Finding Lynch’s 10-Baggers

Peter Lynch is well-known for his stock picking abilities. The term “ten-baggers” was coined by him. It means stocks that move up 10x or 1000%. I have reproduced an article below on him. The original article is from http://www.fool.com/investing/general/2004/05/26/finding-lynchs-10baggers.aspx

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Peter Lynch is recognized by investors the world over. More than 1 million read his book One Up on Wall Street at least, that many bought it. Sadly, many seem either to have 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 rise 10-200 times in value.

I haven’t forgotten. A “student” of Lynch for years, I don’t deny that what I’ve learned has influenced the way I invest. Nor that, when we conceived of our Motley Fool Hidden Gemsnewsletter 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 his primary principles, all of which are core components to 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 at a time 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 such dominant franchises as Hilton Hotels (NYSE: HLT) and Marriott International (NYSE: MAR) 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. When searching for hidden gems, 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%-30% per year. The classic Lynch play over the last decade might be Starbucks (Nasdaq: SBUX), 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, repurchased every day at a premium by its loyal customers.

The real trick is to find fast growers like Starbucks or Krispy Kreme (NYSE: KKD) in their early stages. 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 — mutualfund manager, but Lynch absolutely loved dreary, colorless businesses in stagnant or declining industries. A company like Masco Corporation (NYSE: MAS), which developed the single-handle ball faucet (yawn), rose 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 (NYSE: PBY), all the better. 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 doesn’t care
Lynch’s dream stock at Fidelity Magellan was one that hadn’t yet attracted any attention from Wall Street. No analysts covered the business, which was less than 20% institutionally owned. None of the big money cared. Toys “R” Us (NYSE: TOY), though it might not be so great an investment today, after being spun out from bankrupt parent Interstate Department Stores, 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 businessService Corporation (NYSE: SRV), which had no analyst coverage. He suggests investors compare that to “the fifty-six brokerage analysts that normally cover IBM (NYSE: IBM) or the forty-four that cover Exxon (NYSE: XOM).”

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 tiny company like Spar Group (Nasdaq: SGRP), which has featured persistent insider buying, but also a Moody’s(NYSE: MCO), which methodically buys back its shares on the open market.

“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.

Personally, I anticipate an average holding period of three years, with the greatest of the group being held for a decade or more. 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 we do here at the Fool and within our Hidden Gems community.

Finding the next hidden gem
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 giving your whole life over 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.

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

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7 thoughts on “Finding Lynch’s 10-Baggers

  1. good luck finding!!! i think as move further from the earlier financial crisis, such multi-bagger will get scarcer and scarcer…. it is easier to pick multi baggers off a market bottom then to spot them in a market that has since re-flated 60 percent or there abouts

  2. I think as investors, we should be too optimistic of such superlative returns. As long as one gets a decent return on his investment of 10-12% per annum, one should be happy. If you can consistently do better than that, then good for you!

  3. Hi MW,

    Yes, when we think of buying ten-baggers, greed comes in and when greed strikes, our rational thinking will be cut off. Thus, one has to stick with what has worked for him and not be diverted from his objectives and goals.

    From your comment, I have learnt to be focused and not be attracted by finding the ten-baggers and the likes. If any of the stock picked becomes a ten-bagger, good for me (that’s just a reward) and just keep doing what I normally do.

  4. The economic crises will come, it has to. It can be proven mathematically. If the US had no other expenditures other than SS,Medicare, Medicaid and Welfare, nothing else. No defense, no Departments of Agriculture, Energy(whatever they do),Education, etc., it still would not be able to pay this massive debt of 14Trillion @ 100%GDP.
    If every second would be a dollar, 1trillion would set you back in history 320,000 years.
    Musicwhiz sound great as far a being optimistic, that’s great, but unless one is a realist with the economy we have today, if you are not invested heavy in gold and a lot more silver, you will loose everything you have, everything.
    Be an optimist, but a realist, do your homework.
    We are on the shaft side of the hockey stick graph. If you don’t know what that is, you need to find out.

  5. Hi Dekker,

    Thanks for your input. The article is a reproduced one as stated in my post.

    I know that he doesn’t embrace diversification. He even coined a term “diworsification” to warn investors against unnecessary diversification.

    Cheers!

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