10 cheap growth shares for bullish investors

Current conditions resemble the early 1980s with inflation in double digits and economies in recession. Here’s how one of the world’s most successful investors outperformed then and lessons we can learn today.

Legendary money manager Peter Lynch made a fortune buying shares in fast-growing companies but without overpaying for them. While growth stocks have recently struggled to perform in the face of higher inflation, they could be among the early winners when markets eventually turn bullish. So how does Lynch’s strategy work and what can we learn from him?

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Peter Lynch, pictured below, is famous for a few reasons. One is the stellar performance he delivered while managing a major fund for Fidelity Investments between 1977 and 1990.

In that time, he guided the Magellan Fund to an average annual return of 29.2%, making it one of the best-performing funds in the world. With returns and inflows soaring, assets under management grew from $18 million to $14 billion.

It was made more impressive by the fact that Lynch was only 33 years old when it all started. Not only that, but it coincided with a spell in the early 1980s when US inflation was in double digits and recession was ravaging the economy.

So there are certainly reasons to look at how he managed to outperform in conditions that echo what we’re experiencing today.

Lynch is also responsible for some of the pithiest investing quotes you’ll come across. He once described the term “market correction” as “a euphemism for losing a lot of money rapidly”.

But, on the subject of corrections, he’s also pragmatic. He once observed: “Far more money has been lost by investors trying to time corrections than has been lost in all the corrections combined.”

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In the years after Fidelity, he wrote a handful of books in which he revealed himself to be a serious advocate for the individual investor.

Despite earning his stripes on Wall Street, he said he loved the idea of finding stocks that analysts either hated or hadn’t noticed. So he advised readers to invest in what they know and to look for ideas close to home and companies whose products they were familiar with.

A growth strategy for the long term

In one of his best-known books, One Up on Wall Street, Lynch describes how companies can be classified in one of a handful of categories, including: Asset plays, Turnarounds, Cyclicals, Slow growers, Stalwarts and Fast growers.

They all have their attractions, but it was Fast growers that Lynch liked the most. He was particularly interested in smaller companies enjoying rapid growth in earnings but with shares trading at reasonable prices.

To mimic this approach, there are a few strategy rules to consider. They include stocks in the £50 million to £1.5 billion market cap range, with above-average operating margins (as a measure of profitability) and low broker coverage (as a way of finding hidden gems).

But the priority is all about getting to grips with the strength of a company’s earnings and how much of it is showing up in its share price. This is where Lynch deployed what’s called the PEG, or the price-to-earnings growth rate.

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The idea behind the PEG is that it can help you find bargains. You work it out by dividing a company’s trailing price/earnings (PE) ratio by its earnings per share (EPS) growth rate. If the PE is less than the growth rate - giving you a PEG of less than 1 - then it could be cheap.

Now it’s worth pointing out that a company with an equally high PE and high growth rate can technically have the same PEG as a company with a much more modest PE and equally modest growth rate. Lynch was wary of this. He didn’t much like excessive growth because it can be hard to sustain. He wanted to see shares trading on PEs that were below their medium-term average, and those of their peers.

Screening for Peter Lynch growth shares

The past three years have delivered some stunning highs and gut-wrenching lows for small-cap investors. A combination of Covid upheaval, rising inflation, higher rates and stagnant growth (if not recession) has unsettled companies and made it more difficult than usual to predict earnings with any certainty.

With small-cap indices still depressed, a small-cap growth strategy in the style of Peter Lynch could be riskier than normal. But it could also be the kind of area that begins to recover quickly when conditions improve.

This week, I’m taking a snapshot of the shares passing these rules and will come back to them later in the year to see how they have performed.

Source: SharePad

When it comes to company size, this strategy currently picks up stocks as small as Best of the Best (LSE:BOTB), at £51 million, and as large as Kape Technologies (LSE:KAPE), at £1.23 billion.

In terms of PEGs, all except Gamma Communications (LSE:GAMA) come in under ‘1’, which indicates that their expected earnings growth rates exceed their P/E ratios.

Some, like Kape, Severfield (LSE:SFR), Cairn Homes (LSE:CRN) and Tharisa (LSE:THS)are trading on single-figure PEs, which is where many value-focused investors start to get interested. But that’s not to say they’d all look immediately cheap if you were just eye-balling their PEs. YouGov (LSE:YOU) has a PE of 39.7x, and Water Intelligence (LSE:WATR) and Eckoh (LSE:ECK) both have PEs well above 20x.

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Not only is there wide variation in PEs but there is also a range of average growth rates over the past five years. It shows how important it is to examine the relationship between historic and expected growth, and the PE ratio of a stock to really understand whether the price is justified or whether the market is treating it unfairly.

Lynch once remarked that “if you can follow only one bit of data, follow the earnings...I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.”

That advice might be easier to accept in better times, but the spirit of his approach is robust. After such a strong run through late 2020 and 2021, small- and mid-cap stocks have sold off heavily. Seeking out mispriced shares with expected earnings growth that is not being priced-in, makes a lot of sense in periods of recovery. While it’s far from clear when confidence will take hold, it’s worth keeping an eye on the potential growth stars of tomorrow.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.