Two Retailers Peter Lynch Would Love

12/16/2010 3:23 pm EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

Gamestop and Dollar Tree offer fast earnings growth at a reasonable price according to John Reese, editor of Validea Hot List.  

Perhaps the greatest mutual fund manager of all time, Peter Lynch guided Fidelity Investment's Magellan Fund to a 29.2% average annual return from 1977 until his retirement in 1990, almost doubling the S&P 500's 15.8% yearly return over that time.

Lynch's approach centers on a variable that he is famous for developing: The price/earnings/growth ratio, or "PEG". The PEG divides a stock's price/earnings ratio by its historic growth rate to find growth stocks selling on the cheap. Lynch's rationale: The faster a firm is growing, the higher the p/e multiple you should be willing to pay for its stock.

Don’t Just Buy ‘What You Know’
Lynch is known for saying that investors can get a leg up on Wall Street by "buying what they know", but that's really just a starting point for him; his strategy goes far beyond investing in a restaurant chain you like or a retailer whose clothes you buy.

Along with the PEG, he focused on fundamental variables like the debt/equity ratio, earnings-per-share growth rate, inventory/sales ratio, and free cash flow. It's important to note that Lynch used different criteria for different categories of stocks, with the three main categories being "fast-growers" (stocks with EPS growth rates of at least 20% per year); "stalwarts" (stocks with growth rates between 10% and 20% and multi-billion-dollar sales); and "slow-growers" (those with single-digit growth rates and high dividend payouts).

Here are two retail chains that pass his test.

Gamestop’s PEG is No Misprint
GameStop (NYSE: GME) is a retailer of video games. The company sells new and used hardware, software and accessories from some 6,450 stores in the United States, Australia, Canada and Europe.

Comparing Gamestop's price/earnings ratio of 9.06 with its historical growth rate of 31.1%, the the P/E/G ratio is a very favorable 0.29.

Lynch's methodology favors stocks that have several years of fast earnings growth, as these companies tend to have a proven formula for growth that in many cases can continue many more years. This methodology seeks earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The earnings-per-share growth rate for GME is 31.1%, based on the average of the three-, four- and five-year historical growth rates, which is certainly acceptable.

Buy That for a Dollar
Now let's take a look at Dollar Tree (Nasdaq: DLTR), an operator of discount variety stores offering merchandise at the fixed price of one dollar.

Comparing the price/earnings ratio of 19.60 to the historical growth rate of 21.2% produces a favorable P/E/G ratio of 0.92.

Lynch would consider DollarTree's debt/equity ratio of 18.87% acceptable. This ratio is one quick way to determine the financial strength of the company.

[Reese last recommended another retailer based on the stock-selection criteria used by Warren Buffett. And while Aeropostale (NYSE: ARO) has not yet justified that vote of confidence, it’s up big today on reports the company is preparing to fend off approaches by potential private-equity purchasers—Editor.]

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