Peter Lynch's 6 categories of stocks: Asset Plays

Asset plays the last piece in the puzzle

GREG HOFFMAN
February 26, 2010

Over the past two weeks we've been on a tour of the way legendary US investor Peter Lynch classified stocks in his classic book, One up on Wall Street. Now, like the end of a game of Trivial Pursuit, we'll fill in the last piece of pie: asset plays.

The idea with asset plays is to identify untapped or unappreciated assets. These situations can arise for several reasons. A good historical example was Woodside Petroleum in the early part of this decade.

At the time, Woodside's annual profits didn't fully reflect its long-term earnings power. On 5 September 2003 (Long Term Buy - $13.40) our resources analyst enthused: ''It's hard to contain our excitement about the sheer quality of Woodside's assets, and we find dissecting the latest set of entrails (accounts) far less revealing than thinking about how things may play out at Woodside over the next five to 10 years or more.''

He was right, and those who followed his advice have so far more than tripled their money. Yet there was no magic involved. Woodside's enormous reserves and long-term contracts were there for all to see. But you needed to look past the then rather meagre profits and make an investment in the future potential of these assets.

''Recency bias''

It's easy to fall victim to ''recency bias'' in the sharemarket; placing far too much emphasis on the most recent financial results and not focusing on where a business is heading long term. Sometimes an asset play is plain enough to see but investors, for whatever reason, choose to ignore it. In the case of bombed-out SecureNet it was because everyone had sworn off ``tech stocks''.

On 26 July 2002 (Buy - $0.81), we pointed out that, ''SecureNet has an estimated $90-$92m cash in the bank, very little debt and 76m shares on issue. That means that were the company to return this cash to shareholders, each share would entitle the holder to about $1.18. That's 46% above the current market price. So, as long as the company isn't burning too much cash and management doesn't waste the money, at these prices it looks like a no-brainer.''

The company was taken over 12 months later by American group beTRUSTed at more than $1.50 per share, fully valuing the group's cash plus its IT security business. SecureNet was a classic asset play in the tradition of Benjamin Graham (author of our company's namesake, The Intelligent Investor in 1949).

Graham was a legendary investor and teacher (his most famous student being Warren Buffett) and, among other strategies, advocated buying stocks when they were available at less than their ''net cash assets'' (their cash balance less all liabilities) as SecureNet was.

RHG is a more recent example. Having steered our members clear of what proved to be a disastrous float, we ran the numbers as the stock price plummeted during the credit crisis and a clear picture began to emerge.

With a healthy portion of the group's multi-billion dollar loan book financed in the boom times by income-hungry funds at fixed margins, RHG was set to make hundreds of millions in profit as these loans were repaid. By our calculations, these profits would bring the group's total value to somewhere close to $1 per share.

At the depths of despair in June 2008, RHG shares changed hands for less than 5 cents each (several of our members report being happy buyers on that very day). That valued the company at less than $20m; an astonishing figure for a group that not two months later, would report a full year profit of $125m.

The stock now trades north of 60 cents and was a wonderful holding to have through early 2009 as it soared while most other stocks sank. And that's the beauty of a well-selected asset play; under the right circumstances it can offer a degree of protection to your portfolio.

Summing it up

That wraps up our practical introduction to Peter Lynch's six stock categories;

• slow growers, 
• stalwarts, 
• fast growers, 
• cyclical, 
• turnarounds and 
• asset plays. 

These are only a guide, as companies won't always fit neatly into a single category, and the same company may move through several categories over the course of its life.

The biggest risk for investors is mis-categorising a stock. Buying a stock which you think is a fast grower, for example, only to find out a couple of years down the track that it is really a cyclical, is a chastening experience. And your own life situation and risk tolerance should dictate the weightings of each category in your portfolio.

If you've found these distinctions helpful, you might find it worthwhile heading to the source, Lynch's easy-to-read One Up on Wall Street, which is number two on the reading list we provide to members of The Intelligent Investor when they first join up.

Next week I'll take you through some of the other books on that list. They're a great education.

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

http://www.businessday.com.au/business/asset-plays-the-last-piece-in-the-puzzle-20100226-p7lc.html

Peter Lynch's 6 categories of stocks: Turnaround Stocks

Turnaround stocks: The pleasure and pain

GREG HOFFMAN
February 24, 2010


In this fourth instalment of a five-part series, we'll examine turnarounds; a category beginner investors should be very careful of.

Like ice cream, turnarounds come in many varieties. The mildest form is the ''little-problem-we-didn't-anticipate'' kind of turnaround typified by Brambles' loss of 15 million pallets in Europe a few years ago.

Another is Aristocrat Leisure, which I recommended to The Intelligent Investor's members in June 2003 at $1.15 with the following quotes, fittingly, from Peter Lynch: ''Turnaround stocks make up lost ground very quickly'' and ''the occasional major success makes the turnaround business very exciting, and very rewarding overall.''

While I'm proud to have steered members into this great stock in its darkest days, I recommended people begin taking money off the table far too early in the turnaround process, beginning in March 2004 at $2.73 having recorded a gain of ''only'' 137%, when much more was to come. Thankfully we were recently given another bite at the cherry (as I explained in Betting on prosperous times).

Perfectly good company

Another category of turnaround is the perfectly-good-company-inside-a-troubled-one. I missed AMP in its ''lost years'', because I wasn't comfortable enough with the complexities of life insurance accounting to take the plunge. But Miller's Retail (now Specialty Fashion Group) provided an opportunity at its 2005 nadir, with progress in its women's apparel business being clouded by problems in its discount variety division.

Those brave enough to draw breath and buy the stock when I upgraded in May 2005 at 68.5 cents per share were rewarded with a 148% return in just 10 months before we sold in March 2006 at $1.70 (although the stock had provided a painful ride down prior to its relatively sudden resurrection).

Potential fatalities are probably the most uncomfortable type of turnaround. They can be explosive on both the up- and down-side.

My analysis of timber group Forest Enterprises on 8 March 2002 (Speculative Buy - $0.12) began: ''This company could go broke. But we're about to recommend you buy some shares in it.''

It may shock you that a conservative service like The Intelligent Investor could ever recommend a stock which has a significant chance of going to zero. But if the profit potential is large enough, and the percentage chance of it materialising is great enough, then we're prepared to risk a prudent percentage of our portfolios in a potential wipe-out situation.

Probability is the key

The key to turnarounds is to think about them in terms of probabilities. With Forest Enterprises back in March 2002, my probability calculation would have looked something like the accompanying table. (see below)

The stock ran even further after I recommended our members sell at 35 cents in April 2004, but that advice to sell quoted the words of famed American financier Bernard Baruch: ''Don't try to buy at the bottom and sell at the top. It can't be done except by liars.'' We were content with a near tripling of our initial outlay in just over two years.

The Intelligent Investor's sell-side record is a bit embarrassing on these turnarounds - tending to sell far too early. But buying is by far the riskiest part. Get one of these investments wrong and you could well be staring at a financial fatality - a ''bagel'', in the parlance of Wall Street.

Don't worry, though. You can live a rich and rewarding investing life without ever going near a turnaround situation in the sharemarket. You could also say the same about the final stock category we'll turn to on Friday: Asset plays. But asset plays appeal to a certain type of investor (I, for one, love 'em) and can offer great returns often with a good deal of underlying protection.

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.



http://www.businessday.com.au/business/markets/turnaround-stocks-the-pleasure-and-pain-20100224-p2pt.html

The Economic Climate (8): Cold Climates and Recession

Reviewing the recessions in US since World War II to 1995:  all last an average of 11 months, and cause an average of 1.62 million people to lose their jobs.

In a recession, business goes from bad to terrible. 

Companies that sell soft drinks, hamburgers, medicines - things that people either cannot do without or can easily afford - can sail through a recession unscathed. 

Companies that sell big-ticket items such as cars, refrigerators, and houses have serious problems in recessions.  They can lose millions, or even billions, of dollars, and unless they have enough money in the bank to tide them over, they face the prospect of going bankrupt.

Many investors have learned to "recession-proof" their portfolios. 

• They buy stocks only in McDonald's, Coca-Cola, or Johnson & Johnson, and other such "consumer growth" companies that tend to do well in cold climates. 
• They ignore the likes of General Motors, Reynolds Metals, or U.S. Home Corp.  These are examples of "cyclical" companies that suffer in cold climates. 

Cyclical companies either

• sell expensive products,
• make parts for expensive products, or
• produce the raw materials used in expensive products. 

In recessions, consumers stop buying expensive products. 

Market Multiple or "What the market is selling for".

The P/E ratio is a complicated subject that merits further study, if you are serious about picking your own stocks. 

Here are some pointers about P/Es.

If you take a large group of companies, add their stock prices together, and divide by their earnings, you get an average P/E ratio. 

On Wall Street, they do this with the Dow Jones Industrials, S&P 500 stocks and other such indexes.  The result is known as the "market multiple" or "what the market is selling for."

• The market multiple is a useful thing to be aware of, because it tells you how much investors are willing to pay for earnings at any given time. 
• The market multiple goes up and down, but it tends to stay within the boundaries of 10 and 20. 
• The stock market in mid-1995 had an average P.E ratio of about 16, which meant that stocks in general weren't cheap, but they weren't outrageously expensive, either.

In general, the faster a company can grow its earnings, the more investors will pay for those earnings. 

• That's why aggressive young companies have P/.E ratios of 20 or higher.  People are expecting great things from these companies and are willing to pay a higher price to own the shares. 
• Older, established companies have P/E ratios in the mid to low teens.  Their stocks are cheaper relative to earnings, because established companies are expected to plod along and not do anything spectacular.

Some companies steadily increase their earnigns - they are the growth companies. 

Others are erratic earners, the rags-to-riches types.  They are the cyclicals -

• the autos, the steels, the heavy industries that do well only in certain economic climates. 
• Their P/E ratios are lower than the P/.Es of steady growers, because their perfomance is erratic. 
• What they will earn from one year to the next depends on the condition of the economy, which is a hard thing to predict.

Market strategy: Moving from recovery to expansion

The cyclical run in the market remains firmly intact throughout 1H2010 on three counts below:

• Market performance historically strongest when GDP accelerates
• Earnings-driven re-rating cycle never been shorter than 12 months from trough.
• Risk to earnings on upside, as economic growth accelerates.

Our economist expects GDP to expand by a robust 5.3% in 1Q10, and by 4.2% in 2Q10.  The macro growth momentum, however, is expected to decelerate, with GDP expanding by only 2.5% in 3Q10 and 2.1% in 4Q10 as the low base effect tapers off moving towards the second-half of the year.

The present rally is now coming to 10 months from lows seen in March 2009. 

Cyclicals are expected to deliver the strongest earnings rebound as end-demand and margin recovery kick in to accentuate the growth trajectory off a low base in 2009 where earnings were diluted by writeoffs and pre-emptive loss provisions.

Overweight stance maintained on the Glove sector, with buys on both Top Glove and Kossan

Despite meteoric share price appreciation for glove manufacturer stocks, valuation remains undemanding given robust earnings performance.  At current share prices, both Top Glove and Kossan are trading at PE of 11x and 10x FY10F earnings, well below its respective peaks of 30x and 18x.

Solid earnings growth as supplanted by

• capacity expansion, and
• positive newsflow

should lead to further expansion in PE multiples.

Key risks include

• a sudden surge in latex price,
• energy input costs or
• an unfavourable ringgit/US$ foregin exchange rate movement.

Benny Chew
AmResearch
Published in the Edge Jan 18, 2010

Normalizing Earnings for PE ratios

Normalizing Earnings for PE ratios

The dependence of PE ratios on current earnings makes them particularly vulnerable to the year-to-year swings that often characterize reported earnings.

In making comparisons, therefore, it may make much more sense to use normalized earnings.

The process used to normalize earnings varies widely but the most common approach is a simple averaging of earnings across time.

For a cyclical firm, for instance, you would average the earnings per share across a cycle. In doing so, you should adjust for inflation.

If you do decide to normalize earnings for the firm you are valuing, consistency demands that you normalize it for the comparable firms in the sample as well.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

Look at the long term and be aware of stocks that dip as the business cycle dips.

Always be wary of cyclical stocks.

True, companies may look irresistable with low PE and high short-term sales and earnings growth rates.

But a closer look at the long term reveals a PE in the teens and years of marginal earnings or even losses mixed in.

Look at the long term and be aware of stocks that dip as the business cycle dips.

Basic industries, such as capital equipment, natural resources, paper, farm mchinery, automobiles, and auto suppliers, are notorious for sending signals of intermittent strength while showing little in the way of sustained growth.

The recent tanking of homebuilding stocks is an extreme case in point. It is amazing how many short-term-oriented investors bit on the apparent "value" in this sector.

Also read:

Is the Firm Cyclical?
For cyclical stocks, your best bet is to look at the most recent cyclical peak, make a judgment whether the next peak is likely to be lower or higher than the last one, and calculate a P/E based on the current price relative to what you think earnings per share will be at the next peak.

The expanding P/E in cyclical stocks
Here’s the rub about cyclical stocks: Their valuations are counterintuitive. In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

Recognizing Value Situations - Cyclical Plays
Generally, cyclical companies shouldn't be confused with value investments. Growth, although apparent in the short term, usually isn't sustainable. If a company seems cheap and has something new in its portfolio to avoid cyclical price and earnings behaviour, it may be worth a look.

5 Value Traps to Avoid Right Now

5 Value Traps to Avoid Right Now
By Joe Magyer
April 24, 2009 Comments (14)

History’s greatest investor, Warren Buffett, has two simple rules.

Rule #1: Never lose money.
Rule #2: Never forget rule #1.


A big, sarcastic thank-you, Warren!

Sure, practically everyone has lost money in this market -- including Buffett. But take it easy on the Oracle here, because he’s dead-on. Buffett’s intense focus on not just investing in great opportunities but avoiding terrible ones has been the key to epic success.

Avoiding soul-sucking investments -- what we investing nerds dub “value traps” -- is hardly rocket science. Yet, incredibly, I see investors new and salty alike make the same mistakes over and over again, breaking Buffett’s rules and walking right into what seem like obvious value traps.

Having spent way too much time thinking about it, I’ve concluded that there are five primary categories of these dreaded mistakes. Avoiding these five traps will save you time, money, and more than a little heartache.

1. The quarter-life crisis
These are a real heartbreaker. You find a dominant company whose once sky-high growth has stalled, and its shares along with it. “TechWidget Corp. is trading at only 15 times earnings right now, only half its five-year average!” you say. “Its earnings have doubled over the past five years, but the shares are down over the same time period. Sounds like a steal!”

Snap! You just walked into a value trap.

Investors falsely believe that names like Dell or eBay (Nasdaq: EBAY) will see their relative valuations return to their headier days. They won’t.

Why? Captain Obvious would say that growth has slowed, technology evolved, and competition emerged. But all that misses the real reason. Instead of returning incremental profits to shareholders via dividends, such companies wreck shareholder value by chasing growth through overexpansion and high-profile acquisitions. Oh, and the ill-timed share repurchases that exist primarily to juice per-share earnings and help sop up all that stock option-driven dilution.

Steer clear of flailing tech titans until they’re willing to follow the lead of Microsoft (Nasdaq: MSFT) and Oracle (Nasdaq: ORCL) into dividend-paying adulthood.

2. The soaring cyclical
Here’s the rub about cyclical stocks: Their valuations are counterintuitive. They always look the cheapest when they’ve reached their priciest, and look priciest when they’re reached their cheapest.

Take nearly any oilfield service stock from last summer as an example. Transocean (NYSE: RIG) looked dirt cheap via a crude, PEG-style valuation. But savvy investors know that cyclical companies’ profits mean-revert, which is why cyclical stocks’ P/E multiples stay low during booms and high during busts.

In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

3. The small-cap Methuselah
The six-year small-cap bull run that came crashing to a halt last year was a painful reminder of a little-known value trap: the Small-Cap Methuselah.

Century-old small-caps you’d never heard of were wrapping up five-year runs of 20% annualized earnings growth. Analysts went gaga, extrapolating those growth rates forward like the party would never end. Valuations followed suit. Gaga analyst, meet mean-reversion.

You won’t find long-run compounding machines within the small-cap space. Show me a company with a long, proven history of creating serious shareholder value, and I’ll show you a mid- or large-cap stock.

4. The too-high yielder
A company usually has a high yield (think above 7%) for one of three reasons:

• It has limited growth potential, so managers return as much cash as they can to shareholders (think regional telecoms).
  


• The company is in a clear state of decline and investors expect a dividend cut (think newspapers).
  


• The company is in a tax-advantaged structure that doesn’t allow it to retain much capital (think REITs, MLPs, or BDCs).

Broadly speaking, a high payout is a good thing. There’s a fine line, though. At Motley Fool Income Investor, we’re looking for that sweet spot where an attractive payout meets rest-easy status.

Take my most recent recommendation, Procter & Gamble (NYSE: PG). The stock’s yield of 3.5% is near a multi-decade high despite the company’s underlying earnings power remaining unchanged, if not improving. That’s low-hanging fruit for the income-loving investor.

5. The unopened book
I can already see the Ben Graham fanatics gearing up to peg me with tomatoes, but hear me out. Book values need to be adjusted -- especially heading into and during recessions.

Acquisition-happy companies inevitably end up slashing the goodwill they’d booked while making bloated acquisitions in the years previous. The book values of asset-centric plays (homebuilders, natural resource producers, etc.) also need a good tweaking to reflect the depressed values of those assets. And financials, well, what can I say? Just ask any Citigroup (NYSE: C) or AIG (NYSE: AIG) investor about the ease of assessing their balance sheets.

Don’t get me wrong: I’m all for buying stocks on the cheap. We do just that at Income Investor. But there’s a catch: We’re only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.

But I digress.

Wrapping the traps
To recap, you can smooth and improve your returns if you:

1. Avoid the stalled-out growth stock undergoing a quarter-life crisis.
   


2. Steer clear of hot small-caps with blah track records.
   


3. Don’t get tripped up by seemingly cheap soaring cyclicals.
   


4. Think twice about the yield that looks too good to be true.
   


5. Don’t lean on inflated or unadjusted book values.
   

You’ve probably picked up on an underlying theme here: You need unconventionally conventional thinking if you want low-stress success in the stock market.

Looking for great, simple-to-understand businesses at good prices is the easiest way to avoid stepping into a value trap -- and bag great returns besides. That’s what I do alongside advisor James Early over at Income Investor, and more than 85% of our active picks are beating the market.

Senior analyst Joe Magyer owns no companies mentioned in this article, though he’s planning to nab a few. Microsoft, Dell, and eBay are Motley Fool Inside Value recommendations. eBay is also a Stock Advisor recommendation. Procter & Gamble is an Income Investor recommendation. The Motley Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.

Read/Post Comments (14) Recommend This Article (113)

http://www.fool.com/investing/dividends-income/2009/04/24/5-value-traps-to-avoid-right-now.aspx

The expanding P/E in cyclical stocks

The soaring cyclical

Here’s the rub about cyclical stocks: Their valuations are counterintuitive. They always look the cheapest when they’ve reached their priciest, and look priciest when they’re reached their cheapest.

Take nearly any oilfield service stock from last summer as an example. Transocean (NYSE: RIG) looked dirt cheap via a crude, PEG-style valuation. But savvy investors know that cyclical companies’ profits mean-revert, which is why cyclical stocks’ P/E multiples stay low during booms and high during busts.

In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

Recognizing Value Situations - Cyclical Plays

Recognizing Value Situations - Cyclical Plays

Generally, cyclical companies shouldn't be confused with value investments. Growth, although apparent in the short term, usually isn't sustainable. Investors are getting wiser and aren't as likely to bid up prices in good times, nor bid them way down in bad times, so this form of market timing doesn't work as well.

But occasionally companies caught in the cyclical pool come up with strategies to climb out of it, and move more steadily up and to the right International expansion can reduce cyclical effects.

Manufacturing companies diversify into more recession-proof financial services (which make more money as poor business conditions beget lower interest rates). General Electric has figured this out, and Ford has tried. Other smaller companies may have more effective cycle-beating strategies, because it's hard to keep such big ships as Ford and GE from turning when the wind shifts. If a company seems cheap and has something new in its portfolio to avoid cyclical price and earnings behaviour, it may be worth a look.

Also read:
Recognizing Value Situations
Recognizing Value Situations - Growth at a Reasonable Price
Recognizing Value Situations - The Fire Sale
Recognizing Value Situations - The Asset Play
Recognizing Value Situations - Growth Kickers
Recognizing Value Situations - Turning the Ship Around
Recognizing Value Situations - Cyclical Plays
Recognizing Value Situations - Smoke and Mirrors

Peter Lynch's Classification of Companies

There are different ways of classifying shares. Here is Peter Lynch's classification of companies (and by derivation, shares).

Slow growers: Large and ageing companies that are expected to grow slightly faster than the gross national product.

Stalwarts: Giant companies that are faster than slow growers but are not agile climbers.

Fast growers: Small, aggressive new enterprises that grow at 10 to 25% a year.

Cyclicals: Companies whose sales and profit rise and fall in a regular, though not completely predicatable fashion.

Turnarounds: Companies which are steeped in accumuated losses but which show signs of recovery. Turnaround companies have the potential to make up lose ground quickly.

Stock Market Classification of Equity Shares

Stock market classification of Equity Shares

Blue chip shares: Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.

Growth shares: Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.

Income shares: Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.

Cyclical shares: Shares of companies that have a pronounced cyclicality in their operations.

Defensive shares: Shares of companies that are relatively unaffected by the ups and downs in general business conditions.

Speculative shares: Shares that tend to fluctute wdely because there is a lot of speculative trading in them.

Note that the above classification is only indicative. It should not be regarded as rigid and straightjacketed. Often you can't pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.

Is the Firm Cyclical?

Firms that go through boom and bust cycles - semiconductor companies and auto manufacturers are good examples - require a bit more care. Although you'd typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they're likely to fall off soon. For cyclical stocks, your best bet is to look at the most recent cyclical peak, make a judgment whether the next peak is likely to be lower or higher than the last one, and calculate a P/E based on the current price relative to what you think earnings per share will be at the next peak.