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