Hunting Lynch's 10-Baggers

Published January 26, 2006
by Jack Hough (Author Archive)

Hunting Lynch's 10-Baggers

PETER LYNCH SOUGHT and captured stock returns so large that he created a new terminology to discuss his winners. In his 1989 stock-picking primer "One Up On Wall Street," the former Fidelity Magellan fund manager used the word "10-bagger" to describe a stock that increased ten-fold in value. Dunkin' Donuts and Pep Boys (PBY: 8.70, +0.20, +2.35%) are examples of 10-baggers Lynch owned for Magellan. Magellan itself was a 28-bagger during his 13 years at the helm.

Lynch would seem a perfect inspiration, then, for a guru-style stock screen, one based on the investment strategies of a renowned investor. There's one hitch, though: Not all guru strategies lend themselves neatly to screening.

For example, aside from the term "10-bagger," Lynch is perhaps best known for the phrase "buy what you know." Many of his picks came from companies with products or services he used. A stock screener, of course, can't test for what you know. In fact, it does quite the opposite. A stock screener excels at judging companies based not on personal preferences, but on a cold calculus of their financial statements.

Fortunately, Lynch used plenty of hard metrics, too, and these give us some guidelines for how to build our screen. Rather than use a one-size-fits-all approach, he broke companies into six classes. These include slow growers, stalwarts, cyclicals, turnarounds, asset opportunities and fast growers. Of the last type, he wrote, "If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers." Sounds like fast-growers are for us.

Spotlight Stock
Quality Systems (QSII)
Develops and markets health-care information systems that automate medical and dental practices, physician and hospital organizations, management service organizations and community health centers, among others.
Thursday's Close $79.86
Market Value $1.1 billion
Trailing 12-Month Sales $105 million
Forward P/E 47
Proj. Long-Term EPS Growth Rate 30%
Additional Data:
Earnings Financials Key Ratios Ratings Insiders

Fast growers are small, aggressive new enterprises growing at 20% to 25% a year, according to Lynch. We'll call "small" anything with a market value below $5 billion. And we'll look for companies that have boosted their sales and earnings by at least 20% apiece for the past three years, and which are projected to boost their earnings by at least 20% in their current fiscal year. Already, these demands reduce our database of more than 8,000 stocks to a mere 99.

Lynch called companies with little or no institutional ownership potential winners, and companies with scant analyst coverage double-winners. So we'll look for companies where institutions own no more than 40% of outstanding shares and are followed by no more than four analysts. That leaves 17 stocks.

Of course, our screen survivors should be affordable and financially stable. Since Lynch liked to compare companies' price/earnings ratios with their earnings growth rates, we'll do so by looking for price/earnings-to-growth, or PEG, ratios (P/E divided by long-term earnings growth projection) that are below 1.7. (The broad market's average PEG is about 1.5.) And we'll require that debt/capital ratios be no higher than 0.5.

That leaves us with a mere 11 stocks. Use our stock screener anytime to run the search for yourself. We've preloaded it into the pull-down menu of screen recipes.

Note that three of our screen survivors were 2005 picks. Pet Meds (PETS: 55.13, +0.94, +1.73%) is up a tail-thumping 56% since we called it "the most promising pick of the litter" in October (see "Such a Good Buy, Yes You Are"). Kitchen gadgeteer Lifetime Brands (LCUT), which we highlighted just last month ("The Chance of a Lifetime") is already up 8%, despite a flat performance for the market. And we really shouldn't tell you how far circuit-board maker MultiFineline Electronix (MFLX) has climbed since we described its valuation as "wafer thin" in March ("M-Flex Inside"). But if you must know: 168%, mocking the market's 8% increase.

Let's look now at another of the Lynch screen's survivors. Quality Systems (QSII) is the kind of company name that could just as easily describe a hydraulics outfit as it could a maker of hot-dog casings. In fact, it makes health-care information systems — software used by private-practice doctors and network participants to manage their patient care and billing. The company's NextGen suite tracks patient information, manages appointment scheduling and referrals, stores prescriptions and clinical images, prints bills and letters and goes after insurer reimbursements. It also prints educational materials for patients and efficiency reports for doctors.

NextGen brings in more than 85% of Quality Systems' sales — not exactly income-stream diversification. But one-product companies whose products are hot can produce stunning gains, both in their earnings and their share prices. In its second quarter, which ended Sept. 30, Quality Systems' sales and earnings jumped 39% and 56%, respectively, over the same quarter last year. Over the past year, the company has produced an operating margin of nearly 29% on sales of $105 million. The average operating margin for health-care information companies is below 5%.

Quality Systems' stock has already been a two-plus-bagger over the past year, a seven-bagger over the past three years and an 18-bagger over the past five. The trio of analysts who cover the stock expect the company to boost its earnings by 40% in its fiscal 2006, which ends March 31, and by 26% in fiscal 2007. Over the next five years, they're looking for annual earnings growth of 30%. That helps make the stock's 2006 P/E of 47 seem reasonable. Scalp the $5 a share Quality Systems holds in cash off of its $80 share price, and you end up with an even more reasonable P/E of 44. (The company is debt-free.)

Those numbers give Quality Systems shares a PEG ratio of 1.57 or 1.46, depending on whether you factor in the cash. The company's closest competitors, Cerner (CERN) and Amicas (AMCS), carry PEGs of 1.66 and 7.36, respectively. (Though in fairness, the latter number is skewed by the company's low earnings base, thanks to its recent swing to profitability.)

All told, the numbers we're seeing on Quality Systems say bag these shares before they head any higher.

Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."


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