What Are Good Investment Tips? Peter Lynch’s Philosophy And Selection Process
Good Investment Tips: Peter Lynch’s Philosophy
Peter Lynch developed his investment principles in his 2 flagship books, One Up On Wall Street and Beating The Street. In essence, One Up served as theory while Beating the Street is application. One Up On Wall Street lays out Lynch’s investment technique including chapters devoted to stock classifications, the two-minute drill, famous numbers, and designing a portfolio. Most of Beating the Street consists of an extensive stock by stock discussion of Lynch’s 1992 Barron’s Magazine selections, essentially providing an illustration of the concepts previously discussed. As such, both books represent study material for investors of any knowledge level or ability.
Lynch coined some of the best known mantras of modern individual investing strategies. He’s a “story” investor. His most famous investment principle is simply, “Invest in what you know,” According to him, you, the amateur investor, have a good chance of outperforming professional investors. To achieve this you must invest in companies that are a part of your daily life (the concept of local knowledge): the individual investor is more capable of making money from stocks than a fund manager, because they are able to spot good investments in their day-to-day lives before Wall Street. That way, you get totally legal “insider information” on companies that professional investors won’t hear about before months or even years.
The more familiar you are with a company, and the better you understand its business and competitive environment, the better your chances of finding a good “story ” that will actually come true. For this reason, Lynch is a strong advocate of investing in companies with which one is familiar, or whose products or services are relatively easy to understand. Thus, Lynch says he would rather invest in”pantyhose rather than communications satellites,” and “motel chains rather than fiber optics.”
One of your main goals as an amateur investor should be to invest in a reasonably priced growth stock. If you’re patient, that stock price can grow ten-, twenty-, or even a hundred-fold. The hardest thing at that point might be to refrain from selling too soon and missing out on future growth. Those who sold Cisco, Microsoft, or Wal-Mart after ten-fold growth have missed out on another ten-fold growth, if not more!
Peter Lynch’s technique is to look for undervalued stocks, in sectors that are temporarily overlooked by the majority of investors. It must be pointed out, though, that this technique isn’t for just anybody, because you must be able to adequately understand how several different business sectors operate. Lynch does not believe in restricting investments to any one type of stock. His “story” approach, in fact, suggests the opposite, with investments in firms with various reasons for favorable expectations. In general, however, he tends to favor small, moderately fast-growing companies that can be bought at a reasonable price.
Good Investment Tips: Peter Lynch’s Selection Process
He considers there are six different categories of stocks.
1. Slow Growers. Slow growers are large and companies such as public utilities that grow only slightly faster than the rate of the national economy. Often times, investors buy these companies for the large, regular dividends they pay and don’t expect large appreciation in the share price. These are not among his favorites.
2. Medium Growers. Large companies that are still able to grow, with annual earnings growth rates of around 10% to 12%; examples include Coca-Cola, Procter & Gamble, and Bristol-Myers. If purchased at a good price, Lynch says he expects good but not enormous returns–certainly no more than 50% in two years and possibly less. Lynch suggests rotating among the companies, selling when moderate gains are reached, and repeating the process with others that haven’t yet appreciated. These firms also offer downside protection during recessions.
3. Fast Growers. Small, aggressive new firms with annual earnings growth of 20% to 25% a year. These do not have to be in fast-growing industries, and in fact Lynch prefers those that are not. Fast-growers are among Lynch’s favorites, and he says that an investor’s biggest gains will come from this type of stock. However, they also carry considerable risk.
4. Cyclical Stocks. Companies in which sales and profits tend to rise and fall in somewhat predictable patterns based on the economic cycle; examples include companies in the auto industry, airlines and steel. Lynch warns that these firms can be mistaken for stalwarts by inexperienced investors, but share prices of cyclicals can drop dramatically during hard times. Thus, timing is crucial when investing in these firms, and Lynch says that investors must learn to detect the early signs that business is starting to turn down. Cyclicals are a tricky business but a lot of money can be made (or lost) with this category of companies.
5. Turnarounds - Special Situations. These companies usually are coming out of bankruptcy or a long slump. His examples include Chrysler, Penn Central and General Public Utilities (owner of Three Mile Island). The stocks of successful turnarounds can move back up quickly and provide great returns to shareholders if “turnaround plans” work out.
6. Hidden Assets - Asset Plays. These are companies that have an asset, such as land or a subsidiary company that is worth more than the actual company and that Wall Street analysts and others have overlooked. The game here is to find a company with this sort of “hidden” asset and wait for the market to realize its value. Asset plays are usually hard to find, but it’s possible to make solid returns with these types of companies. Lynch points to several general areas where asset plays can often be found–metals and oil, newspapers and TV stations, and patented drugs. Most of the time, the best play is to conduct normal research activities and keep an eye out for potential asset plays instead of just searching for asset plays directly. However, finding these hidden assets requires a real working knowledge of the company that owns the assets, and Lynch points out that within this category, the”local” edge–your own knowledge and experience–can be used to greatest advantage.
It is possible for a company fall in multiple categories. For example, a small company might have great growth rates and a hidden asset which would allow us to classify this type of company as a fast grower and an asset play. Also, it’s possible for a company to switch categories. For example, when Starbucks was first starting out it was definitely a fast growing company. Now that there is a Starbucks on every corner in America the firm is probably a medium grower.
Trying to predict the direction of financial markets is a pointless (not to mention perilous) exercise. Your best bet is to concentrate on finding reasonably-priced, well-performing companies. In the long run, it’s well-known that the stock market averages a roughly 11% annual return. So investing can be almost risk-free, if your time horizon is long enough and the purchase price of your investments is reasonable enough. Pretty much everyone has the necessary intelligence to successfully invest in the stock market, but few have the necessary stomach. If you’re the type that would panic during a crash and sell (thus at the lowest prices), then you’re probably better off staying away from stocks and look for other investment vehicles.
Investing in a company without analyzing its balance sheet is a very bad thing to do. Historically, the biggest, most spectacular failures have happened in heavily indebted companies. On the other hand, if after analyzing a company’s balance sheet, you find that its performance is acceptable but its price is not, one good strategy would be to invest a modest amount (to sort of get your feet in the door) and then increase your investment if the stock price decreases. Of course you have to do your homework and make sure that the decrease is a market aberration instead of a symptom of serious trouble in the company.
In the long run, a well-picked stock portfolio will outperform just about any other investment vehicle. On the other hand, if you have a poorly picked stocked portfolio, you will lose most or all of your money. In that case you would have been better off holding on to your cash, since your losses to inflation would have been less severe.
Here are Peter Lynch’s criteria for initial consideration. Specific factors depend on the firm’s “story,” but these factors should be examined:
* Year-by-year earnings: Look for stability and consistency, and an upward trend.
* P/E relative to historical average: The price-earnings ratio should be in the lower range of its historical average.
* P/E relative to industry average: The price-earnings ratio should be below the industry average.
* P/E relative to earnings growth rate: A price-earnings ratio of half the level of historical earnings growth is attractive; relative ratios above 2.0 are unattractive. For dividend-paying stocks, use the price-earnings ratio divided by the sum of the earnings growth rate and dividend yield-ratios below 0.5 are attractive, ratios above 1.0 are poor.
* Debt-equity ratio: The company’s balance sheet should be strong, with low levels of debt relative to equity financing, and be particularly wary of high levels of bank debt.
* Net cash per share: The net cash per share relative to share price should be high.
* Dividends and payout ratio: For investors seeking dividend-paying firms, look for a low payout ratio (earnings per share divided by dividends per share) and long records (20 to 30 years) of regularly raising dividends.
* Inventories: Particularly important for cyclicals, inventories that are piling up are a warning flag, particularly if growing faster than sales.
Other favorable characteristics
* The name is boring, the product or service is in a boring area, the company does something disagreeable or depressing, or there are rumors of something bad about the company.
* The company is a spin-off.
* The fast-growing company is in a no-growth industry.
* The company is a niche firm controlling a market segment.
* The company produces a product that people tend to keep buying during good times and bad.
* The company can take advantages of technological advances, but is not a direct producer of technology.
* The is a low percentage of shares held by institutions and there is low analyst coverage.
* Insiders are buying shares.
* The company is buying back shares.
Unfavorable characteristics
* Hot stocks in hot industries.
* Companies (particularly small firms) with big plans that have not yet been proven.
* Profitable companies engaged in diversifying acquisitions. Lynch terms these “diworsifications.”
* Companies in which one customer accounts for 25% to 50% of their sales.
Stock monitoring and when to sell
* Do not diversify simply to diversify, particularly if it means less familiarity with the firms. Invest in whatever number of firms is large enough to still allow you to fully research and understand each firm. Invest in several categories of stock for diversification.
* Review holdings every few months, rechecking the company “story” to see if anything has changed. Sell if the “story” has played out as expected or something in the story fails to unfold as expected or fundamentals deteriorate.
* Price drops usually should be viewed as an opportunity to buy more of a good prospect at cheaper prices.
* Consider “rotation”-selling played-out stocks with stocks with a similar story, but better prospects. Maintain a long-term commitment to the stock market and focus on relative fundamental values.
And all things being equal, you’re better off investing in a company where the top executives are significant shareholders, rather than in one where they’re just salaried employees.
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Finally, here are Peter Lynch’s three main investing ideas, that form the bulk of his philosophy:
1. Each stock selection is based on a well-grounded expectation concerning the firm’s growth prospects. The expectations are derived from the company’s”story”–what it is that the company is going to do, or what it is that is going to happen, to bring about the desired results.
2. You can’t predict a company’s earnings numbers-wise. Your best bet is to look at it on the qualitative side and ask yourself what the company is going to do to keep increasing its profits. There are five ways to do so: 1) Reduce costs, 2) Increase prices, 3) Increase sales on current market(s), 4) Penetrate new markets, and 5) Revitalize, shut down, or sell a money-losing subsidiary.
3. Stay away from high-growth sectors because the competition is fierce. You’re better off looking into niches or slow-growing sectors. Within them, look for well-performing medium growers. They will likely be undervalued because the sector is considered “boring”.
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