The Only 2 Income Stocks That Might Pass the Peter Lynch 10-Bagger Test

StreetAuthority Network

In One Up on Wall Street, super investor Peter Lynch detailed a few of the techniques he used to find winning stocks. His goal was to find "10-baggers" -- stocks he believed could be eventually sold for at least 10 times the amount he paid for them.

One of the stock-picking techniques he described was a strategy to find undervalued stocks with above-average earnings growth, strong financials and low institutional ownership. The specific criteria he defined were:

-- Value is measured with the price-to-earnings (P/E) ratio. Investors should buy stocks with P/E ratios that are below the industry average and also below the stock's own five-year average P/E ratio.

-- Growth is measured by the change in earnings per share (EPS). Look for companies whose EPS has increased faster than average over the past five years.

-- Financial strength is defined with the balance sheet. In Lynch's opinion, the ratio of liabilities to assets needs to be less than the industry average for a stock to be a buy.

-- Institutional ownership should be lower than average. This should allow for price gains when institutions discover the stock and crowd into it.

Lynch's record shows that he was able to uncover at least a few 10-baggers. From 1977 until his retirement in 1990, Lynch delivered average annual gains of 29.2% to investors in his Fidelity Magellan Fund.

I used Lynch's screen to look for income stocks. In the current market, only two stocks passed the screen.

RF Industries (RFIL) makes and sells specialized cables and connectors that are used by a variety of industries, including communications, medical and aerospace, as well as the military.

Over the past seven years, sales have grown an average of 12.6% a year while annual EPS growth has averaged 28.2%. No analysts follow RFIL, and about 16% of the company's shares are held by institutions.

RFIL has a P/E ratio of 10.2 based on earnings over the past 12 months. The company is debt free and has strong cash flow, which should allow it to continue paying a dividend of $0.28 a year or more. RFIL currently offers a yield of 4.8%.

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RFIL is near a support level. To manage risk, a stop-loss near the recent gap could be used. With a close below $5, RFIL would be a sell.

Recommended Trade Setup:

-- Buy RFIL up to $6
-- Set stop-loss at $5
-- Set initial price target at $7.35 for a potential 23% gain in 6-12 months

Longer term, even bigger gains are possible.

Chemical & Mining Co. of Chile (SQM) sold off sharply in the last two weeks after one of the two cartels controlling the potash market collapsed. The world's largest potash producer announced that it would lower its prices by up to 25% this year to increase market share.

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Potash is used to make fertilizer, and fertilizer accounts for more than 40% of SQM's revenue. The company is also a leading producer of iodine and lithium, chemicals that are used in a variety of applications. This business should not be affected by events in the potash market.

SQM has a P/E ratio of 11.6 based on earnings over the past 12 months and is trading at about 15 times next year's estimated earnings. Estimates might be cut in the next few months as analysts revise their models to account for the drop in potash prices, but estimates may already reflect lower potash prices. In the past three months, the consensus estimate for 2014 has dropped to $1.88 from $2.81.

In the past seven years, SQM has grown revenue at an average of 15.3% a year, and EPS growth has averaged 26.4%. Growth is expected to slow in the future, but investors should be able to count on income from dividends.

Based in Chile, SQM is required to pay at least 30% of its net income to shareholders as a dividend. Like other foreign companies, the dividend payment will vary with earnings.

Recommended Trade Setup:

-- Buy SQM up to $30
-- Set stop-loss at $25.30, the downside target based on a weekly double-top pattern
-- Set initial price target at $43.60 -- the 38.2% retracement of the recent decline -- for a potential 45% gain in 6-12 months

Like RFIL, additional gains are possible in the long term.

Both of these companies have delivered fast growth in the past and currently have strong financials. They could be 10-baggers in the future.

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