One up on Wall Street

Peter Lynch is an author of "One up on wall street." But he is more well known as a former manager of the Fidelity Magellan Fund, which was the world's largest mutual fund. During his tenure, Magellan outperformed 99 % of all stock funds growing from $20 million to $14 billion. One of the core strategies of his investment is "circle of competence." He insists to know the nature of business as well as industry before he makes an investment. There are a plenty of sources to get information. You can talk to employees, competitors, suppliers, etc. More importantly, you as a consumer have a pretty good idea of what products/services are superior than the others. Lynch found Taco Bell by eating a burrito on a trip to California. He found La Quinta by talking to people at the rival Holiday Inn. He found apple computer when his children insisted on owning one. As simple as it might look, a good investment could be nothing more than a good buy at Walmart.
Once he finds the company he wishes to invest in, Lynch likes to organize his picks into 6 different categories, which are
1. Slow grower
2. Stalwarts
3. Cyclicals
4. Fast grower
5. Turnaround
6. Asset plays

Here's the explanations for each.

1. Slow growers are usually large in size and older companies that used to be small but matured and have stable performance. Example would be utility companies like AT&T, Verizon, National grids. Their capital appreciation would not be much. In fact, it could move downward but they usually pay good dividends.

2. Stalwarts are large and old but they have not matured yet and are still growing. In 1988, Warren Buffer allocated $1 billion to invest in Coca-Cola. By that time, Coca-Cola was well established company and its stock price has risen fivefold in 6 years. In fact, it had risen over 500 folds since 1928. Many investors thought it was over priced and had no more spaces to grow. Yet its business expanded internationally finding new markets and successfully set its position as a global king of beverage. In this case, Coca-Cola is a classic example of Stalwarts.

3. Cyclicals are companies that are heavily affected by economy. If economy does well, so does the company, vice versa.

4. Fast growers are small young companies that grew at least 20% or more a year and have potential to become ever bigger. This is where a massive fortune or risks can be found. Although they are no longer fast growers, Starbucks, Iomega and the Gap were all fast growers who returned massive fortune to founding-investor who provided initial capital.

5. Turnarounds are internally good, solid companies that have been beaten down by external factors/markets. In the early 80s, Lynch bought Chrysler at $1.50 and it became 32 beggers.

6. Asset plays are companies with valuable resources that are not discovered by investors. Pebble beach in California and Alico in Florida owned valuable real estates that no investors paid attention. Later on, those real estate value rocket soared. Another example would be telecommunication companies 20-30 years ago. Asset plays are most likely to be new tech companies, who have intelligent ideas/product that have potential to be an industry leader.

Note that Lynch's classification is to know what you are buying. To set out to buy a stalwart or actively looking for fast grower might be very difficult. Once you make a decision to make an investment, use those categories to know nature of a company and know your expectation. If the stock you are buying is turnaround, you know that its stock is undervalued and you should not be concerned with market fluctuation because your expectation is that market will realize the intrincsic value of the company and will bring its price back to what it should be.

Lynch points out several compenents of a good company. First, simple business is better. Lynch emphasizes an importance of understanding the business before making an investment. If you own 10 different stocks in your portfolio and 9 out 10 have complex nature such medical related, bio-tech or computer engineering, you probably don't have in-depth knowledge about the business and industry. Knowing your company and industry vital to investment success.
In addition, Lynch likes companies that are overlooked by others. Everyone likes fancy, flash companies with new tech but then again all the bubbles busted in the early 2000s. Seven Oaks International is one of the most boring businesses you will ever find. It processes grocery store coupons. While everyone else is looking for new high tech companies, Lynch invested in Seven Oaks and its stock price rose from $4 to $33, impressive retrn of 725%. Think about Waste management, as the name implies the company manages waste which is a bit digusting to some investors. This company turned out to be 100 bagger.
Fast-growing companies are best inside slow growth industry if not no growth at all. This is no brainer. If your company is the one and only, who is rapidly growing while competitors are off the market then it is an obvious advantage. Such growth comes from having a niche. That niche can be anything from a quality product/services to excellent management. But one common characteristic that all niches share is its uniqueness. To have patents, trademarks, strong brand loyalty, companies have valuable niches that competitors do not and it drives the growth of company along with the increase in sales and profit.
Lych, like other investment masters, have his own way of protection against stock. He computes his margin of safety by subtracting cash per share from stock's current price. In 1988, Ford's stock was trading at $38 and its cash per share was $16.30. This means his margin of safety is 38-16.30, which is 21.70. Until the stock price goes down to $21.70, you can withstand the loss because you bought your stock at a discount. Also, Lynch points out importance of having a little debt. Long term debts are like deadly. It is overlooked in good time but when situation turns around, those debt strick the company hard.
Lynch recommends valuing stock price relative to company's value. In more detail, Lynch likes his stock P/E ratio equal to its earning growth rate. If a company's P/E 20 then he wants to see earning growth rate of 20%. If the growth rate is greather than the P/E then you have a bargain.
One other thing that Lynch mentions is insider/company buying the shares. Insiders such as employees and executives are the ones who are most knowledgable about the company. If they are buying shares, then you know at least the company won't go bankruptcy in next 6 months. Plus, those who buy stocks are partial owner of the company and they will likely to put more effort in their works because performance of company is directly related to their welfare. Note that while insidering buying is a good sign, insiders selling their stocks is not necessarily a bad sign. There are many reasons to sell stocks. Stock is an investment but before that, it is nothing more than a part of your property. If you wishes to buy a new car, have some expenses coming up for your college kids, or planning an exotic vacation, you can always sell your stock to get quick cash. But then again, there is only one reason buy stock: you expect it to go up.
One top of that, company buying its shares back can be seen a positive sign. If it is expecting a better performance in the future and have a plenty of cansh in its hand, it actually might be a good investment to buy its shares back. Note that those companies listed on stock market are legal entites. They are quite different from sole proprieties, partnerships and LLCs. They are separate legal entities from owners and can sometimes act as an individual investor. When a company buys its shares back, all things being equal, there are less number of shares outstanding for general public. A shortage in supply will cause the stock price to increase. Also, decrease in shares outstanding means increase in EPS. If a company buys back half of its shares while earning reamins the same then EPS just doubled.
Lastly, Lynch advises investors to know why he/she is buying the stock. He calls it the 2 minutes drill. Before buying a stock, you give 2 minute speech that covers the reason why he's interested in the stock, what should happen to succeed and pitalfall standing in its path. In this case when price stock goes up or down, you can look back and rely on those reasons to make a new decision. Say you bought your stock because sales have increased 15% past 3 years and net income increased 10 % annually on the average past 5 years. That is the reason why you bought the stock. After the purchase, stock price declines by 10% and there are no changes in sales or net income. Should you sell the stock? probably not. If a company reports quarter income statement and both sales and net income declined by 20%. Due to that stock price declined by 30%, should you sell the stock? maybe. Wheter to hold it or sell it off because it violated the reasons for your purchase is up to you. The point here is that your decision to buy/sell stock should not be solely based on stock movement.


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