In the previous weeks, David Einhorn has been all over the news. We covered the news, but thought some of his old speeches/ideas before he was super famous would be of interest to readers. We found some material from 2007/08. If you have anything earlier we would LOVE to see it send us a tip. Here is another one, a speech Einhorn made in 2005 on Peter Lynch and the PEG ratio. We will be posting more. sign up for our free newsletter to ensure you do not miss any.
David Einhorn’s Speech:”How to make money through the proper application of the PEG ratio”
Value Investing Congress
November 15, 2005
Peter Lynch is one of the greatest investors of all time. As a professional investor he clearly had all the analytical skills to properly value stocks and identify superior opportunities. He combined smarts and energy to be one of the best stock pickers of a generation. He realized that non-professional investors who don’t have 100 hours a week to devote to selecting the best portfolio of stocks couldn’t do everything that he could and they may not have the access or technical skills that he did.
Nonetheless, he believed that he could contribute some basic investing skills to the average, or even above average, individual investor. So he wrote a best selling book called One Up on Wall Street. I read it years ago. It was an excellent book. The thesis was that if you identify companies that are doing great on Main Street, you will do well with them on Wall Street.
My Grandma Cookie used to love to invest in stocks. This was the basic advice she followed. When she saw all her grandkids in NIKEs, she bought the stock. When she passed away a few years ago, I had a chance to look over her portfolio. She had done pretty well for a non-pro. She built a portfolio filled with blue chip growth companies like, NIKE, IBM, AT&T (when that was a good thing), believe it or not McDonalds and best of all WalGreens. She would buy these stocks bit by bit over decades and hold forever.
She did much better than my Grandpa Ben, who has spent most of his retirement constantly checking the markets. He subscribes to about a dozen news letters and cites the latest thinking of his favorite guru’s at all family events. He is a Goldbug and has been waiting for the economic ruin of our country through a paper money, deficit driven, hyper inflation at least since I was ten. Grandpa Ben decries our lack of sound money. Grandpa Ben owns gold bullion, gold stocks, mining companies, options on gold and gold stocks. Grandpa Ben is one of the best people I know, one of the nicest people I have ever met. But Grandma Cookie coming out of the Peter Lynch school beat the pants off him as an investor for thirty years. For individual investors, I would bet on Grandma Cookie’s style for the next thirty, as well.
Nonetheless, I digress. Coming back to Peter Lynch’s book, One Up on Wall Street. It really tried to avoid a lot of technical valuation skills. He realized that those were either beside the point or likely beyond the attention span of the mass audience he was writing to. But he threw in a valuation hint, a rule of thumb if you will. He advised individual investors to pay just a little attention to the possibility that when you identify a company doing well on Main Street, take a moment to check to make sure that Wall Street hasn’t already figured it out. He advised investors to figure out how fast the company is growing its earnings and compare it to the Price/earnings ratio. If the PE ratio was greater than the growth rate, it was probably too late to join the party.
The wonder of this analysis is its simplicity. You can compare a growth rate with a PE ratio in about 5 minutes — or less. I don’t know if Grandma Cookie did this, but I know if she wanted she could. A good thing, too, because I’d bet Grandma Cookie had about the same chance of properly constructing a discounted cash flow analysis that I had of carrying on Robin Yount’s legacy as the star of the Milwaukee Brewers.
As best I can tell, Peter Lynch’s description is the genesis of the PEG ratio. What is the PEG ratio? Simply defined, you calculate two numbers. First the trailing PE ratio and second the expected growth rate of earnings for the next five years. Convert the growth rate from a percentage to an integer, so 15% becomes 15. Now divide the PE ratio by the growth rate and you have a PEG ratio. So a PE of 20 and a growth rate 10% gets you a PEG ratio of 2. A PE of 10 and a growth rate of 20% gets you a PEG ratio of one-half.
For today’s discussion, I am going to stick to this “classical” definition. I have seen ridiculous concoction of this ratio using three- year growth rates or forward PE ratios. Etc. I have seen analysis that says, this company is going to grow its earnings 40% next year to $1 so it should trade at $40 using a PEG ratio of 1. Obviously, this is a big problem, because even if the earnings grow 40% for 1 year, the following year may not be so good and a slightly lower subsequent growth rate, might lead to a lower stock price using the PEG methodology. Look what happens to this math when the earnings only grow 20% to say $.85…would that make the stock worth $17. So if you thought it was worth $40, a modest shortfall might cost you more than half your investment.
Picking on abuses of the PEG ratio is too easy. Everyone knows them when they see them. I’d like to spend a few minutes on the “classical” PEG ratio. This a ratio that is seldom analyzed but widely used. In fact, Merrill Lynch conducts an annual survey of professional money managers where they ask them what factors they consider when making stock selections. Mind you, these aren’t individuals. These are the Pros. The survey gives them 26 metrics to chose from: PE ratio, Price to Book, Price to Sales, ROE etc. According to Merrill Lynch’s 2003 survey, the number 1, most common used metric by Pros is the PEG ratio. In 2004 PEG fell to third, narrowly behind EPS surprises and Price to Cash Flow. Nonetheless, 43% of professionals admit to considering the PEG ratio when selecting stocks. In contrast, only 33% use PE ratios and only 25% use dividend discount models. There were 201 pros surveyed, with one-third foreign. PEG analysis appears to be disproportionately an American phenomena. Well over half the US participants use PEG and it was easily the number 1 factor