Thursday, 25 March 2010

Peter Lynch's 6 categories of stocks: Fast Growers

Stalking the ten-bagger

February 19, 2010

In Wednesday's column, we looked at what are generally less risky stock categories - sluggards and stalwarts. But what about the potential ten-bagger - a stock that rises by 10 or more times the price you paid for it?

Peter Lynch, the famous 1980s American fund manager and author, terms such stocks fast growers. Naturally, they're notoriously difficult to pick, inhabiting a land of broken dreams and expensive investment lessons for those too quick to put their faith in a good but elusive story.

The traps are numerous and deep. There are plenty of fast-growing industries - airlines, for example - that have been graveyards for investors. So it's vital to ascertain whether the company you have in your sights really has a sustainable competitive advantage.

Many a blistering growth stock has been lifted on the back of a single, hot product. Ballistics company Metal Storm was a favourite a few years ago, as was animal-focused biotech Chemeq; both ended up crashing spectacularly.

So it's crucial that you understand the risks and allocate your portfolio accordingly. Don't place all your hopes on one hot product.

And always make sure the company is delivering growth in earnings per share as well as net profit. It's too easy to grow net profit by raising more money from shareholders; double the amount of money you have in a plain old savings account and you'll double its ``profits''. What counts is growth in earnings on a per share basis.

Time to bale

The time to bale out is when you think the business might be maturing or saturating its market and no-one else has noticed. And, yes, unfortunately that is as hard as it sounds.

You should also pay heed to the loss of any key executives. Ten-baggers are often driven by one key entrepreneur like Chris Morris at Computershare, or a small team of motivated individuals, as is the case at QBE Insurance. If they're jumping ship then you might consider joining them.

As for retailers - often fast growers when they initially list - it's crucial to keep an eye on the same-store sales figure. When this number drops off it can be a sign that the concept is getting tired or that competition is staring to bite, even as profitability continues to grow through new store rollouts.

Is this 'nuts'?

More positively, the prices of these stocks can sometimes get way ahead of themselves and that's a good time to think about taking some or all of your money off the table.

Good examples would include Harvey Norman, Flight Centre and Cochlear back in 2001. All are great companies and, generally speaking, I'd be a happy holder (if not a buyer) of them, but there comes a point where you just have to say ''this is nuts''.

What constitutes a ''nutty'' price? It's difficult to say, but as Justice Potter Stewart once opined in the US Supreme Court on the subject of pornography: ''I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it.''

Be warned though: Too many high valuations can make one blasé. In the boom years, investors routinely paid price/earnings ratios of 16, 18 and even 20 for fairly mediocre business. As with many aspects of investing, success is determined by the price you pay to buy in, more than the price at which you sell to get out.

Next on our agenda is a tour through the land of cyclicals, then turnarounds and, finally, asset plays. Each has the potential to provide exciting returns and excruciating losses, so stay tuned.

This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor which provides independent advice to sharemarket investors.

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