Where do good stock ideas come from?
According to mutual fund legend Peter Lynch, one good source is your own experience as a consumer. The star Fidelity manager believed one way to find good investment ideas is to focus on companies you deal with personally — and like.
Taco Bell (NYSE:YUM), Apple (NASDAQ:AAPL), Dunkin’ Donuts (NASDAQ:DNKN) — Lynch wrote in One Up on Wall Street that he got turned on to these big winners not because of talks with CEOs or analysts, but because he stumbled on to their products, and liked them. And, he said, individual investors who follow a similar tact can get a leg up on the pros, because they may try out new products or services before Wall Street analysts and big institutions get around to analyzing the firms that make those products.
But investors often overlook a couple key points when considering Lynch’s buy-what-you-know mantra. First, Lynch warns that focusing on what you know is a good starting point when examining a company, but far from a be-all and end-all. “Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth,” he wrote.
Second, while it was the most publicized, “focus-on-what-you-know” was just one of many jumping-off points Lynch used when looking for stock ideas. He cited in his book a number of qualities a firm could have that would also pique his interest, and I’ve listed several of them below. Remember, as with “buy-what-you-know”, these only serve as jumping off points for further research. That’s why with each I’ve included an example of a stock that currently possesses that quality, and has the fundamentals to pass my Lynch-inspired Guru Strategy (which is based on the quantitative stock-picking criteria he laid out in One Up On Wall Street), or another of my guru-based models.
A BORING NAME
Lynch found that companies with boring names can fly under the radar — and that gives you a lot of time to purchase the stock at a discount before others catch on.
The Pick: Actuant Corporation (NYSE:ATU): This 104-year-old Wisconsin-based diversified industrial company serves customers from operations in more than 30 countries. It is active in a wide range of markets, including branded hydraulic tools and solutions; specialized products and services for energy markets; and highly engineered position and motion control systems.
Actuant’s name has a rather generic feel to it, but its performance is anything but generic. Its 21.5% long-term earnings per share growth rate (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate) make it a “fast-grower” according to my Lynch-based approach — Lynch’s favorite type of investment.
To find good stocks selling on the cheap, Lynch famously used the P/E-to-Growth ratio; PEGs below 1.0 are signs of a good value, with those below 0.5 the best case. When we divide Actuant’s 14.7 P/E by its growth rate, we get a PEG of 0.68 — a sign that it’s a bargain.
A DULL BUSINESS
Forget high-flying tech stocks — Lynch found that if a company with terrific earnings and a strong balance sheet also does dull things, it can fly under the radar of most investors.
The Pick: Lexmark International (NYSE:LXK): While this Kentucky-based firm provides important printing and imaging products and services, printers are far from sexy. But Lexmark ($2.6 billion market cap) has the sort of fundamentals my Lynch model likes to see. It considers it a “slow-grower”, thanks to its single-digit (9.6%) long-term growth rate. Slow-growers are primarily attractive for their dividends, and Lexmark is paying a nice 3.4% dividend. It’s also cheap, trading for 12.6 times EPS. For slow-growers, Lynch adjusted the “G” portion of the PEG to include dividend yield. When we divide Lexmark’s P/E by the sum of its growth rate and yield, we get a yield-adjusted PEG of 0.97, which comes in just under the model’s 1.0 upper limit.
A DISAGREEABLE PRODUCT LINE
If a firm does something that makes you a bit queasy or uneasy, that’s another sign it might get passed over by others, allowing you to get it on the cheap.
The Pick: Rollins, Inc. (NYSE:ROL): Does the thought of a spider crawling across your bed or kitchen table make you want to shriek? Well, Rollins — the parent of Orkin — provides pest and termite control services to customers in North America, with international franchises in Central America, the Caribbean, the Middle East, Asia, the Mediterranean, Europe and Africa. It’s a dirty job, but somebody’s got to do it.
And Rollins seems to be doing it quite well. The $4.8-billion-market-cap firm has upped EPS in all but one year of the past decade, part of what earns it some interest from my Warren Buffett-based model. Two more reasons the Buffett model likes Rollins: The firm’s lack of any long-term debt and its 29.9% average return on equity over the past decade.
A NICHE BUSINESS
Lynch found that if a company focused on a particular niche, it often had little competition.
The Pick: Alaska Air Group, Inc. (NYSE:ALK): Alaska Air — which is actually based in Washington state — is the parent of Alaska Airlines and Horizon Air Industries. With partners, it serves over 90 locations in the US, Canada, and Mexico, with a major focus on the Pacific Northwest. It’s another favorite of my Lynch model, which likes the firm’s stellar 35.7% long term growth rate. Shares trade for 14.5 times earnings, making for an excellent 0.41 PEG ratio. Alaska Air also has a very reasonable 37.1% debt/equity ratio.
COMPANY IS BUYING BACK SHARES
If a company is buying back its own shares, that’s decreasing the total number of shares outstanding. That can make earnings per share “magically” increase, Lynch found. Since earnings are a key driver of stock price, that can give these firms’ shares a nice extra boost.
The Pick: Credit Acceptance Corporation (NASDAQ:CACC): Credit Acceptance provides auto loans to consumers through a network of dealer-partners. It has a market cap of about $3 billion, and has grown earnings per share at a 28% pace over the long term.
Credit Acceptance gets strong interest from my Peter Lynch- and Warren Buffett-inspired models. The Lynch approach likes its 28% long-term growth rate and 12.7 P/E, which make for a stellar 0.46 PEG. The Buffett approach likes that it has upped EPS in all but one year of the past decade and has averaged a 25.8% return on equity over that stretch — and that it has reduced its shares outstanding from about 31 million to 22 million over the past five years. Its most recent round of buybacks came in October.
According to TipRanks.com, which measures analysts’ and bloggers’ success rate based on how their calls perform, blogger John Reese has a total average return of 7.9% and a 56% success rate. John Reese is Ranked #529 out of 4057 Bloggers