Peter Lynch knows a thing or two about picking winners in the stock market. From 1977 to 1990, he delivered 29% annualized returns as the manager of the Fidelity Magellan Fund.
Lynch was famous for identifying small, fast-growing consumer brands before they became household names. There are four things that stand out about lululemon athletica (LULU 1.30%) that illustrate the type of stocks Lynch loved to buy.
1. Consistent grower
One of Lynch's favorite investment opportunities was finding a company that consistently grew earnings per share between 20% to 25% per year. The reason stems from what makes stocks go up (or down) over the long term.
Image source: Lululemon.
Stocks can do anything in the short run, but in the long run, there is a high correlation between a stock's performance and the underlying growth of the company's profits. A company that delivers compounding growth in profits at high rates over many years can deliver millionaire-making returns.
Lululemon's brand power and "Science of Feel" approach to product design has translated to high growth in revenue and profits. Between fiscal 2016 and fiscal 2020, revenue grew at a compound annual rate of 18% per year. But earnings per share rose at a rate of 27%, partly thanks to higher margins from the booming e-commerce business.
The pandemic slowed Lululemon's momentum, but revenue growth reached 24% in the fiscal fourth quarter, and management is guiding for revenue and adjusted earnings per share to grow 27% and 35%, respectively, in fiscal 2021.
Earlier in the decade, Lululemon got into trouble over quality issues with its popular Luon yoga pants under previous management. Lululemon recalled its Luon product, which caused a shortage in supply and revenue growth to decelerate from 37% in fiscal 2012 to 16% in fiscal 2013. But the company's ability to get past this and reaccelerate growth is a testament to the company's brand power.
Overall, Lululemon's ability to deliver stellar operating results has fueled a 617% climb in the stock price over the last 10 years.
LULU data by YCharts.
2. Expansion opportunities
In addition to high earnings growth, Lynch also looked at whether the company had room to keep growing.
Lululemon ended fiscal 2020 with 521 stores open worldwide, but CEO Calvin McDonald sees plenty of room for further expansion.
We continue to be underpenetrated from a brick-and-mortar perspective across all our markets, including North America and around the world.
-- McDonald, fiscal fourth-quarter 2020 conference call
Lululemon's brand "translates across cultures and geographies," as McDonald mentioned. The company has a long runway of growth ahead, with international revenue comprising only 14% of Lululemon's business at the moment.
3. Improving growth story
Lynch liked to think of a company's growth path as an unfolding story. It was Lynch's way of monitoring a company's progress at tackling its addressable market. For example, if a retailer continued to open new stores, but same-store or comparable sales growth began to head south, that would mean the story is getting worse and it might be time to sell.
Is Lululemon's story getting better or worse? Even though comparable store sales declined last year, the COVID-19 pandemic was outside of Lululemon's control, so the company gets a pass on this metric for the moment. Other indicators point to a strengthening business.
The brand has been making headway to expand the men's business, which currently makes up 22% of total revenue. Lululemon scored big-time with its ABC pants in recent years, placing the company on track to double 2018 men's revenue by 2023.
What's more, management is targeting new product categories for expansion. Last year, Lululemon acquired the home-fitness platform Mirror, and so far, it is outperforming management's expectations.
Next year, Lululemon plans to launch its own line of technical footwear. Management sees areas in the market where it can compete effectively.
Lululemon acquired Mirror in 2020 for $500 million. Image source: Lululemon.
4. A low PEG ratio
Lynch got famous for savvy growth picks, but he didn't follow a buy-at-any-price approach.
The ideal price that got Lynch interested in making the initial investment was when the stock traded at a price-to-earnings ratio that was at or near the underlying growth rate in earnings. Today, this metric is known as the PEG ratio -- the price-to-earnings ratio divided by earnings growth.
Given the store closures and costs that weighed on Lululemon's results last year, the PEG ratio based on trailing earnings growth is not very useful. However, if we use the consensus analyst estimate for earnings growth for fiscal 2021, Lululemon currently sports a forward PEG ratio of 1.13, which is close to the level where Lynch would be interested in buying shares.
With a record of consistent growth and plenty of opportunities to keep expanding, Lululemon checks a lot of boxes that famed investor Peter Lynch would love in a long-term investment.
