“One Up On Wall Street” by Peter Lynch goes into great detail about what kind of stocks to choose. In general, Peter thinks that big companies tend to make small moves and vice versa. Therefore, spotting what he called a “ten bagger,” or a stock that has increased in value ten times, is more likely to occur in a small company with a market capitalization of less than $10 billion.
Peter Lynch has also divided businesses into six general categories, which have their own unique characteristics. Based on these six categories, investors will be able to know the reason why they are investing in such companies and therefore the expected return on each type of company. The six general categories are: slow growers, mainstays, fast growers, cyclicals, asset plays, and turnarounds.
Slow Producers – As the name suggests, these are the type of businesses that grow slowly, barely above the nation’s gross domestic product. Slow growth exists for two reasons. On the one hand, they developed rapidly during their first years and had saturated the market, or on the other hand, they did not fully exploit their opportunities. The book names utilities as slow producers. During the 1950-1970 period, however, they grew rapidly. As electricity consumption increased (people installed air conditioners, electric heaters, refrigerators, etc.), electricity consumption increased and so did their growth rates. It doesn’t happen anymore. Thus, a business will inevitably become slow growing. A fast producer of the past will be the slow producer of tomorrow. Examples of industries in this category: railroads, aluminum, steel, chemicals, soft drinks.
Faithful – They are not fast growers and yet they grow faster than slow growers. Most pillars are huge companies with huge cash flow production. Due to their huge size, the pillars do not move much and Peter always tries to make a profit whenever its value has increased by 30-50% in a short time. Some mainstays include: Procter & Gamble, General Electric, Bristol Myers and Kellogg.
Fast Producers – It’s all in the name. These categories are for companies that have high growth rates. This is where the potential of the ten baggers lies. The other five categories won’t give you as much of a chance of finding your next ten baggers. Fast Growers is not necessarily part of the fast growing industry. It can grow quickly in a slow growing industry. For example: WalMart in the retail sector, Marriott in the 2% growth hospitality industry, Anheuser-Busch in a slow growing beer market or Taco Bell in a not so fast fast food industry. There are, however, many risks involved in investing in fast-growing producers. The trick is figuring out how much to pay for them and when they will stop growing, because eventually the party is over.
Cyclic – Not all businesses can consistently profit all the time on all occasions. Typically, cyclical earnings rise and fall in a regularly predictable fashion, most often moving in tandem with the economy. Companies that can be considered cyclical are: airlines, automotive, defense companies or chip industries. For defense companies, it’s cyclical not relative to the economy but rather relative to White House politics. For chip industries, it is cyclical with the upgrade cycle of computers. Timing is everything in cyclics. Unlike other categories, Peter avoids cyclicals that are trading at a low P/E, which usually means the cycle is currently at its peak. While this rule of thumb doesn’t work 100%, it does work quite well to avoid picking cyclical companies that drop even lower.
Turnarounds – These are high risk, high reward prepositions. Typically, there are specific issues plaguing the business. Moreover, if the company fails to fix this particular mess, it will likely end up in bankruptcy court. Despite this, there are several compelling reasons to invest in a turnaround. One, of course, is the reward. Once the issue is resolved and resolved, the stock price will rise sharply to trade in line with the valuation of its peers. The other beneficial factor of investing in a turnaround is that it is the least likely to be affected by the general state of the market. The market goes up, the rally can stay low and vice versa. A recent example of a turnaround might be Altria (MO) in the early 2000s. Faced with hundreds of billions in lawsuits from smokers, the stock price has sunk so low you can buy it at 5 times the earnings and 10% dividend yield. Altria also had a stable subsidiary of Kraft and Miller (which was later sold). Turnaround investors will see if the lawsuit problem can be resolved, then investing in Altria will be handsomely rewarded. Sure enough, the lawsuit problems are diminishing and its share price has quadrupled since then. Of course, turnarounds aren’t always successful. The bankruptcy of K-Mart is another past example.
Asset sets – This is the type of business that normally has a hidden asset that is not obviously on its balance sheet. All assets must be on the balance sheet, of course. But the Asset Play company often does not list its asset at market value. For example, the value of real estate which is depreciated according to the current accounting rule. During this time, the land itself will most likely be worth more than its purchase price. Also, a company that has huge tax losses carried forward is considered an asset.
That’s it. All six classes of shares according to Peter Lynch. I hope that didn’t put you into a deep sleep. As boring as this may sound, it will be a valuable lesson that will make your investment journey much more exciting and worthwhile.