Finding Lynch's 10-Baggers

Peter Lynch is recognized by investors the world over. More than a million people read his book OneUp on Wall Street -- or, at least, that many people bought it. Sadly, many seem to have either disregarded or forgotten the book's tenets for finding great investments.

And that's a shame. After all, the greatest of these investments -- in his words, the "10- to 40-baggers ... even 200-baggers" -- can increase 10 to 200 times in value.

I sure haven't forgotten. A "student" of Lynch for years, I don't deny that what I've learned has influenced the way I invest. And I don't deny that when we conceived our Motley Fool Hidden Gems newsletter service and online community, digging up just a few of these 10- to 40-baggers was very much on our minds.

It might be worthwhile, then, to take a look at six of Lynch's primary principles, all of which are core components of our Hidden Gems investing approach. I strongly encourage you to consider them when building or fine-tuning your own stock portfolio.

1. Small companies
Lynch loves emerging businesses with strong balance sheets, and so do I. His extraordinary returns in La Quinta Inns came when the company was young and small, traded at a discount to estimated future growth, and sported a healthy balance sheet. Why did he veer away from larger franchises such as Hilton Hotels and Marriott International in favor of the promising upstart? He writes, "Big companies don't have big stock moves ... you'll get your biggest moves in smaller companies."

Couldn't have said it better myself, Peter. And when searching for prospects, I focus explicitly on strong, well-run companies capitalized under $2 billion.

2. Fast growers
Among Lynch's favorites are companies whose sales and earnings are expanding 20% to 30% a year. The classic Lynch play during the past decade might be Starbucks, which has consistently grown sales and earnings at superior rates. The company has a sterling balance sheet and generates substantial earnings by selling an addictive product, which its loyal customers purchase every day, at a premium.

The real trick is to find fast growers, such as Starbucks, in their early stages. Some candidates that I recently added to my watch list include Quality Systems and StrayerEducation (Nasdaq: STRA  ) , which sport three-year sales and earnings growth rates north of 20%, as does my recommendation Zumiez (Nasdaq: ZUMZ  ) . At the same time, don't shy away from a slower-growth business selling at a truly great price. Hidden Gems can take either form.

3. Dull names, dull products, dead industry
You might not think this of the world's greatest -- and, arguably, most famous -- mutual fund manager, but Lynch absolutely loved dreary, colorless businesses. A company such as Masco, which developed the single-handle ball faucet (yawn), increased more than 1,300 times in value from 1958 to 1987.

And if he could find that kind of business with a ridiculous name, like Pep Boys or Bob Evans Farms, all the better. Lynch writes about both in One Up on Wall Street. No self-respecting Wall Street broker could recommend such an absurdly named unknown to his key clients. And that left the greatest money managers an opportunity to scoop up a truly solid business at a deep discount.

4. Wall Street secrets
Lynch's dream stock at Fidelity Magellan was one that hadn't yet attracted any attention from Wall Street. One way Lynch recommends finding these companies is to buy spinoffs. Tim Hortons (NYSE: THI  ) and Kraft are examples (spun off from Wendy's (NYSE: WEN  ) and Altria, respectively). For instance, after being spun off, Toys "R" Us went on in relative obscurity to rise more than 55 times in value.

And Lynch is effusive in explaining the wonderful returns from funeral and cemetery business Service Corp. (NYSE: SCI  ) , which had no analyst coverage in the past (and still has very little).

The point is clear: Small, underfollowed companies present the greatest opportunities to long-term investors.

5. Insider buying and share buybacks
Lynch loves companies whose boards of directors and executive teams put their money where their mouths are. A combination of insider buying and aggressive share buybacks really piqued his interest. He would have given a close look to a small retailer such as Fossil, which has featured insider buying recently, and also Harley-Davidson (NYSE: HOG  ) , which has been aggressively buying back its shares on the open market over the past three years.

"Buying back shares," Lynch writes, "is the simplest, best way a company can reward its investors." Bingo.

6. Diversification
Finally, don't forget that Lynch typically owned more than 1,000 stocks at Fidelity Magellan. He embraced diversification and focused his attention on upstart businesses with excellent earnings, sound balance sheets, and little to no Wall Street coverage. He admits that, going in, he never knew which of his investments would rise five or 10 times in value. But the greatest of his investments took three to four years to reward him with smashing returns.

I anticipate an average holding period of three years, with the greatest of the group being held for at least a decade. I believe you can and should run a broad, diversified portfolio of stocks, if you have the time and the team to do so -- like the team we have here at the Fool and within our Hidden Gems community.

Finding the next prospect
Peter Lynch created loads of millionaires with his Fidelity Magellan Fund -- investors who went on to live comfortably, send their kids to college, and give generously to deserving charities.

You might be surprised to hear that he thinks you can succeed at stock investing without devoting your whole life to financial statement analysis. He's outlined a method whereby the total research time to find a stock "equals a couple hours." And he doesn't think you need to check back on your stocks but once a quarter. Doing more than that might lead to needless hyperactive trading that wears down your portfolio with transaction costs and taxes.

Hidden Gems practices each and every one of these Lynchian precepts. If this is how you like to invest, I guarantee you'll love our newsletter service. Try it free for 30 days, and if you don't absolutely love it, you can cancel without paying a tin-lizzy nickel.

The next 10-bagger is out there. Good luck finding it!

This article was originally published on Sept. 3, 2003. It has been updated.

Fool co-founder Tom Gardner does not own shares of any company mentioned. Quality Systems and Starbucks are Stock Advisor recommendations. Kraft is an Income Investor pick. The Motley Fool isinvestors writing for investors.


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