•The Peter Lynch Approach to Investing
in "Understandable" Stocks
•No
modern-day investment "sage" is better known than Peter Lynch.
•Not
only has his
investment approach successfully passed the real-world performance test, but he
strongly believes that individual investors have a distinct advantage over Wall
Street and large money managers when using his approach.
•The Peter Lynch Approach to Investing
in "Understandable" Stocks
•Individual
investors, he feels, have
more flexibility in
following this basic approach because they are unencumbered by
bureaucratic rules and short-term performance concerns.
•The Peter Lynch Approach to Investing
in "Understandable" Stocks
•Mr. Lynch developed his
investment philosophy at Fidelity Management and Research, and gained
his considerable fame managing Fidelity’s Magellan Fund.
•The
fund was among the
highest-ranking stock funds throughout Mr. Lynch’s tenure, which
began in 1977 at the fund’s launching, and ended in 1990, when Mr. Lynch
retired.
•The Peter Lynch Approach to Investing
in "Understandable" Stocks
•Peter
Lynch’s approach is strictly
bottom-up,
with selection from among companies with
which the investor is familiar, and then through fundamental analysis that emphasizes a thorough
understanding of the company, its prospects, its competitive environment, and whether the
stock can be purchased at a reasonable price.
•The Peter Lynch Approach to Investing
in "Understandable" Stocks
•His
basic strategy is detailed in his best-selling book "One
Up on Wall Street" [Penguin Books paperback, 1989], which provides
individual investors with numerous guidelines for adapting and implementing his
approach.
•His
most recent book, "Beating the
Street" [Fireside/Simon & Schuster paperback, 1994], amplifies the theme
of his first book, providing examples of his approach to specific companies and
industries in which he has invested.
•These
are the primary sources for this article.
•The Philosophy: Invest in What You Know
•Lynch
is a "story"
investor.
•That
is, each stock
selection is based on a well-grounded
expectation concerning
the firm’s growth prospects.
•The
expectations are
derived from the company’s "story"--what it is that the
company is going to do, or what it is that is going to happen, to bring about
the desired results.
•The Philosophy: Invest in What You Know
•The
more familiar you are with a company, and the better
you understand its
business and competitive environment, the better your
chances of finding a good "story" that will actually come true.
•The Philosophy: Invest in What You Know
•For
this reason, Lynch is
a strong advocate of investing in companies with
which one is familiar, or whose products or
services are relatively easy to understand.
•Thus, Lynch says he would
rather invest in "pantyhose rather than
communications satellites," and "motel
chains rather than fiber optics.”
•The Philosophy: Invest in What You Know
•Lynch
does not believe in restricting investments to any one
type of stock.
• His "story"
approach,
in fact, suggests the opposite, with investments in firms with various reasons for
favorable expectations.
•The Philosophy: Invest in What You Know
•In
general, however, he
tends to favor small, moderately fast-growing companies that can
be bought at a reasonable price.
•
•Selection Process
•Lynch’s
bottom-up approach means that prospective stocks must be picked
one-by-one and
then thoroughly investigated--there is
no formula or screen that
will produce a list of prospective "good stories.”
•Selection Process
•Instead, Lynch suggests that
investors keep alert for possibilities based on their own
experiences--for
instance, within their own business or
trade, or as consumers
of products.
•Selection Process
•The
next step is to
familiarize yourself thoroughly with the company so that you can form
reasonable expectations concerning the future.
•Selection Process
•However, Lynch does
not believe that investors can predict actual growth rates, and he is skeptical
of analysts’ earnings estimates.
•Selection Process
•Instead, he suggests that you
examine the company’s plans--how does it intend to increase its earnings, and how
are those intentions actually being fulfilled?
•Selection Process
•Lynch
points out five
ways in which a company
can increase earnings:
1.It can reduce costs;
2.raise prices;
3.expand into new markets;
4.sell more
in old markets;
or
5.revitalize,
close, or sell a losing operation.
•Selection Process
•The company’s plan to increase earnings and
its ability to fulfill that plan are its "story," and the more
familiar you
are with the firm or industry, the better edge you have in
evaluating the company’s plan, abilities, and any potential pitfalls.
•Selection Process
•Categorizing
a company, according
to Lynch, can help you develop the "story" line, and thus come
up with reasonable expectations.
1. He
suggests first categorizing a company by size. Large companies
cannot be expected to grow as quickly as smaller companies.
2.Next, he suggests categorizing a
company by "story" type, and he identifies six.
•Selection Process
•Next, he suggests
categorizing a company by "story" type, and he identifies six:
1.Slow Growers
2.Stalwarts
3.Fast-Growers
4.Cyclicals
5.Turnarounds
6.Asset opportunities
•Slow
Growers
•Slow
Growers: Large and
aging companies expected to grow only slightly
faster than the U.S. economy as a whole, but often paying large regular
dividends.
•These
are
not among his favorites.
•Stalwarts
•Stalwarts: Large
companies that
are still able to grow, with annual earnings
growth rates of around 10% to 12%; examples include Coca-Cola, Procter & Gamble, and
Bristol-Myers.
•If
purchased at a good
price, Lynch says he expects good but not enormous returns--certainly
no more than 50% in two years and possibly less.
•Lynch
suggests rotating among the companies, selling when
moderate gains are reached, and repeating the process with others that haven’t
yet appreciated.
•These
firms also offer
downside protection during recessions.
•Fast-Growers
•Fast-Growers: Small,
aggressive new firms
with annual earnings growth of 20% to 25% a year.
•These
do not have to be in fast-growing industries, and in fact Lynch prefers
those that are not.
•Fast-growers
are among
Lynch’s favorites,
and he says that an investor’s biggest gains will come from
this type of stock.
•However, they also carry
considerable risk.
•Cyclicals
•Cyclicals: Companies in which sales
and profits tend
to rise and fall in somewhat predictable patterns based
on the economic cycle;
examples include companies in the auto industry, airlines and steel.
•Lynch
warns that these firms can be mistaken for stalwarts by inexperienced
investors, but
share prices of cyclicals can drop dramatically
during hard times.
•Thus, timing is crucial
when investing in these firms, and Lynch says that investors must learn to detect
the early signs that business is starting to turn down.
•Turnarounds
•Turnarounds:
Companies that have been battered down or
depressed--Lynch
calls these "no-growers"; his examples include Chrysler, Penn Central and
General Public Utilities (owner of Three Mile Island).
•The
stocks of successful turnarounds can move
back up quickly,
and Lynch points out that of all the categories, these upturns are least
related to the general market.
•Asset
opportunities
•Asset
opportunities: Companies that have assets that Wall
Street analysts and others have overlooked.
•Lynch
points to several general areas where asset plays can often be found--metals
and oil, newspapers and TV stations, and patented drugs.
•However,
finding these hidden assets requires a real working
knowledge of the company that owns the assets, and Lynch points out
that within this category, the "local"
edge--your own knowledge
and experience--can be used to greatest advantage.
•Selection Criteria
•Analysis is
central to Lynch’s approach.
•In
examining a company,
he is seeking to understand the firm’s
business and prospects, including any competitive
advantages,
and evaluate any potential pitfalls that may prevent the
favorable "story" from occurring.
•Selection Criteria
•In
addition, an investor
cannot make a profit if the story has a happy ending but the stock was
purchased at a too-high price.
•For
that reason, he
also seeks to determine reasonable value.
•Some Key Numbers Lynch suggests Investors examine
•Here
are some of the key numbers Lynch suggests investors examine:
1.Year-by-year earnings
2.Earnings growth
3.The price-earnings ratio
4.The price-earnings ratio relative to its historical average
5.The price-earnings ratio relative to the industry average
6.The price-earnings ratio relative to its earnings growth
rate
7.Ratio of debt to equity
8.Net cash per share
9.Dividends & payout ratio
10.Inventories
•Some Key Numbers Lynch suggests Investors examine
•Year-by-year
earnings: The
historical record of earnings should be examined for
stability and consistency.
•Stock
prices cannot deviate
long from the level of earnings, so the pattern of
earnings growth will help reveal the stability and strength of the company.
•Ideally, earnings
should move up consistently.
•Some Key Numbers Lynch suggests Investors examine
•Earnings
growth: The growth
rate of earnings should fit with the
firm’s "story"--fast-growers should have higher growth rates
than slow-growers.
•Extremely high levels of earnings growth rates
are not sustainable, but continued high growth may be factored into the price.
•A high level of growth
for a company and industry will attract a great deal of attention from both
investors, who bid up the stock, and competitors, who provide a more
difficult business environment.
•Some Key Numbers Lynch suggests Investors examine
•The
price-earnings ratio:
The earnings potential of a company is a primary determinant
of company value,
but at times the market may get ahead of itself and overprice a stock.
•The
price-earnings ratio helps
you keep your perspective, by comparing the current price to most recently reported
earnings.
•Stocks
with good prospects
should sell with higher price-earnings
ratios than stocks with poor
prospects.
•Some Key Numbers Lynch suggests Investors examine
•The
price-earnings ratio
relative to its historical average: Studying the pattern of price-earnings
ratios over a period of several years should reveal a level
that is "normal" for the company.
•This
should help you avoid
buying into a stock if the
price gets ahead of the earnings, or sends an early
warning that it may be time to take some profits in a stock you own.
•Some Key Numbers Lynch suggests Investors examine
•The
price-earnings ratio relative to the industry average: Comparing a company’s
price-earnings ratio to the industry’s may help reveal if
the company is a bargain.
•At
a minimum, it leads to questions as to why the company is
priced differently--is
it a poor performer in the industry, or is it just neglected?
•Some Key Numbers Lynch suggests Investors examine
•The
price-earnings ratio
relative to its earnings growth rate: Companies with better
prospects should
sell with higher price-earnings ratios, but the
ratio between the two can reveal bargains or overvaluations.
•A price-earnings ratio of half the level of
historical earnings growth is considered attractive, while relative ratios above 2.0 are
unattractive.
•For
dividend-paying stocks, Lynch refines this measure by adding
the dividend yield to the earnings growth [in other words, the price-earnings ratio divided by the
sum of the earnings growth rate and dividend yield]. With this modified technique, ratios above
1.0 are considered poor, while ratios below 0.5 are
considered attractive.
•Some Key Numbers Lynch suggests Investors examine
•Ratio
of debt to equity :
How much debt is on the balance sheet? A strong balance sheet provides
maneuvering room as the company expands or experiences trouble.
•Lynch
is especially wary
of bank debt,
which can usually be called in by the bank on demand.
•Some Key Numbers Lynch suggests Investors examine
•Net
cash per share: Net cash per share is calculated by adding the level of cash
and cash equivalents, subtracting long-term debt, and dividing the result by
the number of shares outstanding.
•High levels provide a support for the stock
price and indicate
financial strength.
•Some Key Numbers Lynch suggests Investors examine
•Dividends
& payout ratio: Dividends are usually paid by the larger companies, and
Lynch tends to prefer smaller growth firms.
•However,
Lynch suggests that investors who prefer dividend-paying firms should
seek firms with the ability to pay during recessions (indicated by a low
percentage of earnings paid out as dividends), and companies that have a
20-year or 30-year record of regularly
raising dividends.
•Some Key Numbers Lynch suggests Investors examine
•Inventories:
Are inventories piling up? This is a particularly
important figure for cyclicals.
•Lynch
notes that, for manufacturers or retailers, an inventory buildup
is a bad sign,
and a
red flag is waving when inventories grow faster
than sales.
•On
the other hand, if a company is
depressed, the
first evidence of a turnaround is
when
inventories start to be depleted.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•When
evaluating companies,
there are certain characteristics that Lynch finds particularly favorable.
These include:
•The
name is boring, the product or service is in a boring area, the company does
something disagreeable or depressing, or there are rumors of something bad
about the company--Lynch likes these kinds of firms because their ugly duckling
nature tends to be reflected in the share price, so good bargains often turn
up. Examples he mentions include: Service Corporation International (a funeral
home operator--depressing); and Waste Management (a toxic waste clean-up
firm--disagreeable).
•The
company is a spin-off--Lynch says these often receive little attention from
Wall Street, and he suggests that investors check them out several months later
to see if insiders are buying.
•The
fast-growing company is in a no-growth industry--Growth industries attract too
much interest from investors (leading to high prices) and competitors.
•The
company is a niche firm controlling a market segment or that would be difficult
for a competitor to enter.
•The
company produces a product that people tend to keep buying during good times
and bad--such as drugs, soft drinks, and razor blades--More stable than
companies whose product sales are less certain.
•The
company is a user of technology--These companies can take advantage of
technological advances, but don’t tend to have the high valuations of firms
directly producing technology, such as computer firms.
•There
is a low percentage of shares held by institutions, and there is low analyst
coverage--Bargains can be found among firms neglected by Wall Street.
•Insiders
are buying shares--A positive sign that insiders feel particularly confident
about the firm’s prospects.
•The
company is buying back shares--Buybacks become an issue once companies start to
mature and have cash flow that exceeds their capital needs. Lynch prefers
companies that buy their shares back over firms that choose to expand into
unrelated businesses. The buyback will help to support the stock price and is
usually performed when management feels share price is favorable.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
name is boring, the
product or service is in a boring area, the company does something disagreeable
or depressing, or there are rumors of something bad about the company--Lynch
likes these kinds of firms because their ugly duckling nature
tends to be reflected in the share price, so good bargains often turn up.
•Examples
he mentions include:
Service Corporation International (a funeral home operator--depressing); and Waste
Management (a toxic waste clean-up firm--disagreeable).
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
company is a spin-off--Lynch says these
often receive little attention from Wall Street, and
he suggests that investors check them out
several months later to see if insiders are buying.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
fast-growing company is in a no-growth
industry--Growth
industries attract too much interest from investors (leading to high prices)
and competitors.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
company is a
niche firm controlling
a market segment or that would be difficult for a
competitor to enter.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
company produces a
product that people tend to keep buying during good times and bad--such as drugs, soft
drinks, and razor blades--more
stable than companies
whose product sales are less certain.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
company is a user of technology--These companies can take
advantage of technological advances, but don’t tend to have the high valuations of firms
directly producing technology, such as computer firms.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•There
is a low
percentage of shares held by institutions, and there is low analyst coverage.
•Bargains can
be found among firms neglected by Wall Street.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•Insiders
are buying shares.
•A positive sign that insiders
feel particularly confident about the firm’s prospects.
•When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable.
•The
company is buying
back shares.
•Buybacks
become an issue once
companies start to mature and have cash flow that
exceeds their capital needs.
•Lynch
prefers companies that buy their shares back over firms
that choose to expand into unrelated businesses.
•The
buyback will help to support the stock
price and is usually
performed when management feels share price is favorable.
•Selection Criteria
•Characteristics
Lynch finds unfavorable are:
1.Hot stocks in hot
industries.
2.Companies
(particularly small firms) with big plans that have not yet been proven.
3.Profitable companies engaged in diversifying
acquisitions.
Lynch terms these "diworseifications."
4.Companies in which one customer accounts
for 25% to 50% of their sales.
•Portfolio Building and Monitoring
•As
portfolio manager of
Magellan, Lynch held as many as 1,400 stocks at one time.
•Although
he was successful in
juggling this many stocks, he does point to significant
problems of managing such a large number of stocks.
•Portfolio Building and Monitoring
•Individual
investors, of course,
will get nowhere near that number, but he is wary of
over-diversification
just the same.
•There
is no
point in diversifying just for the sake of diversifying, he argues,
particularly if it means less familiarity with
the firms.
•Portfolio Building and Monitoring
•Lynch
says investors should
own however many "exciting prospects" that they
are able to uncover that pass all the tests of research.
•Portfolio Building and Monitoring
•Lynch
also suggests investing in several categories of stocks
as a way of spreading the downside risk.
•On
the other hand, Lynch
warns against investment in a single stock.
•Portfolio Building and Monitoring
•Lynch
is an advocate of
maintaining a long-term commitment to the stock market.
•He
does not favor market timing, and indeed feels
that it is impossible to do so.
•Portfolio Building and Monitoring
•But
that doesn’t
necessarily mean investors
should hold onto a single stock forever.
•Instead, Lynch says
investors should review their holdings every few months, rechecking the
company "story" to see if anything has
changed either
with the unfolding of the story or with
the share price.
•Portfolio Building and Monitoring
•The
key
to knowing when to sell, he says, is knowing "why you bought it in the
first place.”
•Portfolio Building and Monitoring
•Lynch
says investors should sell if:
1.The story has played out
as expected and
this is reflected in the price; for instance, the price of a stalwart has gone up as
much as could be expected.
2.Something in the story fails to
unfold as expected or
the story changes, or fundamentals
deteriorate;
for instance, a cyclical’s
inventories start to build, or a smaller firm enters
a new growth stage.
•Portfolio Building and Monitoring
•For
Lynch, a
price drop is an opportunity to buy more of a good prospect at cheaper
prices..
•Portfolio Building and Monitoring
•It
is much
harder, he says, to stick with a winning stock once the price goes up, particularly with fast-growers where the tendency
is to sell
too soon rather than too late.
•With
these firms, he suggests holding on
until it is clear the firm is entering a different growth stage.
•Portfolio Building and Monitoring
•Rather
than simply selling a
stock, Lynch suggests "rotation“ -- selling the company and replacing
it with another company with a similar story, but better
prospects.
•The rotation
approach maintains the investor’s long-term commitment to the stock market, and keeps the focus
on fundamental value.
•
•Summing It Up
•Lynch
offers a practical
approach that
can be adapted by many different types of investors, from those
emphasizing fast growth to those who prefer more stable, dividend-producing
investments.
•His
strategy involves
considerable hands-on research, but his books provide lots of practical
advice on what
to look for in an individual firm, and how to view the
market as a whole.
•Summing It Up
•Lynch
sums up stock
investing and his outlook best:
"Frequent follies
notwithstanding, I continue to be optimistic about America, Americans, and
investing in general. When
you invest in stocks, you have to have a basic faith in human nature, in
capitalism, in the country at large, and in future prosperity in general. So far, nothing’s
been strong enough to shake me out of it."
•
•
•http://www.csulb.edu/~pammerma/fin382/screener/lynch.htm
•
•AAII Journal - January 1997
•By Maria Crawford Scott
•Maria Crawford Scott is editor of the AAII Journal.
