Dividend Investing Like Peter Lynch

Peter Lynch is one of the most well-known and successful investors from the latter half of the 20th century.

The Fidelity Magellan Fund, which Lynch managed from 1977 to his retirement in 1990, dramatically outperformed the broader stock market, averaging 29.2% annual returns during Lynch’s tenure. His total returns beat the S&P 500 (SPY) by nearly two times.

Lynch’s investing success didn’t go unnoticed in the investor community. In 1977, the (at the time, quite tiny and little known) Magellan Fund had $18 million in assets under management. By 1990, that number had skyrocketed to $14 billion.

There are many, many insights to be gained from Lynch as a thoughtful, commonsensical investor. But how can Lynch’s investment philosophy and principles help a dividend-focused investor like me? Lynch didn’t shy away from dividend stocks, but he didn’t specifically target them either.

Actually, I think there are some valuable lessons to be learned from Lynch for dividend investors, especially dividend growth investors.

In this article, I want to highlight some of the most important and helpful principles in Peter Lynch’s thought and show how they can be applied to a dividend-focused investment strategy.

Principle #1: Invest In What You Know

Lynch is perhaps best known for his advice to “buy what you know,” empowering individual investors to use the knowledge they have from their own daily lives and careers to their advantage. This method is only a starting point to give individual investors places to look for future winners by examining the products and brands they already use, but many (myself included!) have found it a compelling and exciting concept.

His popular book, One Up On Wall Street, explores how investors can use what they already know and the brands they already gravitate towards as a launch pad for stock picking.

• If you work in the healthcare field, you likely have unique insights into medical technologies and products along with trends in healthcare provision.
• If you work in commercial real estate, you likely have insights into the CRE landscape, including what’s undersupplied and what’s oversupplied.
• If you work in oil and gas, you probably have insights into the energy market that most others lack.
• If you are a full-time parent, you probably have insights into products and services specifically designed for children. Maybe your kid and all his or her friends like the kids shows on one streaming service but not another.
• If you are an avid shopper who frequents multiple stores, you can probably discern which ones are regularly the busiest and which ones attract the fewest shoppers.
• If you feel left out in your friend group because you are the only one who doesn’t own X product, that could indicate something about that product.

As Lynch said in an interview conducted by Fidelity Investments (which I copied and pasted some time ago but can no longer find on the Internet):

Ask yourself: Do you know something about the company? What can you add to the math? Do you have an edge?

Of course, the point of this thought exercise is merely to point you in the direction of some interesting investment opportunities. It isn’t meant to be the entire stock selection process.

I’ll give an example from my own portfolio. Since I work from home, I like to keep my fridge stocked with frozen meals and similar items I can quickly warm up for lunch. I like Gardein products and the Healthy Choice frozen meals that use Gardein meat substitutes. I figure other people working from home are probably eating more frozen meals like I am.

So, I did some research and found out that Conagra Brands (CAG) owns the Gardein and Healthy Choice brands, pays an attractive dividend, and has solid growth plans to capture more of the frozen meals market. I didn’t buy CAG merely because it owns brands I like, but I probably wouldn’t have considered CAG if not for my affinity for some of its brands.

Principle #2: Know What You Invest In

While the first principle is about generating ideas, the second principle concerns how to choose which of those ideas to actually buy.

The principle can be summed up simply as this: Do your due diligence. Don’t skimp on the research. Understand the fundamentals.

Compare the nonchalance with which many investors buy stocks with the care and thoughtful consideration that goes into buying a home. Quoting Lynch from the Fidelity interview again:

The public’s careful when they buy a house, when they buy a refrigerator, when they buy a car. They’ll work hours to save a hundred dollars on a roundtrip air ticket. They’ll put $5,000 or $10,000 on some zany idea they heard on the bus. That’s gambling. That’s not investing. That’s not research. That’s just total speculation.

Just like buying a home, which is a very real asset, stocks represent ownership stakes in real businesses with real assets. They are more than mere numbers on a screen.

Says Lynch:

Stocks aren’t lottery tickets. Behind every stock is a company. If the company does well, over time the stocks do well, and vice versa. You have to look at the company—that’s what you research.

This is especially true for dividend-paying stocks, because dividends are cash outflows from the company to the shareholder. To commit to a dividend requires a plan to continue generating the cash flow needed to fund that dividend.

Principle #3: (Dividend) Growth At A Reasonable Price

Peter Lynch pioneered the “Growth at a Reasonable Price,” or GARP, investment philosophy during his professional career. Before that point, the two most popular schools in the investment management world were value investing, represented by the figurehead of Benjamin Graham, and high-growth investing, represented by the “nifty fifty” concept popular in the 1960s.

GARP combines both styles, targeting fast-growing companies but at a reasonable price that is likely to limit the downside while maximizing the upside.

The ingenious method of measuring one stock against another to arrive at the most attractive GARP play is the PEG ratio. This measures the price-to-earnings ratio against the company’s historical earnings growth rate. The lower the PEG number, the cheaper the stock relative to its growth rate.

Let’s say a company has a P/E ratio of 15. That sounds pretty average, but it can actually indicate either overvaluation or undervaluation depending on the company’s growth rate. Let’s say the company only grows earnings 3% per year on average. That marks a PEG ratio of 5x – pretty darn high!

Now assume the 15x P/E company has an earnings growth rate of 10%. That would give it a PEG number of 1.5x – much more reasonable.

How can dividend investors use this principle?

Well, they could simply substitute earnings for dividends and the earnings growth rate for the dividend growth rate, but it comes with a caveat. What caveat, you ask? Different companies will have different payout ratios. A company paying out only 20% of its earnings as dividends will have a lot more room to boost the dividend over time than a company with a 90% payout ratio. One must take care not to compare apples to oranges.

Nevertheless, for two companies with roughly the same payout ratio, the “PDDG” (price/dividend divided by dividend growth rate) measurement can work. But investors should expect it to be higher than the PEG would be, because (1) the dividend is lower than the EPS, therefore the price-to-dividend will be higher, and (2) EPS growth is usually faster than dividend growth.

Take a company with a stock price of $20, a $1 annualized dividend (5% dividend yield), and a dividend growth rate averaging 5%.

• The price-to-dividend is 20.
• The PDDG multiple is 4x.

Now take a company with a stock price of $20, a $0.50 annualized dividend (2.5% dividend yield), and a dividend growth rate averaging 8%.

• The P/D ratio is 40.
• The PDDG multiple is 5x.

In this hypothetical scenario, the first dividend stock is a better buy, according to the PDDG.

Frankly, though, I don’t use the PDDG, even though it’s a viable analytical tool. I find it too time consuming, and it doesn’t get at the core goal of dividend growth investing, which is to generate a growing stream of dividend income as measured by yield-on-cost (“YoC”) – the current dividend divided by your average cost basis. I prefer the term “yield on invested capital,” but nobody uses that term, so neither will I.

A big problem with YoC is that, on its own, it does not take the time value of money into account. You might boast of your 10% YoC for Coca-Cola (KO), but if you’ve held it for 20-30 years that YoC may actually not be that impressive compared to the YoC you could have gotten from buying a different stock.

I like to perform an estimated future YoC based on my best estimate of forward dividend growth. Pick a time span, perhaps five or ten years, and assume an average annual dividend growth over that time span. Then compare it to the current dividend yield.

Here’s how the math works for two different hypothetical examples based on a 10-year horizon:

• 3% Yield x 8% Average Annual Dividend Growth = 6.48% 10-Year YoC
• 4% Yield x 5% Average Annual Dividend Growth = 6.52% 10-Year YoC

As long as you are using the same time span for the stocks being compared and estimating forward dividend growth (the trickiest part) with as much accuracy as possible, using future YoC estimates can be a helpful tool in picking dividend growth stocks.

Principle #4: Understand What Kind of Stocks You Own

Peter Lynch liked to categorize stocks in different buckets based on the type of investment thesis or “story” applicable to each.

In an article for the American Association of Individual Investors first published in January 1997, Maria Crawford Scott outlines Lynch’s six categories of stocks. To quote Scott at length:

• Slow Growers: Large and aging companies expected to grow only slightly faster than the U.S. economy as a whole, but often paying large regular dividends. These are not among his favorites.
• Stalwarts: Large companies that are still able to grow, with annual earnings growth rates of around 10% to 12%; examples include Coca-Cola, Procter & Gamble (PG), and Bristol-Myers Squibb (BMY). If purchased at a good price, Lynch says he expects good but not enormous returns–certainly no more than 50% in two years and possibly less. Lynch suggests rotating among the companies, selling when moderate gains are reached, and repeating the process with others that haven’t yet appreciated. These firms also offer downside protection during recessions.
• Fast-Growers: Small, aggressive new firms with annual earnings growth of 20% to 25% a year. These do not have to be in fast-growing industries, and in fact Lynch prefers those that are not. Fast-growers are among Lynch’s favorites, and he says that an investor’s biggest gains will come from this type of stock. However, they also carry considerable risk.
• Cyclicals: Companies in which sales and profits tend to rise and fall in somewhat predictable patterns based on the economic cycle; examples include companies in the auto industry, airlines and steel. Lynch warns that these firms can be mistaken for stalwarts by inexperienced investors, but share prices of cyclicals can drop dramatically during hard times. Thus, timing is crucial when investing in these firms, and Lynch says that investors must learn to detect the early signs that business is starting to turn down.
• Turnarounds: Companies that have been battered down or depressed–Lynch calls these “no-growers”…. The stocks of successful turnarounds can move back up quickly, and Lynch points out that of all the categories, these upturns are least related to the general market.
• Asset Opportunities: Companies that have assets that Wall Street analysts and others have overlooked. Lynch points to several general areas where asset plays can often be found–metals and oil, newspapers and TV stations, and patented drugs. However, finding these hidden assets requires a real working knowledge of the company that owns the assets, and Lynch points out that within this category, the “local” edge–your own knowledge and experience–can be used to greatest advantage.

(Austin here again.) Here is how I would label a number of my own dividend stock holdings into Lynch’s six stock categories:

Slow Growers	W. P. Carey (WPC), National Retail Properties (NNN), Spirit Realty (SRC), Enterprise Products Partners (EPD), Kinder Morgan (KMI), Enbridge (ENB), Conagra Brands (CAG), Unilever (UL), Verizon (VZ)
Stalwarts	Agree Realty (ADC), Clearway Energy (CWEN.A), Crown Castle (CCI), Essential Properties Realty (EPRT), Medtronic (MDT), Brookfield Renewable (BEP), Mid-America Apartment (MAA)
Fast Growers	NextEra Energy Partners (NEP), Medifast (MED), Innovative Industrial Properties (IIPR), National Storage Affiliates (NSA), Booz Allen Hamilton (BAH), Snap-on (SNA), EastGroup Properties (EGP)
Cyclicals	Avient Corporation (AVNT), Packaging Corporation of America (PKG), TotalEnergies (TTE), Whirlpool (WHR), Leggett & Platt (LEG)
Turnarounds	Intel (INTC), Algonquin Power & Utilities (AQN)
Asset Opportunities	VICI Properties (VICI), Armada Hoffler Properties (AHH), Bar Harbor Bankshares (BHB)

Click to enlarge

This exercise helped me to identify that the vast majority of my own stock holdings are what I would categorize as “fast growers,” “slow growers,” or “stalwarts.” That’s exactly how I prefer it.

Bottom Line

There are numerous other insights one could garner from studying Peter Lynch’s writings and interviews. What makes Lynch’s way of thinking so compelling is the commonsense approach that feels dramatically opposed to the complex, quant-based approaches so often taken by Wall Street professionals.

To sum up, the four principles we discussed above are:

1. Invest in what you know and understand.
2. Understand thoroughly what you want to invest in.
3. Seek to buy growing companies at reasonable prices.
4. Understand the different categories of investment “stories” and where your stocks fit into them.