Peter Lynch’s “One Up On Wall Street” talk comprehensively about what kind of stocks one should pick. In general, Peter believes that bigger companies tend to make smaller move and vice versa. Therefore, in spotting what he called a ‘ten bagger’, or stock that has risen ten times in value, it will occur more likely in smaller company with market capitalization of say less than $ 10 Billion.
Peter Lynch also divided companies based on six general categories, which has their own unique characteristics. Based on these six categories, investors will be able to know the reason why they invest in such companies and consequently the return expected on each kind of companies. The six general categories are: slow growers, stalwarts, fast growers, cyclicals, asset plays and turnarounds.
Slow growers – As the name implies, this is the type of companies that grow slowly, barely above the nation’s Gross Domestic Product. Slow grower exists for two reasons. First, they expand rapidly during their early years and had saturated the market or second, they did not make the most of their chances. The book names utilities as slow growers. During the 1950-1970 period however, they are fast growers. As electricity consumption increased (folks installed air conditions, electric heater, refrigerators etc.), power consumption rose and hence their growth rates. That does not happen anymore. Thus, a company inevitably will become a slow grower. A fast grower of the past will be tomorrow’s slow growers. Example of industries in this category include: railroad, aluminum, steel, chemicals, soft drink.
Stalwarts – These are not fast grower and yet they grow faster than the slow grower. Most stalwarts are huge companies with huge production of cash flow. Due to their enormous size, stalwarts won’t move much and Peter always try to take a profit whenever it has run up 30-50% in value in a short period of time. Some stalwarts include: Procter & Gamble, General Electric, Bristol Myers and Kellogg.
Fast Growers – The name says it all. These categories are for companies which has high growth rates. This is where the potential of the ten baggers lie. Other five categories will not give you as much chance of finding your next ten baggers. Fast Growers does not necessarily be in the fast growing industry. It can be growing fast in a slow growth industry. For example: WalMart in the stodgy retail industry, Marriott in the 2% growth hotel business, Anheuser-Busch in a slow growing beer market or Taco Bell in a not-so-fast fast food industry. There is however, plenty of risk in investing in fast growers. The trick is figuring out how much to pay for them and when they will stop growing because eventually, the party comes to an end.
Cyclicals – Not all companies can profit consistently all the time at every occasions. Generally, cyclicals profit rise and fall in regularly predictable fashion, most often moving in tandem with the economy. Businesses that can be considered cyclicals are : airlines, autos, defense companies or even chip industries. For defense companies, it is cyclical not with respect with the economy but rather with the policy of the white house. For chip industries, it is cyclical with the computer upgrade cycle. Timing is everything in cyclicals. Contrary to other categories, Peter avoids cyclicals trading at a low P/E which generally means that the cycle is currently at its peak. While this rule of thumb does not work 100%, it works pretty well to avoid picking cyclical companies that fall even lower.
Turnarounds – These are high risk high reward preposition. Generally, there are specific problems plaguing the company. Further, if the company fails to fix this particular mess, it will probably end up in bankruptcy court. Despite this, there are several appealing reasons for investing in a turnaround. One, of course, is the reward. Once the problem is fixed and solved, the stock price will rise sharply to trade in line with what its peers valuation are. The other beneficial factor of investing in a turnaround is that it is least likely affected by the general market condition. Market goes up, turnaround may stay down and vice versa. A recent example of a turnaround might be involving Altria (MO) in early 2000s. Facing hundreds of billions of lawsuit from smokers, the stock price sank so low that you can buy it at 5 times earnings and 10% dividend yield. Altria also owned a stable Kraft and Miller subsidiary (which was later sold). Turnaround investors will see if the lawsuit problem can be solved, then investing in Altria will be rewarded handsomely. Sure enough, lawsuit problems diminish and its stock price has increased four fold since then. Of course, turnarounds do not always turn around successfully. K-Mart bankruptcy is another past example.
Asset Plays – This is the type of companies that normally own a hidden asset that is not obviously listed on its balance sheet. All assets should be listed on the balance sheet, of course. But Asset play company often times do not list its asset at market value. For example, the value of real estate holding which is depreciated under the current accounting rule. Meanwhile, the land itself most likely will be worth more than its purchase price. Also, company that has huge tax-loss carryforward qualifies as asset plays.
That’s it. All the six categories of stocks according to Peter Lynch. Hope that didn’t put you into deep sleep. As boring as it sounds, this will be a valuable lesson that will make your investing journey a lot more exciting and worthwhile.