Thursday, 28 March 2013

The Peter Lynch Approach in Brief

The Peter Lynch Approach in Brief
Philosophy and style
Investment in companies in which there is a well-grounded expectation concerning the firm’s growth prospects and in which the stock can be bought at a reasonable price.
A thorough understanding of the company and its competitive environment is the only "edge" investors have over other investors in finding reasonably valued stocks.
Universe of stocks
All listed and over-the-counter stocks - no restrictions.
Criteria for initial consideration
Select from industries and companies with which you are familiar and have an understanding of the factors that will move the stock price.
Make sure you can articulate a prospective stock’s "story line"-the company’s plans for increasing growth and any other series of events that will help the firm-and make sure you understand and balance them against any potential pitfalls.
Categorizing the stocks among six major "story" lines is helpful when evaluating prospective stocks.
Criteria for initial consideration
Specific factors depend on the firm’s "story," but these factors should be examined:
1.Year-by-year earnings: Look for stability and consistency, and an upward trend.
2.P/E relative to historical average: The price-earnings ratio should be in the lower range of its historical average.
3.P/E relative to industry average: The price-earnings ratio should be below the industry average.
4.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.
5.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.
6.Net cash per share: The net cash per share relative to share price should be high.
7.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.
8.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 "diworseifications."
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.

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