Legendary fund manager Peter Lynch, who found investment world fame during his stellar 13-year stint at the helm of the Fidelity Magellan Fund, broke stocks down into three categories: fast growth, slow growth and stalwarts. It is the steady and easy-to-overlook earnings growth offered by Mr Lynch's stalwarts - 10 to 20 per cent - that we are hunting for with our screen this week, which aims to identify bargains in this part of the market.
Mr Lynch doesn't regard finding stocks that match his screening criteria as presenting an end in itself. In fact, he advocates thorough research, with a particular focus on certain key themes. The best-known aspect of the qualitative elements of his investment approach is probably his 'buy what you know' philosophy. This is based on his belief that first-hand experience of a company's products or services can give the 'man in the street' a major advantage over people living in the bubble of the professional investor world. Other things Mr Lynch looks for include dull businesses which the market may be overlooking, easy-to-understand business models that management will find hard to mess up, director buying, share buy-back programmes, and high levels of cash.
Given that Mr Lynch's screen should be regarded as a starting point, we are not too concerned that the 14 stocks that passed the screen last year have underperformed the index, delivering a total return of 11 per cent compared with 15.7 from the FTSE All-Share between 17 April 2012 to 16 April this year. In fact, in itself 11 per cent is not to be sniffed at anyway. But we have tried to hone the screen a bit. A key change we have made to the screen this year is that we have focused on forecast earnings growth for the current financial year. It should be noted that this breaks from Mr Lynch's focus on historic growth. To take account of the vagaries of forecasting, we have cross referenced the screened data from S&P Capital IQ with Bloomberg consensus forecasts to eliminate any results where there are large variations in expectation. We feel the list of seven stocks that have passed the screen are a genuinely interesting bunch from a 'Lynchian' perspective, with only one - Qinetiq - sitting genuinely at odds with the overarching objectives of the screen. This is what we've screened for:
■ Forecast growth of more than 10 per cent but less than 20 per cent;
■ PE/total return (TR) of less than one. While Mr. Lynch is often associated with his use of the price-to-earnings-growth (PEG) ratio, he points out that yield can be an important factor in determining returns from stalwarts and slow growth stocks. He therefore suggests this can be added to the growth rate used in the classic PEG formula. This is the same ratio employed to great effect by another hugely successful US fund manager, John Neff, although Mr Neff reverses the ratio's numerator and denominator so that higher values rather than lower ones imply 'value';
■ Turnover of more than £250m. Mr Lynch believes size is important for stalwarts but believes turnover is a better way of gauging this than market capitalisation;
■ Three years of positive earnings;
■ Gearing of less than 75 per cent.
SEVEN CHEAP GROWTH SHARES
