Calculating a Stock’s Risk-Reward Ratio by Jim Cramer

Calculating a Stock’s Risk-Reward Ratio
Published: Tuesday, 30 Aug 2011
By: CNBC.com


Focusing on a stock’s upside without giving proper consideration to potential losses, Cramer said Tuesday, can be “a grave mistake.” Too often people think only of the reward, without assessing the risk. And investors must calculate both.

“Because the pain from a big loss,” Cramer said, “hurts a whole lot more than the pleasure from an equivalent-sized gain.”

But how do you figure out the risk-reward on a stock? As a general rule, Cramer looks at the lowest price that a value-oriented money manager would pay for that stock to calculate the downside. For the upside, he uses the most a growth-focused manager would pay.

To arrive at these numbers, Cramer refers to something called “growth at a reasonable price,” or GARP, a method of stock analyzing first popularized by Peter Lynch. If you want to know just how much growth investors will pay, you need to understand GARP. And it involves a comparison of a stock’s growth rate to its price-to-earnings multiple.

But you can use this rule of thumb to figure out the value side of the equation, too, and here’s how Cramer does it: If a stock has a price-to-earnings multiple (PE) that’s lower than its growth rate, it’s probably cheap. And any stock that’s selling at a multiple that is twice the size of its growth rate or greater is probably too expensive and should be sold.

Example: A stock trading at 20 times earnings with only a 10 percent growth rate would be considered expensive. But the reverse—10 times earnings on a 20 percent growth rate—would be incredibly cheap.

This gives rise to another piece of Wall Street jargon: the PE-to-growth ratio, or PEG, which is the multiple divided by the stock’s long-term growth rate. A PEG of one or less is “extremely cheap,” Cramer said, while a PEG of two or more is “prohibitively expensive.”

This means then that the risk floor created by value investors will probably be somewhere near a stock’s PEG of one, while its ceiling, created by growth investors, rarely exceeds a PEG of two. That’s why Google [GOOG  570.11    -9.89  (-1.71%)   ] back between 2004 and 2007 was considered cheap, because its 30 percent long-term growth rate matched its 30 multiple. But if that multiple reached 60, growth managers would probably cash out of their positions.

There is one caveat to keep in mind, that this is a general rule of thumb, an approximation. But there are times when the numbers can be wrong. Cramer said stocks can look cheap based on earnings when those earnings estimates need to be cut, much like the banks and brokers were ahead of the 2008 crash. Or a stock could look cheap because its growth is slowing, like Dell[DELL  14.30    -0.53  (-3.57%)   ] after the dot-com collapse between 2000 and 2003. In these cases, the stock could trade well below a PEG of one, but that obviously doesn’t mean it’s a buy.

One final anomaly of multiples regards industrial companies, or cyclical names in general. The time to buy these stocks is when their multiples look outrageously high, Cramer said, because the earnings estimates are too low and read to be raised to catch up with their strengthening businesses.

(Written by Tom Brennan; Edited by Drew Sandholm)

http://www.cnbc.com/id/44334471/Calculating_a_Stock_s_Risk_Reward_Ratio

Interview: Sir John Templeton and Peter Lynch

Peter Lynch - Finance and Investing

Company business should be the focus, not the price.

Peter Lynch on Stock Market

A lot of good advice on these topics:

Upsides of a downmarket.
Historical market rebounds.
Timing the market is not a Winning Strategy.
Why it's important to stay the course.
Don't listen to background noise.
Know your Time Horizon, stay invested.
Benefit of Regular Investing for Retirement.
Portfolio Diversification
Be comfortable with what you own.
How can Fidelity financial planning help you?

Nature of the Stock Market
Market went down 1% per month and 2% per month regularly in the past.
Once in 2 years, market went down 10% per month.
Every 18 months, some market somewhere was down 10% per month.
Once every 5 or 6 years, the stock market declined 20% to 25% per month.

Historical market rebounds
Over the last 15 years, there were 13 months when the market went down 8% or more.
Of these, 11x out of these 13, the market was higher subsequently.

Stay fully invested. Know your time horizon.
The market went down 10 to 12 x, I went down 10 to 12 x.
When market went up I went up.
The upside is more than the downside.
Need to know your own time horizon.

Timing the market is not a winning strategy
All the wealthy people in the world are not market timers.
You might be right to miss some declines.
However, market turned up very fast.
Over the last 15 years, missing the best 15 months (that is 1 month per year) ..
.. meant a fall of portfolio return from 11% to 3%.

Portfolio Diversification
As long as it makes sense.

Peter Lynch Induction and Speech - Academy of Distinguished Bostonians

Peter Lynch talks about bottom-fishing on Wall Street

http://multibaggersindia.blogspot.com/2010/11/investing-strategies-from-peter-lynch.html

Peter Lynch: Market Prediction

Market ought to be irrelevant to your investing.
I made money in lousy market and I lose money in good market.

Investing strategy of Peter Lynch
http://multibaggersindia.blogspot.com/2010/11/investing-strategies-from-peter-lynch.html

Getting real about returns

I have added the link below to highlight that a fund may outperforms the market in the long run and yet many of the investors may lose money due to various reasons. "After he retired at the age of 47, Lynch reported that, wonder of wonders, most of the investors in the Fidelity Magellan Fund lost money during his stellar run! They had bought into the fund when the market was doing well. Obviously, they paid a high price at that time as the market was peaking. Unfortunately, they panicked and sold out during the times the fund went south."  Imagine that: the investors were actually holding a winner and yet, they lost money!

Getting real about returns

Peter Lynch

Ten great investors

6. Peter Lynch

Job description
Now retired, Lynch secured his reputation as one of the most successful fund managers in history while in charge of the Fidelity Magellan fund between 1977 and 1990.

Investment style

Highly active investment in a variety of stocks, with special emphasis on growth and recovery stories, and holding periods ranging from a couple of months to several years.

Profile
Lynch only ever worked for Fidelity, the international investment management firm based in Boston. He started as an analyst in 1969, was promoted to director of research in 1974, and took over the Fidelity Magellan fund in 1977. At the time, it had $22m in assets. By 1990, when he decided to take early retirement in order to spend more time with his family, its value had swollen to $14bn. No manager in history has ever run so large a fund, so successfully, for so long.

His secret was a punishing work schedule, lasting six and sometimes seven days a week, in which he talked to dozens of company managers, brokers and analysts every day. With a total staff of just two research assistants, he ran a portfolio of up to 1,400 stocks at any one time. Some he bought at an early stage of growth or recovery and held for years. The majority he became dissatisfied with and sold within months, admitting that over half his choices were mistakes.

Although you cannot copy his portfolio management style, Lynch is adamant that any small investor can research stocks better than most professionals, and make smarter decisions about what to buy. This is because he or she is often better placed to spot potentially profitable investments early, and is always free to act independently, rather than constrained by committees, trustees and superiors.

Long-term returns
During his tenure at Magellan, Lynch averaged 29% compound over 13 years. This remains a record for funds of this size.

Biggest success
The biggest successes Lynch lists in his book Beating the Street were all small growth companies when he bought them: Rogers Communications Inc, a 16-bagger, Telephone Data Systems, an 11-bagger, and plastic cutlery manufacturer Envirodyne and King World Productions, both tenbaggers. The last of these is Oprah Winfrey's production company, and also owns the TV rights to Wheel of Fortune and Double Jeopardy.

Method and guidelines

Firstly, keep your eyes and ears open for ideas.
Lynch's key concept is that you can spot investment opportunities all around you, if only you concentrate on what you already know and are familiar with. Maybe you notice a crowded shop or restaurant, or your neighbours all start buying a new make of car, or a nearby factory suddenly seems to be expanding - all these may be pointers to companies on the stock market that are worth further investigation.

Among your best sources of information are:

• Your job, which familiarizes you with your company, its customers and its suppliers
• Your hobbies and leisure pursuits, from sport to shopping
• Your family and friends, thanks to all their jobs and hobbies
• Your observation and experience of companies in your home town.

Secondly, categorize your ideas

Companies can be categorized into 6 main types:

1. Slow growers - raising earnings at about the same rate as the economy, about 2-4% a year.
2. Stalwarts - good companies with solid EPS growth of 10-12%
3. Fast growers - small, aggressive new companies growing 20-25% or more.
4. Cyclicals - whose earnings rise and fall as the economy booms and busts
5. Turnarounds - companies with temporarily depressed earnings, but good prospects for recovery.
6. Asset plays - companies whose shares are worth less than their assets, provided these assets could be sold off for at least book value.

Source: One Up on Wall Street, P Lynch, 1989

Consider concentrating your efforts on finding fast growers. If bought at the right price, some of these can become 'tenbaggers' - shares that multiply your investment ten times over. Otherwise, look for turnarounds and perhaps the occasional asset play.

Consider trying to avoid holding cash. It is better to stay fully invested by putting any spare money into stalwarts. That way, you will not miss out on rising markets.

Avoid slow growers (too unprofitable) and cyclicals (too hard to time).

Thirdly, summarize the story behind your stock.
Prepare a 2-minute monologue about the stock you have in mind, describing

1. The reasons you are interested in it
2. What has to happen for the company to succeed
3. The obstacles that might prevent its success.

This is the stock's 'story'. Make sure it is simple, accurate, convincing, and appropriate for the category of stock in question. For example, 'if it's a fast grower, then where and how can it continue to grow fast?'
Fourthly, check the key numbers.

1. If you are excited by a particular product or service, check it accounts for a sufficient percentage of total sales to make a significant difference to profits.
2. Favour companies with a forecast P/E ratio well below their forecast EPS growth rate (i.e. a low PEG ).
3. Favour companies with a strong cash position.
4. Avoid companies with a high debt-to-equity ratio ('gearing'), especially if the debt takes the form of bank overdrafts, which are repayable on demand, rather than bonds, which are not.
5. In the case of stalwarts and fast growers, look for a high pretax profit margin. In the case of turnarounds, look for a low one with the potential to rise.

Fifthly, base your buy and sell decisions on specifics.
Your profits and losses do not depend on the economy as a whole. They depend on the factors specific to the stocks you hold. So ignore the ups and downs of the market.

Buy whenever you come across an attractive idea, with a compelling story behind it, at an attractive price.

Consider selling stalwarts when their PEGs reach around 1.2-1.4, or when the long-term growth rate starts to slow.

Consider selling fast growers when there appears to be no further scope for expansion, or expansion starts to produce only disappointing sales and profits growth, or when their PEGs reach around 1.5-2.0.

Consider selling asset plays when they are taken over, or when assets that are sold off fetch lower than expected prices.

Key sayings
"If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them."

"The very best way to make money in a market is in a small growth company that has been profitable for a couple of years and simply goes on growing."

"The way you lose money in the market is to start off with an economic picture."

"You don't get hurt by what you do own that goes up. It's what you do own that kills you."

Further information
Lynch has written two extremely accessible books: One Up on Wall Street (1989) and Beating the Street (1993). The first ranks as one of the best investment primers ever for small investors. The second looks more closely at his time at Fidelity Magellan. A simplified account of his methods is given by John Train in The New Money Masters (1989).

http://www.incademy.com/courses/Ten-great-investors/Peter-Lynch/6/1040/10002

What is the PEG Ratio and How is it Calculated?

 The PEG or “Price/Earnings to Growth” ratio is a measure used to value a stock based on the trade-off between the P/E ratio of the stock and the company’s forecasted growth. Made popular by Peter Lynch in his book “One Up on Wall Street”, the PEG ratio is closely tracked by many investors to help determine whether a stock is currently over or under priced when factoring for growth expectations of the company.

The formula for the PEG ratio can be written as:

PEG Ratio = (Price/Earnings) / Annual Earnings per Share Growth

	Stock Research Pro
	PEG Ratio
	P/E Ratio
	Earnings Growth
	PEG Ratio

A PEG ratio equal to one is thought to represent a fairly valued stock. For example, a company with a P/E ratio of 20 with a growth rate of 20% would have a PEG of 1. Like the P/E ratio, stocks with lower PEG ratios are seen as offering better value and a PEG ratio of less than 1 can indicate that the stock is currently undervalued. Value investors in particular may look for this attribute when choosing stocks for investment.

The PEG ratio is typically most beneficial when considering small and mid-cap growth companies as these organizations are more likely to pour their earnings back into the company to stimulate continued growth. Large-cap companies often allocate these earnings to dividend payments.

__________________________

http://www.stockresearchpro.com/what-is-the-peg-ratio-and-how-is-it-calculated

The Thrill of Investing in Common Stocks

The 2008-2009 stock market crash may have made you pessimistic about investing.

However, history tells us that you have an advantage.  This event actually offers you a great opportunity to find good stocks to invest in.

Buffett recently wrote in the New York Times that for his personal account, he bought common stocks in this market.

Another legendary investor with an outstanding record over several decades wrote, "One principle that I have used throughout my career is to invest at the point of maximum pessimism."

So, spend some time learning to invest wisely.

Based on a long historical record, the expected return on the market is about 7 percent to 10 percent per year.  Let's use the 10 percent as a benchmark.

If you have some money to invest for the long run, why not invest in common stocks?

With common stocks, you can improve your returns, especially if you enjoy the process and put some effort into learning the principles that master investors like Buffett have laid out.

Another great investor, Peter Lynch, echoes this viewpoint:

"An amateur who devotes a small amount of time to study companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun doing it."


Also read:
Commenting on selected KLSE stocks.

Should these 'not knowable in advance' factors influence your investing?

The economy, interest rates, fuel prices, commodity prices, foreign exchange, price of gold and geopolitical situations; should not these influence your investing?


Yes, these are hugely important factors. However, they are not predictable and largely out of our control. They are not knowable in advance. It is better to distance oneself from thinking about them when assessing the business to invest in.


Therefore, the approach adopted should generally not be a top-down macroeconomic one, but a bottom-up microeconomic one.


“The implication is with the passage of time, a good business over a long period of time produce results to the investor over time.”


Also read:
The Ultimate Signal to Load Up on Stocks?

Legendary fund manager Peter Lynch famously said that if investors spend 13 minutes thinking about the economy, they've wasted 10 minutes. Granted, Lynch wasn't managing money during a mega-macroeconomic crisis of the sort we're facing ...

Peter Lynch's 6 categories of stocks: Summing it up

Summing it up

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

• slow growers (sluggards), 
• medium growers (stalwarts), 
• fast growers, 
• cyclicals, 
• 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.


Click:

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

Peter Lynch's 6 categories of stocks: Fast Growers

Peter Lynch's 6 categories of stocks: Cyclical Stocks

Peter Lynch's 6 categories of stocks: Turnaround Stocks

Peter Lynch's 6 categories of stocks: Asset Plays

Peter Lynch's 6 categories of stocks: Summing it up

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

Peter Lynch's 6 categories of stocks: Cyclical Stocks

The pitfalls and profits of cyclical stocks

GREG HOFFMAN
February 22, 2010

Famous American investor Peter Lynch, in his great book ‘‘One Up On Wall Street’’, described how he split stocks into six different categories. In my previous two columns we covered sluggards, stalwarts and fast growers.

Now it’s time to move on to cyclicals which, along with the two categories we’ll cover on Wednesday and Friday, can offer lucrative opportunities. But they can also deliver crushing financial blows if you get them wrong.

If the sharemarket were a sporting competition, these stocks would be reserved for "first grade" players only. The market, though, is not like that. Beginners can quite easily lose their life savings on a cyclical stock bought at its peak, or on a turnaround that doesn’t turn around.

Most companies have a cyclical element to their operations. Even so-called defensive businesses benefit to some degree from a booming economy and suffer when things turn sour. But those particularly exposed to the ebbs and flows of a business cycle are known as cyclicals.

Retailers, vulnerable to fluctuations in discretionary consumer spending, are a good example. When unemployment or interest rates rise and consumers tighten their purse strings, they are hit hard. Shares in David Jones more than halved in the 14 months between December 2007 and February 2009. Then, as consumer confidence returned, they doubled over the ensuing 12 months.

There are also industry-specific cycles. Steelmaking and air travel can be deeply affected by movements in the supply and demand of their international marketplaces. The same is true of mining and related services groups, whose fortunes are much more tied to global economic conditions than to the local scene.

So, how does one spot a cheap cyclical stock?

A low price-to-earnings ratio (PER) often catches our eye at The Intelligent Investor. Yet this isn’t necessarily an opportunity with cyclical; it could be a trap. The fluctuating nature of a cyclical stock’s profits means they can appear superficially cheap, just as their earnings are about to fall off a cliff.

BlueScope Steel provided a classic example in 2007. Back then one of The Intelligent Investor’s researchers summed up his analysis like this: "The PER of 11.3 and the dividend yield of 4.4 per cent are deceptive and the stock would need to be a lot cheaper to offer a margin of safety. SELL."

BlueScope’s share price has since fallen by more than 75 per cent. Low PERs are not reliable indicators of value, especially when it comes to cyclical stocks.

To profit from cyclicals, you should seek them out at the point of maximum pessimism, when you’ve noticed signs that the underlying cycle is improving but the share price is still wallowing. Cyclicals aren’t the type of stocks you want to hold forever, though. And bear in mind that selling cyclicals too early can be uncomfortable.

Take my "Buy" recommendation on Leighton Holdings (something of a mix between a cyclical and a fast grower) at a low of $7.83 in May 2004. Less than two years later the stock was trading at $17.70 and I called on our members to take their 126 per cent profit (plus dividends) and run. Yet the stock price continued to soar throughout the resources boom, making my sell call look far too conservative, if not foolish.

A strong cycle can carry profits and stock prices further than you might imagine. But we must guard against greed becoming the dominant factor in any investment decision. While exiting a cyclical too early can lead to ‘seller’s regret’, getting out too late can be extremely hazardous to your wealth.

So one needs an understanding not just of the cycles affecting a stock but also of the expectations built into its share price at any point in time. When it comes to predicting cyclical turning points, I'm reminded of the quip that economists have predicted seven of the last three recessions – so don’t believe everything you read.

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/the-pitfalls-and-profits-of-cyclical-stocks-20100222-oqi4.html

Peter Lynch's 6 categories of stocks: Fast Growers

Stalking the ten-bagger

GREG HOFFMAN
February 19, 2010

In Wednesday's column, we looked at what are generally less risky stock categories - sluggards and stalwarts. But what about the potential ten-bagger - a stock that rises by 10 or more times the price you paid for it?

Peter Lynch, the famous 1980s American fund manager and author, terms such stocks fast growers. Naturally, they're notoriously difficult to pick, inhabiting a land of broken dreams and expensive investment lessons for those too quick to put their faith in a good but elusive story.

The traps are numerous and deep. There are plenty of fast-growing industries - airlines, for example - that have been graveyards for investors. So it's vital to ascertain whether the company you have in your sights really has a sustainable competitive advantage.

Many a blistering growth stock has been lifted on the back of a single, hot product. Ballistics company Metal Storm was a favourite a few years ago, as was animal-focused biotech Chemeq; both ended up crashing spectacularly.

So it's crucial that you understand the risks and allocate your portfolio accordingly. Don't place all your hopes on one hot product.

And always make sure the company is delivering growth in earnings per share as well as net profit. It's too easy to grow net profit by raising more money from shareholders; double the amount of money you have in a plain old savings account and you'll double its ``profits''. What counts is growth in earnings on a per share basis.

Time to bale

The time to bale out is when you think the business might be maturing or saturating its market and no-one else has noticed. And, yes, unfortunately that is as hard as it sounds.

You should also pay heed to the loss of any key executives. Ten-baggers are often driven by one key entrepreneur like Chris Morris at Computershare, or a small team of motivated individuals, as is the case at QBE Insurance. If they're jumping ship then you might consider joining them.

As for retailers - often fast growers when they initially list - it's crucial to keep an eye on the same-store sales figure. When this number drops off it can be a sign that the concept is getting tired or that competition is staring to bite, even as profitability continues to grow through new store rollouts.

Is this 'nuts'?

More positively, the prices of these stocks can sometimes get way ahead of themselves and that's a good time to think about taking some or all of your money off the table.

Good examples would include Harvey Norman, Flight Centre and Cochlear back in 2001. All are great companies and, generally speaking, I'd be a happy holder (if not a buyer) of them, but there comes a point where you just have to say ''this is nuts''.

What constitutes a ''nutty'' price? It's difficult to say, but as Justice Potter Stewart once opined in the US Supreme Court on the subject of pornography: ''I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it.''

Be warned though: Too many high valuations can make one blasé. In the boom years, investors routinely paid price/earnings ratios of 16, 18 and even 20 for fairly mediocre business. As with many aspects of investing, success is determined by the price you pay to buy in, more than the price at which you sell to get out.

Next on our agenda is a tour through the land of cyclicals, then turnarounds and, finally, asset plays. Each has the potential to provide exciting returns and excruciating losses, so stay tuned.

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/stalking-the-tenbagger-20100219-okuj.html

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

http://www.businessday.com.au/business/which-pigeon-hole-for-telstra-20100217-ocap.html

Lessons Learned From Investing Genius Peter Lynch

Lessons Learned From Investing Genius Peter Lynch

by: Wade Slome February 24, 2010

Those readers who have frequented my Investing Caffeine site are familiar with the numerous profiles on professional investors of both current and prior periods (See Profiles). Many of the individuals described have a tremendous track record of success, while others have a tremendous ability of making outrageous forecasts. I have covered both. Regardless, much can be learned from the successes and failures by mirroring the behavior of the greats, not much different than modeling your golf swing after Tiger Woods (O.K., since Tiger is out of favor right now, let’s say Phil Mickelson). My investment swing borrows techniques and tips from many great investors, but Peter Lynch (ex-Fidelity fund manager), probably more than any icon, has had the most influence on my investing philosophy and career as any investor. His breadth of knowledge and versatility across styles has allowed him to compile a record that few, if any, could match – outside perhaps the great Warren Buffett.

Consider that Lynch’s Magellan fund averaged +29% per year from 1977 – 1990 (almost doubling the return of the S&P 500 index for that period). In 1977, the obscure Magellan Fund started with about $20 million, and by Lynch's retirement the fund grew to approximately $14 billion. Cynics believed that Magellan was too big to adequately perform at $1 billion, $2B, $3B, $5B and then $10B, but Lynch ultimately silenced the critics. Despite the fund’s gargantuan size, over the final five years of Lynch’s tenure, Magellan outperformed 99.5% of all other funds, according to Barron’s. How did Magellan investors fare in the period under Lynch’s watch? A $10,000 investment initiated when he took the helm would have grown to roughly $280,00 by the day he retired. Not too shabby.

Background

Lynch graduated from Boston College in 1965 and earned a Master of Business Administration from the Wharton School of the University of Pennsylvania in 1968. Like the previously mentioned Warren Buffett, Peter Lynch shared his knowledge with the investing masses through his writings, including his two seminal books One Up on Wall Street and Beating the Street. Subsequently, Lynch authored Learn to Earn, a book targeted at younger, novice investors. Regardless, the ideas and lessons from his writings, including contributing author to Worth magazine, are still transferrable to investors across a broad spectrum of skill levels, even today.

The Lessons of Lynch

Although Lynch has left enough financially rich content to write a full-blown textbook, I will limit the meat of this article to lessons and quotations coming directly from the horse’s mouth. Here is a selective list of gems Lynch has shared with investors over the years:

Buy within Your Comfort Zone: Lynch simply urges investors to “Buy what you know.” In similar fashion to Warren Buffett, who stuck to investing in stocks within his “circle of competence,” Lynch focused on investments he understood or on industries he felt he had an edge over others. Perhaps if investors would have heeded this advice, the leveraged, toxic derivative debacle occurring over previous years could have been avoided.

Do Your Homework: Building the conviction to ride through equity market volatility requires rigorous homework. Lynch adds,

A company does not tell you to buy it, there is always something to worry about. There are always respected investors that say you are wrong. You have to know the story better than they do, and have faith in what you know.

Price Follows Earnings: Investing is often unnecessarily made complicated. Lynch fundamentally believes stock prices will follow the long-term trajectory of earnings growth. He makes the point that

People may bet on hourly wiggles of the market, but it’s the earnings that waggle the wiggle long term.

In a publically attended group meeting, Michael Dell, CEO of Dell Inc. (DELL), asked Peter Lynch about the direction of Dell’s future stock price. Lynch’s answer:

If your earnings are higher in 5 years, your stock will be higher.

Maybe Dell’s price decline over the last five years can be attributed to its earnings decline over the same period? It’s no surprise that Hewlett-Packard’s (HPQ) dramatic stock price outperformance (relative to Dell) has something to do with the more than doubling of HP’s earnings over the same time frame.

Valuation & Price Declines:

People concentrate too much on the P (Price), but the E (Earnings) really makes the difference.

In a nutshell, Lynch believes valuation metrics play an important role, but long-term earnings growth will have a larger impact on future stock price appreciation.

Two Key Stock Questions: 1) “Is the stock still attractively priced relative to earnings?” and 2) “What is happening in the company to make the earnings go up?” Improving fundamentals at an attractive price are key components to Lynch’s investing strategy.

Lynch on Buffett: Lynch was given an opportunity to write the foreword in Buffett’s biography, The Warren Buffett Way. Lynch did not believe in “pulling out flowers and watering the weeds,” or in other words, selling winners and buying losers. In highlighting this weed-flower concept, Lynch said this about Buffett:

He purchased over $1 billion of Coca-Cola (KO) in 1988 and 1989 after the stock had risen over fivefold the prior six years and over five-hundredfold the previous sixty years. He made four times his money in three years and plans to make a lot more the next five, ten, and twenty years with Coke.

Hammering home the idea that a few good stocks a decade can make an investment career, Lynch had this to say about Buffett:

Warren states that twelve investments decisions in his forty year career have made all the difference.

You Don’t Need Perfect Batting Average: In order to significantly outperform the market, investors need not generate near perfect results. According to Lynch,

If you’re terrific in this business, you’re right six times out of 10 – I’ve had stocks go from $11 to 7 cents (American Intl Airways).

Here is one recipe Lynch shares with others on how to beat the market:

All you have to do really is find the best hundred stocks in the S&P 500 and find another few hundred outside the S&P 500 to beat the market.

The Critical Element of Patience: With the explosion of information, expansion of the internet age, and the reduction of trading costs has come the itchy trading finger. This hasty investment principle runs contrary to Lynch’s core beliefs. Here’s what he had to say regarding the importance of a steady investment hand:

*“In my investing career, the best gains usually have come in the third or fourth year, not in the third or fourth week or the third or fourth month.”

*“Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.”

*“Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100% correlation between the success of a company and the success of its stock. It pays to be patient, and to own successful companies.”

*“The key to making money in stocks is not to get scared out of them.”

Bear Market Beliefs:

I’m always more depressed by an overpriced market in which many stocks are hitting new highs every day than by a beaten-down market in a recession,

says Lynch. The media responds in exactly the opposite manner – bear markets lead to an inundation of headlines driven by panic-based fear. Lynch shares a similar sentiment to Warren Buffett when it comes to holding a glass half full view in bear markets.

Market Worries: Is worrying about market concerns worth the stress? Not according to Lynch. His belief:

I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.

Just this last March, Lynch used history to drive home his views:

We’ve had 11 recessions since World War II and we’ve had a perfect score — 11 recoveries. There are a lot of natural cushions in the economy now that weren’t there in the 1930s. They keep things from getting out of control. We have the Federal Deposit Insurance Corporation [which insures bank deposits]. We have social security. We have pensions. We have two-person, working families. We have unemployment payments. And we have a Federal Reserve with a brain.

Thoughts on Cyclicals: Lynch divided his portfolio into several buckets, and cyclical stocks occupied one of the buckets.

Cyclicals are like blackjack: stay in the game too long and it’s bound to take all your profit,

Lynch emphasized.

Selling Discipline: The rationale behind Lynch’s selling discipline is straightforward – here are some of his thoughts on the subject:

*“When the fundamentals change, sell your mistakes.”

*“Write down why you own a stock and sell it if the reason isn’t true anymore.”

*“Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”

Distilling the genius of an investing legend like Peter Lynch down to a single article is not only a grueling challenge, but it also cannot bring complete justice to the vast accomplishments of this incredible investment legend. Nonetheless, his record should be meticulously studied in hopes of adding jewels of investment knowledge to the repertoires of all investors. If delving into the head of this investing mastermind can provide access to even a fraction of his vast knowledge pool, then we can all benefit by adding a slice of greatness to our investment portfolios.


http://seekingalpha.com/article/190389-lessons-learned-from-investing-genius-peter-lynch