Peter Lynch's 6 categories of stocks: Sluggards and Stalwarts

Which pigeon hole for Telstra?

GREG HOFFMAN
February 17, 2010

''If you don't know where you're going,'' said Austrian psychologist Alfred Adler, ''you'll end up somewhere else.'' Adler probably wasn't thinking of the stockmarket at the time but his quote alludes to a classic investing mistake.

Most investors spend much of their time looking for stocks to buy. Very little time is allocated to thinking about when to sell. Buying stocks warrants intense consideration, selling is often done on a whim.

The problem, as Adler suggests, is that it's easy to forget what you originally expected from an investment. As a result, you end up in a place you neither recognise nor expect.

What's the solution? One way is to write down what you expect from a stock when you're doing your initial research. Some of The Intelligent Investor's analysts talk about ''milestones'' and ''roadmaps'' but they're probably just overdue a holiday.

More famously, Peter Lynch, the American investor and author, places his stocks into six categories:

• slow growers (or ''sluggards''), 
• medium growers (or ''stalwarts''), 
• fast growers, 
• cyclicals, 
• turnarounds and 
• asset plays. 

Such terms capture one's expectations for a stock pretty well.

As Lynch explains in One Up on Wall Street: ''There are almost as many ways to classify stocks as there are stockbrokers - but I've found that these six categories cover all of the useful distinctions that any investor has to make.''

In this column and the four that follow, I'll run through Lynch's categories and draw out some important distinctions using my own experiences and those of The Intelligent Investor team over the years I've been leading it.

Sluggards

Slow growers, or ''sluggards'', are businesses growing at the same rate as the general economy, say 3-4% a year, or less not a place for ''tenbaggers'' (stocks that rise 10-fold from your buy price). But, purchased at the right price, they can be nice, steady providers of dividends.

When looking at sluggards you need to think about the nature of the business, how it's financed and the history of dividend stability and coverage (earnings per share divided by dividends per share - other things being equal, the higher, the better).

The time to think about selling these stocks is when they've enjoyed some kind of significant - and unwarranted - capital appreciation. You didn't buy them for spectacular gains so when you get some, it's often a good time to sell.

Operationally, it should catch your attention if they start losing market share or changing strategy away from their core business (through unrelated acquisitions or shifting into unfamiliar geographic territory, for example).

We aren't flush with these sorts of stocks in Australia but Telstra is probably a good example. It features a number of sluggard hallmarks including market share loss and very thin dividend coverage.

Stalwarts

Stalwarts grow faster than sluggards but at less than double-digit rates. Dividend yield is not as crucial as it is with sluggards as these companies are often still investing for growth. Stocks like Woolworths and Metcash are good stalwart examples.

When looking to buy them, paying a sensible price is paramount. Keep an eye on the price-to-earnings ratio (PER) and make sure the business's strategy is clear and consistent.

If the PER blows out relative to other stalwarts, then it could be an opportune time to consider a switch to ensure your money's working as hard as possible. Share sales by several directors can be another warning sign (www.directorstransactions.com.au can help your research in this regard).

Also, keep an eye on whether profit growth is a result of cost cutting rather than growing sales (Telstra again). This is not a way to sustainable profit growth and can indicate that a stalwart is turning into a sluggard.

On Friday, we'll turn our attention to arguably the most exciting category of stocks; fast growers, and provide a few examples.

This article contains general investment advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor which provides independent advice to sharemarket investors

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