Peter Lynch is a hero of the small investor. In his two best-selling books, One Up on Wall Street and Beating the Street, he laid out an easy-to-understand strategy of how individual investors can succeed in the stock market.
Lynch's most well-known tenet was to invest in what you know. He also liked to buy shares of fast-growing companies with a low PEG ratio, a metric that compares the price-to-earnings ratio with the company's underlying growth rate in earnings per share.
Another important aspect of Lynch's approach was focusing on stocks that had a "story," such as an expanding base of profitable stores, a new product that was going to cause a boom in sales, or anything else that could keep the company's earnings growth up over the long term.
Between 1977 and 1990, Lynch generated a compound annual return of 29% as manager of the Fidelity Magellan Fund. A $1,000 investment in the Magellan Fund in 1977 would have turned into $28,000 at the end of Lynch's tenure.
So, what stocks would the investing legend like today? After scouring through some promising names, I believe Peter Lynch would love Five Below (NASDAQ: FIVE), lululemon athletica (NASDAQ: LULU), and RH (NYSE: RH).
Five Below: A profitable, fast-growing discount store
Five Below is a good example of the type of growth story Lynch would have been interested in. Sales have consistently climbed around 20% every year, driven by new store openings and growth from existing stores. Even better is that Five Below has been able to expand aggressively while maintaining a very profitable model for store openings. That has led to market-smashing stock performance, with the shares up 371% since its IPO in 2012.
There are currently over 800 stores open in 36 states, and management believes it can roughly triple that footprint. The stock price reflects that growth potential, trading at a P/E ratio of 45. However, the PEG ratio is currently less than 2 times the expected earnings growth rate, so I wouldn't call the stock overpriced. As Five Below continues to expand its store base, as well as enter new product categories, the stock should gradually rise with the growth of earnings.
So far, Five Below has been successful selling what it refers to as "wow" products, including toys, sports gear, jewelry, and electronics, for less than $5. But the best thing about the growth story is that as the business has increased in size, it has been able to acquire even better products to sell at cheap prices. The company has recently been testing the sale of products up to $10, including video games.
The willingness of customers to buy items above $5 shows that Five Below has not pigeon-holed itself into selling at a specific price point. It could potentially grow into a much larger discount retailer that sells a wide range of items. You could describe it as the Walmart of toy stores, which is not far off the mark, considering the background of CEO Joel Anderson, who worked for Walmart prior to joining Five Below.
If you're wary of buying the stock at the current high valuation, you'll want to keep Five Below on your watchlist, because it's potentially a great growth stock in the making.
Lululemon: More than just yoga
Wouldn't we all love the chance to go back in time and buy Nike stock around the time the Air Jordan launched in 1985? Well, now you have your chance with another emerging global athleticwear brand, lululemon athletica.
Lululemon is enjoying momentum on a number of fronts, including forward-thinking athletic apparel, digital sales, new product categories, international expansion, and the opportunity for what has been perceived as a mostly feminine brand to capture more sales from men.
The company got its start in 1998 selling yoga apparel primarily for women. It now does $3.8 billion in annual sales, which is nothing compared to Nike's $40 billion. Lululemon estimates its total addressable market to be around $630 billion, combining athleticwear and new product categories like skincare.
Since CEO Calvin McDonald took over a year ago, Lululemon has had its design chops on full display, bridging the gap between what you to wear to the gym and what you wear to the office. While core items like women's pants bring in the profits, new categories like outerwear are padding sales momentum.
Like Five Below, the stock is not cheap. But I wouldn't expect shares of Lululemon to be cheap anyway with the potential it has to keep growing. The stock is currently stretching to new highs heading into the next earnings report on Dec. 11 after the market close. At a PEG ratio of 2.38, investors may want to keep this one on a watchlist. It certainly has Peter Lynch's name written all over it given the improving "story" with its momentum expanding in overseas markets.
RH: An undervalued luxury goods retailer
RH, formerly known as Restoration Hardware, started out a few decades ago selling discovery items and had a total market value of just $20 million as an upstart business. Today, RH generates $2.6 billion in annual revenue, selling luxury home items on a mass scale. Revenue has more than doubled since the stock's IPO in 2012.
Selling furniture is a cutthroat business, so to succeed, RH has been forced to do things differently from the crowd. The company has carved itself a very profitable niche by focusing on high-quality luxury furniture showcased in glamorous galleries in major cities. That, along with the shift to a membership model, which drove 95% of sales last year, has contributed to the company's explosive growth in profits. Last quarter, earnings climbed 25% year over year.
CEO Gary Friedman holds the view that the best retail brands still need a physical presence to be successful. The opening of big galleries in major cities has allowed RH to differentiate its brand. Management is starting to upgrade these stores with what the company refers to as RH Hospitality, where stores include restaurants, cafes, wine vaults, and baristas. This effort was credited for the company's improving sales last quarter, in which revenue growth accelerated to 10% year over year.
The stock is flying under Wall Street's radar, currently trading at a forward P/E of 16.3, even though analysts expect RH to grow earnings 25% annually over the next five years. With a compelling growth story and a PEG ratio of less than 1 times that expected growth rate, RH looks like a classic Peter Lynch play.
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John Ballard owns shares of Lululemon Athletica. The Motley Fool owns shares of and recommends Lululemon Athletica and Nike. The Motley Fool recommends Five Below and RH. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.