unusually low,” Einhorn said by phone. “Go back in time, and we have, as to where multiples peak in bull markets -- it’s all over the place. There is no right or wrong absolute P/E at a bull market peak.”

Monetary stimulus from central banks has bolstered risky assets including stocks as the S&P 500 rose 212 percent since 2009. With the Fed pledging to keep rates lower for longer, equities are offering earnings yields more than twice the payout for 10-year Treasuries.

The S&P 500’s PEG ratio has averaged 1.3 since 1995, spending most of the time above 1, based on Yardeni’s data. The ratio held below the threshold for the first time during the fourth quarter of 2008, just months before the bottom of the 2007-2009 bear market.

Investors who followed the ratio to sell at its peak in 1998, 2004 and 2009 would have missed some of the biggest rallies. Its bottom in late 2000 also sent a false buy signal as the dot-com crash didn’t end until 2002.

Style Change

Analysts project profits over the next five years will rise at an annualized rate of 10 percent, down from a January estimate of 11 percent and compared with 18 percent at the peak of the Internet bubble, according to data from Yardeni. While the P/E in 2000 was 34 percent above where it is now, the ramping up of growth estimates led to a lower PEG ratio of 1.3.

Ed Yardeni, the president and founder of the research firm in Brookville, New York, said the elevated PEG is the result of investors rotating into stocks that pay the highest dividends, normally ones with lower P/Es. Analysts are still too optimistic and in the best-case scenario, profit growth will be in single-digit percentages, he said.

“Nobody is really excited about growth and not that many companies stand out as likely to grow a lot faster than the universe of companies,” Yardeni by phone. “You can’t get away from the fact that stocks are expensive. From here on, the heavy lifting has to be done by earnings.”

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