You all know that Peter Lynch was the first investor that made the stock market make sense to me during childhood. He is one of the greatest investors of all time, having compounded the mutual fund he ran for 13 years at 20%+ annually, generating an absolute return of more than 1,000% for his shareholders. Lynch was a childhood hero to me in the same way Michael Jordan was to others. He wrote several books, but my favorite is One Up on Wall Street. I carried it with me to elementary school and, later, junior high almost every day so I could sneak another read when the teachers weren’t looking. Had he not written, it is very possible that you wouldn’t be reading this blog right now.
One of the Peter Lynch talks about in that book is the importance of first ranking stocks by how large or small they are in terms of market capitalization, and then dividing the stocks into six different categories. I talked about his ranking system a little bit in Not Every Investment is a Buy and Hold but the substance of his points are in Chapter 7 of the book, which you need to buy and read. There, Lynch said he divides stocks as follows:
- Slow Growers – Companies that expand at the basic rate of GDP and pay out almost all of their earnings as dividends, in many cases, because they have no better use for the cash
- Stalwarts – Companies that are high quality, can grow their earnings faster than GDP, and generate regular, consistent profits for owners, many of which pay out rich dividends or have big share repurchase plans. Stalwarts, like Bristol-Myers according to Peter Lynch, might be put away “for twenty years” and forgotten about as they grow. You aren’t going to get super-rich off of them unless you invest money regularly and have a lot of time.
- Fast Growers – These are the firms that can make a career. A single investment in an early Microsoft, Wal-Mart, Berkshire Hathaway, or McDonald’s could turn your original stake into a multi-million dollar fortune. Fast growers all eventually tire out and become another category. The firms I mentioned, for example, are stalwarts now.
- Cyclicals – A cyclical company makes a lot of money when the economy or its product cycle is good then bleeds losses or sees collapsed revenue when times get hard. Peter Lynch says you would never own a cyclical stock as a buy-and-hold position. Cyclicals are airlines, auto manufacturers, aluminum companies, etc.
- Turnarounds – These are companies that have fallen on hard times and are headed for bankruptcy court. In Warren Buffett’s words “turnarounds rarely turn”. If they do, they can generate huge profits but it takes special skill and experience to recognize situations that are hopeless and those that can be salvaged. Lynch says there are several types of turnaround stocks:
- Asset Plays – These are companies that Lynch says have huge hidden assets on the balance sheet. A company might be trading for $30 per share but have $200 per share in real estate that isn’t reflected in the financial statements due to the limitations of GAAP accounting rules. He talks about a company that traded for 12 cents a share in 1977 and increased 250-fold by 1988 to $31 because it owned a subscriber base of cable television customers that was an attractive target for competitors. That means a $10,000 investment would have grown to $2,500,000 in only ten years.
[mainbodyad]Peter Lynch talked a lot about his portfolio management style, mentioning that he held very few, if any, slower growers in his fund, but always liked to keep stalwart stocks on hand because they were great during recessions and if you bough them at the right price, could generate nice 50% to 60% moves over the years. He warns of how cyclicals are the easiest way to separate an inexperienced investor from his or her money because the company names sound like blue chips but they aren’t. They also look like they have really low p/e ratios at the height of an earnings cycle – sometimes only 3x or 4x earnings – right before they collapse.
Lynch retired at the height of his fame and career. He just walked away. Rumor is he has a fortune of $350 million or so, which he manages from a private office in Boston. He controls his time, does what he loves, and lives his life. It is just one more reason I have so much respect for him. He gets it.