In this series, I've been introducing you to some of the great investors, looking at their individual approaches and running stock screens to unearth examples of the type of companies their different styles produce.
So far we've looked at value pioneer Ben Graham, growth guru Phil Fisher, and living legend Warren Buffett. Today, it's the turn of Peter Lynch, a growth investor with a distinctive style, who coined the term "ten-bagger" to describe a share that rises ten-fold.
Reading what you know
Peter Lynch detailed his investing philosophy in two books: One Up on Wall Street and Beating the Street, published in 1989 and 1993, respectively. The titles give a big clue to his approach.
He said 20 years in the fund management business had convinced him "any normal person using the customary 3% of the brain can pick stocks just as well, if not better, than the average Wall Street expert".
How so?
"If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them."
Lynch looked in the everyday world around him for investment ideas among products and services he could easily understand; for instance, "pantyhose rather than communications satellites", and "motel chains rather than fibre optics".
He warned: "Never invest in any idea you can't illustrate with a crayon", and "go for a business that any idiot can run — because sooner or later, any idiot is probably going to run it".
Once a product or service had piqued Lynch's interest, he did thorough research on the company — checking, for example, that the product or service represented a significant percentage of the company's total sales. In fact, Lynch had a phenomenal work ethic that left few stones unturned.
Buying and selling
A key feature, for anyone following Lynch's approach, is to focus on companies that are under-researched by analysts and under-owned by institutional investors. These companies, relatively undiscovered by the pros, are the stuff of ten-baggers if they grow their businesses successfully and the big institutional money starts to flow into the shares.
Companies that sound dull or even ridiculous and that do something disagreeable or depressing are ideal, according to Lynch. If they're in a no-growth industry, all the better:
"In a no-growth industry, especially one that's boring and upsets people, there's no problem with competition … This gives you leeway to continue to grow, to gain market."
While Lynch likes to see annual earnings growth of 15%+, he cautions against companies growing at faster than 30%. Not only is that level of growth extremely difficult to sustain over the long term, but also companies growing at breakneck speed have usually already attracted the attention of analysts.
Lynch offers a disarmingly simple valuation method:
"Find the long-term growth rate, add the dividend yield, and divide by the P/E [price-to-earnings] ratio. Less than 1 is poor, and 1.5 is okay, but what you're really looking for is a 2 or better. A company with a 15 % growth rate, a 3% dividend, and a P/E of 6 would have a fabulous 3."
If a stock met Lynch's earnings requirements and had net cash or modest debt, he would hold for the long term if the story didn't change: No selling out after a 50% or 100% rise for Mr Ten-bagger!
A Lynch screen
I screened for companies with a market cap of less than $1bn; eliminating those that are likely to have the most analyst and institutional interest.
Lynch may like earnings growth of between 15% and 30% a year, but judging what the long-term growth rate of any particular company might be is problematic. I took an average of the last four-year's earnings growth; I eliminated cases where one single year had a disproportionate influence by insisting on growth of between 5% and 40% in all four years.
Finally, I calculated the "Lynch ratio" and screened out companies whose ratio was less than 1.5.
| Company | Market Cap | Latest price ($) | Earnings growth rate (%) | Dividend yield | Earnings growth + div yield | P/E ratio | Lynch ratio |
| Bradken Limited (ASX: BKN) | 995m | 5.54 | 15.1 | 6.9 | 23.4 | 12.4 | 1.9 |
| Fleetwood Corporation Ltd (ASX: FWD) | 689m | 11.15 | 17.0 | 6.4 | 24.8 | 14.1 | 1.8 |
| Mermaid Marine Australia Ltd (ASX: MRM) | 647m | 2.84 | 16.5 | 3.0 | 31.2 | 14.7 | 2.1 |
| Thorn Group Limited (ASX: TGA) | 221m | 1.50 | 18.4 | 6.3 | 34.0 | 8.5 | 4.0 |
| Collection House Ltd(ASX: CLH) | 87m | 0.80 | 28.1 | 8.0 | 29.7 | 7.7 | 3.8 |
| Embelton Limited(ASX: EMB) | 17m | 8.10 | 27.7 | 4.1 | 20.2 | 12.1 | 1.7 |
Source: Capital IQ and Google Finance
What is surprising is that only six stocks made it through the filter. Perhaps no real surprise though, that three of the six (Bradken, Fleetwood and Mermaid Marine) are companies servicing the resources and energy sectors, given the performance of those sectors over the last four years. Whether that will continue is a different story.
Embelton is an interesting company, providing flooring, wood and rubber products, metal fabrication and noise and vibration isolation, and with a market cap of just $17.5m, a P/E ratio of 12.1, could be one for the watchlist. Collection House and Thorn Group also look worthy of further research, with Lynch ratios of over 3.
If I include stocks with a market cap of over $1b, what was also surprising was that just two companies, Commonwealth Bank of Australia (ASX: CBA) and Australia & New Zealand Banking Group Limited (ASX: ANZ) made it through the filter.
Foolish bottom line
When it comes to the 'invest-in-what-you-know' approach, forget stock screens and start from where Peter Lynch starts: open your investors' eyes and ears when you're out and about in the world.
If you find a promising company, you may have to allow for the fact that even the best consumer-facing businesses are currently struggling to do Lynch's high earnings-growth numbers in this era of austerity — and to consider what kind of growth your hidden gem might be capable of producing when more benign economic times return.
Look out for the final article in this series, when I'll be leaving the US investors' Hall of Fame and looking at one of the UK's great practitioners.
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Motley Fool contributor Mike King doesn't own shares in any companies mentioned. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by G A Chester, originally appeared on fool.co.uk.
