How the 'Peter Lynch Rule' Can Help You Net 500% Gains

Every few months, consumers come across a new product or service that impresses them. I still remember the first time I went in to a Chipotle Mexican Grill (NYSE: CMG) and was really impressed. Last fall, I bought a lightly-used Honda Accord made by Honda Motor (NYSE: HMC) and I love how it drives. Just last week, I bought a fun new carbonated-drink machine made by Sodastream (Nasdaq: SODA).

What do they also have in common? Peter Lynch. The legendary mutual fund manager told us back in the 1980s that your source of stock ideas should come from your experiences as a consumer. But he was quick to add that this is just a starting point.

A great product and great stock price are two very different concepts. After all, Chipotle Mexican Grill may be my favorite dining spot, but its stock has risen more than 500% since late 2008, and the company's sales growth has started to slow from the 30% to 40% rate in the middle of the last decade to below 20% these days. It looks like I missed the boat on this one.

The key here is to catch companies when they are fairly new, with plenty growth left ahead of them, and with shares that are still reasonably priced. What about a stock like Sodastream, which completed IPO only seven months ago, and boosted sales more than 50% in 2010? Shares have risen sharply since that IPO and the only reason to justify any further gains in the stock is too see if the company can grow far larger over many years to come.

Here's where you need to act like a sleuth. Green Mountain Coffee Rosters (Nasdaq: GMCR) became incredibly popular with its easy-to-make high-quality coffees. That company is now valued at a hefty $10 billion. Sodastream is valued at just $800 million. Can Sodastream grow large and become the next Green Mountain coffee?

Well, for that to happen, you have to track the company's moves and profit trends. For example, Sodastream is quickly moving into other markets, most recently in Japan, and there's no reason that this sudden North American success can't be replicated elsewhere. Analysts think sales can approach $250 million in 2012 (up from $160 million in 2010), and as the international expansion plays out, the company could hit $400 million in sales by 2015. That works out to be sales growth of 20% a year. Then again, Green Mountain Coffee boosted sales at an average of more than 50% in each of the last five years. So it's very unlikely that Sodastream would become a $10 billion company like Green Mountain Coffee.

Realistically, a company like Sodastream presents two options since it doesn't look like a bargain, trading at more than 40 times projected 2012 profits. You can wait for the stock to take a temporary big hit (which often happens with fairly new companies that experience growing pains). Or you can continue to monitor the company and if see if sales and profit forecasts are accelerating from current levels (hopefully without a commensurate rise in the stock price).

Here's a short checklist of what I look for when I'm researching "Peter Lynch" stocks:

  • Is the company a fad? There's a small chance that a company like Sodastream could lose the interest of consumers that tire of buying replacement CO2 cartridges and soda flavorings. For that matter, many thought that Green Mountain coffee was a fad, underestimating the company at their peril.

  • Does the company have the right marketing strategy? I came across Sodastream after visiting a local Bed, Bath & Beyond (Nasdaq: BBBY).  That retailer, along with Williams-Sonoma (NYSE: WSM), is dedicating major floor space to the product, which should provide a lot of visibility to consumers.

  • Does the company face a large potential market? The reason why Chipotle is so successful is that it has many opportunities for expansion. The company's food appeals to a broad cross-section of consumers, is fairly healthy, and reasonably priced. Those are the ingredients of a large market opportunity.

  • Does the company have enough money to execute its plan? In order to realize its potential, every small company will likely need to raise more money. The key is on how much. Massachusetts-based A123Systems (Nasdaq: AONE) has come up with a strong technology platform to build batteries to power electric and hybrid cars. The company failed to raise enough money at its IPO, and has had to raise money on three more occasions. Its shares have fallen from $25 to just $6 in two years, as existing investors grew tired of seeing their stake in the company steadily reduced.

The perfect "Peter Lynch" stock is a company that is seeing strong sales success but its shares are barely making anyone's radar. Peter Lynch suggests that you move quickly to find out what company makes the appealing product you just bought. Look them up online and see if its stock is already a smash hit with investors. If not, you may be able to hop on before the investor crowd shows up.

To learn more about Peter Lynch's investing wisdom, click here to read 51 Peter Lynch Quotes to Empower Your Investing. 

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