>>> Peter Lynch’s 6 Categories Tool» To Find The Best Stocks To Buy
With instructions on when to sell them too
https://medium.datadriveninvestor.com/peter-lynchs-6-categories-tool-to-find-the-best-stocks-to-buy-abb5e0466db4
Peter Lynch is one of the greatest value investors out there, and thanks to his Magellan Fund he has beaten the market for over 20 years. Not only that, but he also wrote an amazing investing book called “One Up On Wall Street”.
In this amazing book, he talks about investing and the stock market, focusing in particular on how to find investment ideas and good stocks to buy. Because, as he puts it,
“Investing without research is like playing stud poker and never looking at the cards”
One of the main points of the novel is that according to him, the best way to approach stocks is to categorize them into six predefined categories — a breakdown should give an investor a clear indication of whether something is a buy, sell, hold, or stay-away-stock. So, here are the different categories and how to use them.
Slow Growers: Just Avoid Them
Starting off with a bold claim, Peter Lynch believes that companies with very slow revenue growth are straight-up stocks to avoid.
Not only that, but he says everyone should also avoid those stocks that might end up in this category soon (even if they’re currently not). This is because it never looks nice for investors when this happens, just like Netflix and IBM show.
Here are a few things that slow growers tend to have in common:
Generous and regular dividends, plus buybacks. Most slow-growth stocks usually have a relatively high payout ratio, meaning they pay out most of the profits since they don’t have any growth to reinvest for.
Flat earnings, and sometimes a flat stock chart too. Slow-growth stocks tend to have flat earnings over the long term, and sometimes even a stock chart. Not always though, since stocks can still move with multiple expansions and contractions (the P/E might go from 10 to 20 and vice versa).
Strangely high payout ratio and mid-to-high debt: if the company has a high payout ratio with growing dividends and flat profits, the risk is that they might pay out in dividends more than they can afford. Just look at McDonald’s, using debt to sustain the dividend.
Finally, keep in mind that all of this is not to say that slow growers can’t move or make their investors money. They can indeed, but it’s so rare that Lynch believes you should avoid them altogether.
Stalwart Stocks: Good Recession Protection
The second category is that of stalwarts stocks. These are businesses that grow nicely, but not enough to be considered a growth stock essentially (8-12% stable earnings growth is what defines them for Lynch). And the second necessary condition is that these companies are not in a sector that completely melts down during a recession. Think pharmaceuticals, for example.
With these stocks, to make good profits you need to time your purchase well over the cycle. In fact, Lynch says that if a stalwart goes up 50–100% in two or three years after you buy it, you might want to take profits before it’s too late.
Great examples are Bristol Myers Squibb and 3M. They have been growing their revenue at roughly 8% a year over the decade, and their investors have made decent returns. But these people also didn’t make life-changing money, they just made normal returns. These stocks have only managed to double over a decade, which might seem great but is actually just 7% per year. This is why Lynch tells his readers to buy these companies only when the risk of a recession starts to become real. Because perhaps the most important thing is that over the great recession, these stocks were flat. They remained stable during the years in which everything fell by more than 50%.
This is why they are great for recession protection — because they don’t do wonders in regular times, but they usually pull through better than others during recessions. The key is to find a few well-priced ones that have done well in past recessions.
There are two things to look out for though. These are envy, and mergers and acquisitions: Lynch warns investors to be careful about the management of big stable companies essentially. He says that sometimes CEOs tend to be jealous of fast-growing companies, so they do something stupid and this usually ends up hurting investors (like AT&T with Warner Media).
His Favorite Stocks: The Fast Growers
Next up is Lynch’s favorite category: those companies that grow at 20% or more per year. The author here is referring to the land of the 10-to-40-baggers essentially, the Amazons and Apples of the future. Those stocks that you buy and never even think of selling because they are true long-term compounders.
These stocks do not have to belong to a fast-growing industry, all they have to do is have the room to expand in a slow industry. Starbucks for example was a fast grower in the 1990s and 2000s that has now turned into a stalwart: those that invested in the 1990s ended up with a 20-bagger, whereas those that invested later did still good, but not as good.
I don’t really think there’s much more to say about growth stocks, if not about their price. Lynch says that to make a good return on your money, you should always buy them with a P/E Ratio below the growth rate. A 30% growth allows for a P/E of 30 for example, but nothing more if you want to make real money.
Here’s what else you can expect from fast growers:
If growth slows down, the market doesn’t like it and you end up with a Stalwart or Slow Grower — which is a whole different story.
Look for good balance sheets making substantial profits from the start, not unprofitable ventures.
Figure out when they’ll stop growing and how much to pay for growth. Because at some point, they will for sure stop growing and turn into something else.
Check how much more room for growth there is. 20 to 25 percent is the best growth rate, whereas businesses with 50% growth will probably attract many competitors or not last forever.
Look for companies with proven and profitable expansion in more than one city or country. Possibly those that few have heard of in general.
The Cyclicals
Cyclical stocks are those that follow the economy and/or their respective sector. Automotive, airlines, steel, chemical, travel etc. are all cyclical companies. Ford is the perfect example, as it goes down with every recession and up with every boom (it’s currently down again on the expectation that there will be a recession soon).
As you can see, these stocks are not a bad buy if you do it at the right time. Those who bought in 1989 have had a 10x over a decade, and the same goes for 2009. But those who bought at the wrong time essentially lost their money going into a recession. Timing is really the key here:
These stocks flourish when the economy turns good again, but suffer when there is no economic growth. They usually decline when peak earnings are reached and investors expect the next recession (like today).
50 or 75% drops are normal if you buy at the wrong part of the cycle. And you might have to wait years before seeing another upswing, just like Ford which is down ever since 2013.
Timing is everything — watch for inventories, economic growth, interest rates and also for new market entrants in the sector.
Know your Cyclical and figure out the cycles for each sector you are buying these stocks in. Within the car industry, 3 to 4 bad years are usually followed by 3 to 4 good years, but that’s not a universal thing.
The worse the slump, the better the recovery. But it’s also much easier to predict an upturn than a downturn in the industry.
Turnarounds: Buy Only With Maximum Certainty
Turnaround stocks are companies that are deemed as “doomed” by the market, but that might not actually be as bad as everyone thinks. Therefore, the investment thesis with these ones is that the market is being overly pessimistic.
About these stocks, Lynch essentially says you should watch carefully for the moment in which bankruptcy fears ease and the stock explodes as investors re-evaluate earnings and potential (in other words, to look for a catalyst). The problem with these stocks is that you have to be certain that bankruptcy won’t happen, or else you lose your money.
You also need to understand whether the issues are as big as perceived by the market or not, and also remember what Warren Buffett says about these companies: “turnarounds almost never turn around”.
The Asset Plays
Finally, an asset play is a company sitting on something valuable that the market is overlooking. Or even one with a good asset that hasn’t yet started to print cash, which is therefore not baked into the price of the stock.
This asset can be cash, real estate, inventory, even accounting losses, the number of users, etc. For example, during the 2020 crash, there were REITs trading for cents on the dollar when you looked at the value of the assets.
But of course, it’s not as easy as it may seem:
You must know the asset well
You must have the patience to wait until the value unlocks
You must always look at the debt, just like you look for hidden assets.
Finally, check if the management is making or destroying value for the shareholders. If they’re doing well, the value will probably be recognized soon, if not you might have to wait a while.
How To Use The Above Categories
About using this list, in the book, Lynch says that every investor should always categorize each company and find out what kind of stock it is, then closely follow it and only after a while making investment decisions. Or at least, this is what he did to beat the market for two decades.
Of course, if you’d like to know more about these categories, you should definitely go read the amazing book “One Up On Wall Street”. It’s probably the most undervalued investing book out there.
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