We search for bargains using Peter Lynch's formula.
Recently, as part of my series of articles on the great investors, I looked at the career of Peter Lynch and his success at Fidelity. Lynch used an interesting rule of thumb to find cheap growth stocks, so I thought I'd see if it would turn up any bargains in the current UK market.
What Lynch did was to take the expected long-term growth rate, add the dividend yield, and divide the total by the price/earnings ratio (P/E). This is basically the inverse of Jim Slater's PEG ratio, adjusted to account for dividend yield.
Problems with growth
The main difficulty in this process is arriving at a long-term growth figure. How long is long term? In practice we are limited to the time horizons of the analysts following the stocks, so our visibility is usually restricted to two years ahead.
And to call it 'visibility' is according it too much credence. As Neil Faulkner wrote recently, even at the best of times, analysts struggle to forecast earnings with any degree of accuracy. And let's face it, these are not the best of times.
Another problem is that the earnings forecasts for many companies are showing huge growth from depressed earnings figures, and clearly that is not sustainable over the long term. In an attempt to weed these out, I've removed any companies with growth exceeding 50% in either of the next two years, and any companies on trailing P/E in excess of 20.
I've also excluded companies below £10m in size, because I know it will annoy those who think I shouldn't.
The results
The following table shows all companies with a 'Lynch Ratio' greater than 2.0, which was Peter Lynch's guideline.
| Company | Market Cap (£m) | Price (p) | P/E | Dividend Yield | Annual Growth | Lynch Ratio |
|---|
| Jetion Holdings (LSE: JHL) | 43.8 | 59.0 | 4.3 | - | 33.2 | 7.72 |
| GLOBO (LSE: GBO) | 12.4 | 9.5 | 6.1 | - | 35.8 | 5.87 |
| Velti (LSE: VEL) | 49.4 | 146.5 | 8.4 | - | 34.6 | 4.12 |
| Brit Insurance (LSE: BRE) | 601.2 | 191.5 | 8.9 | 7.85% | 34.9 | 3.93 |
| RCG Holdings (LSE: RCG) | 196.5 | 77.5 | 3.4 | - | 13.0 | 3.82 |
| China Medical System (LSE: CMSH) | 77.5 | 164.0 | 8.4 | 5.61% | 29.8 | 3.56 |
| Eros International (LSE: EROS) | 125.1 | 108.5 | 5.1 | - | 17.5 | 3.43 |
| Hargreaves Services (LSE: HSP) | 129.3 | 490.0 | 9.4 | 2.10% | 26.5 | 2.82 |
| Aero Inventory (LSE: AI) | 98.0 | 187.0 | 2.8 | 18.64% | 7.5 | 2.73 |
| Formation Group (LSE: FRM) | 15.4 | 7.0 | 7.0 | - | 18.3 | 2.62 |
| Petmin (LSE: PTMN) | 83.0 | 15.3 | 13 | - | 31.8 | 2.45 |
| Old Mutual (LSE: OML) | 3983.9 | 75.5 | 6.2 | 3.25% | 15.0 | 2.43 |
| OMG (LSE: OMG) | 17.1 | 26.3 | 13.5 | 0.44% | 32.0 | 2.37 |
| Amino Technologies (LSE: AMO) | 34.5 | 59.5 | 15.2 | - | 34.2 | 2.25 |
| Fiberweb (LSE: FWEB) | 77.8 | 63.5 | 8.8 | 6.46% | 18.3 | 2.08 |
| Alkane Energy (LSE: ALK) | 21.6 | 23.3 | 10.7 | - | 21.4 | 2.00 |
It's a very mixed bag, in terms of sizes and industries. In some cases the companies have no dividend, so we're looking at something approximating to the inverse of the PEG. Personally I'd prefer to focus on those companies that are, or at least have been, paying a dividend.
As with any trawling exercise, this is not a buy list, rather a starting point for further research. There is always the possibility that some of these figures are out of date, or simply wrong. And even if they are correct there will be many other factors, positive and negative, that are not revealed in the numbers.
Happy hunting!
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