An Investing Legend's Million-Dollar Insights: Part 4

LONDON -- This article is the fourth of a five-part series that documents the share-picking strategies of Peter Lynch, the Fidelity fund manager who enjoyed average annual returns of 29% for 13 years. Click here to see the series introduction, complete with links to the other articles in the series.

Between 1977 and 1990, Peter Lynch produced a 2,700% gain for investors in Fidelity's Magellan Fund. That stunning rate works out at a compound annual growth rate of around 29%. If you could replicate it, you'd need just 37,000 pounds to reach 1 million pounds in 13 years.

It's not easy to achieve a return like that, so this article series aims to uncover how Lynch applied the tactics from his two books, One Up on Wall Street and Beating the Street, to crush the performance of his peers.

By the way, I also recommend reading this special Motley Fool report, "Ten Steps To Making A Million In The Market," which outlines the types of shares that could really compound your portfolio. It has certainly inspired me to act! Best of all, the report is 100% free.

Shares to shoot the lights out
Many know Peter Lynch for the multibagger returns he gained from fast-growing smaller companies. That's not surprising for he bought hundreds of them for the Magellan fund.

Although he said it was "wide of the mark" to think that small growth shares were the major factor in his success, the category he labeled Fast Growers was still an important factor in his outperformance.

He said: "These are among my favorite investments: small, aggressive new enterprises that grow at 20% to 25% a year." He reckoned that, if you chose wisely, it was possible to see tenfold, 40-fold, and even higher returns. One or two of those winners could transform the performance of an entire portfolio.

Lynch insight: Multibagger gains from one share can transform portfolio results.

Where to find them
Lynch felt that earnings growth above 25% a year could be too high to sustain and could lead to patchy results from investments in volatile industries. With fast growers, he was looking for a consistent, moderately high growth rate that the company could maintain.

Paradoxically, he didn't favor fast-growing companies in fast-growing industries. He believed that competition in a hot industry could be fierce, leading to new players eroding a company's early advantage and profits. He preferred a fast-growing company in a slow-growing industry, especially if it had a simple-to-understand business model and an ordinary-sounding name.

Lynch insight: Favor moderately fast-growing companies in slow-growing industries.

He found his multibaggers in a diverse range of industries such as hotel chains, fashion retailers, and restaurants. This decade's big winners were identified as an eclectic collection in this special Motley Fool report, names such as oil producer Tullow Oil (LSE: TLW.L), whose recent financial record looks like this:

Another is cigarette maker British American Tobacco (LSE: BATS.L), which has this recent track record:

Rapid earnings growth turned Tullow and British American Tobacco into super-performing shares. During the last five years, Tullow has more than tripled and BAT has more than doubled in value -- astonishing performances given the wider market was in that time thumped by the credit crunch.

Tomorrow's multibaggers aren't usually the larger companies on the stock exchange, though.

Great companies, such as pharma giant GlaxoSmithKline, were small once and grew. By the time they make London's premier index, however, their share-price multibagging days are usually over and the pace of growth becomes more pedestrian.

Right now, Glaxo is expecting forward earnings growth of 8% in 2013. At today's 1,486 pence share price, investors tend to be attracted for the forward dividend yield, which is around 5.3%.

So the hunt for fast growers usually begins in junior indexes such as the FTSE Fledgling, FTSE Small Cap, or the AIM markets. Lynch reckons that when young companies learn to succeed in one place, and then grow by duplicating that winning formula over and over, the resulting acceleration in earnings can drive their share prices to stratospheric heights.

Lynch insight: Look for young companies that can duplicate early success.

The risk factor
It's not all easy money, though. Investing in fast growers comes with plenty of risk. Lynch says that younger companies tend to be "overzealous and underfinanced," and when those conditions meet operational challenges, the result often involves bankruptcy.

More mature fast-growing companies tend to be rated for their success with a higher price-to-earnings ratio. Lynch's well-known rule of thumb for valuation compares the growth rate to the P/E ratio; a similar figure for each suggests fair pricing.

But when the company's growth rate slows, the P/E often reduces to match it. That leads to a plunging share price. So Lynch kept an eye on growth rates and sold as soon as they were threatened.

Once again, you'll notice that Peter Lynch was light on his feet when it came to selling -- "buy and hope" didn't find a place in his stock-market-trouncing strategy at all -- just pragmatic and realistic expectations of what the shares he held could do for his portfolio. If they failed to perform, they were out!

Lynch insight: If your fast grower slows its growth rate, don't ask questions, just sell.

The art of fast-grower investing is to react quickly enough to preserve your gains but not so quickly that you lose out on a multibagger.

In the next and final article in this series, I'll be looking at Peter Lynch's approach to turnarounds and asset plays. Also, I'll review how he managed to contain losses from the hundreds of losing shares he backed. 

For now, though, let me just tell you that I'm 100% sold on how Peter Lynch invested his way to compound 29% returns. Indeed, I'm using his lessons -- plus the free "Ten Steps To Making A Million In The Market" report that I mentioned earlier -- to help take my own portfolio to the magic seven-digit milestone!

As I say the report is free -- so if you're an ambitious investor like me, you should download it today while it's still available.

Warren Buffett buys British! The legendary investor has recently topped up on his favorite U.K. blue chip. Discover what he bought -- and the price he paid -- within this special Motley Fool report!

Further Motley Fool investment opportunities:

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