” Behind every stock is a company. Find out what its doing.” Quote by Peter Lynch
Peter Lynch managed the Fidelity Magellan Fund from 1977 to 1990 and achieved an impressive return which reportedly averaged over 20% per year.
While Peter Lynch utilized several different strategies, he is most famous for his stock picking skills with small-cap growth stocks.
Peter was a master at picking the smaller capitalized companies which would ultimately lead to massive growth and correspondingly massive capital gains.
He was a somewhat contrarian investor who bought into companies when no one else was interested.
With a long-term view he patiently waited for the company to become recognized by Wall Street for its growth, which subsequently unleashed an explosive rise in its stock price as institutions scrambled to buy stock.
Since Peter Lynch was a mutual fund manager looking at fairly illiquid small-cap stocks, his tactic was to accumulate stock quietly and unnoticed without any competition from other fund managers – he liked to get in before the crowd.
His main strategy was to find small companies which were financially sound with significant proven earnings growth and get in before the crowd.
Peter had high expectations for his selected stock picks and his target was to make a capital gain of at least ten times his average purchase price – he referred to a stock which rose ten times as a ten-bagger.
The strategies utilized by Peter Lynch are depicted in his book One Up On Wall Street.
Six General Categories of Stocks
Peter Lynch places his stock purchases into one of six general categories:
General categories:
- Slow growers are usually large-cap stocks which grow their earnings at the same rate as the general economy as measured by the Gross Domestic Product (GDP). These stocks usually pay dividends and Peter likes to buy when they provide a reasonable dividend yield.
- Stalwarts are the medium growth stocks growing their earnings at around 10% and Peter may buy these at the right price.
- Fast growers are the higher growth stocks growing at 20% plus. These are usually small-cap stocks and Peter’s main focus – these are his ten-baggers.
- Cyclicals are stocks where their growth expands then contracts then expands again. Peter may buy if he can get in early in the cycle.
- Asset plays are companies with lots tangible assets with little or no earnings growth. Peter likes to buy these if the true value of the assets is greater than that recorded on the balance sheet statement.
- Turn-arounds are financial troubled companies that are fixing their problems. Peter may buy companies with strong balance sheets.
Small-caps in a no-growth Industry
Peter Lynch’s preferred category was the Fast growers.
He likes the small-cap stocks since the biggest price moves come from the smaller companies as they can more readily increase their earnings.
He prefers a fast growing stock that is not in a fast growing industry. This is so that the company can more easily increase its market share.
In a fast growing industry all the other stocks are growing as well due to the industry – they are not growing because of the company itself. He likes the low or no growth industries since the high growth industry will stall sooner or later which increases risk.
The high growth industry is a higher risk because it attracts competitors wanting in on action.
These new competitors striving for their market share increases the risk of them undercutting prices – which is detrimental to the earnings growth of the selected stock. With a no growth industry there is not much risk of new competition since the industry in unattractive.
Company Research
Peter accepts tips, rumors etc. from industry insiders and uses these as a starting point for further evaluation.
He particularly likes stocks which have bad rumors or undesirable rumors. Peter Lynch always thoroughly researches any prospective company and learns as much as he can about company.
He likes stocks which the institutions don’t own or only have a small holding in.
Analysts only follow the larger popular stocks and Peter Lynch likes the smaller stocks which the analysts don’t follow.
As managerial ability is difficult to access, Peter Lynch spent a lot of time visiting these small companies and talking to key employees about their operations, how they were managing it and their future strategic plans.
Peter Lynch likes companies where their key employees are buying stock in the company they work for.
Since they own a lot of stock their priority is with the stock price rather than being focused on increasing their salary.
When their priority is with the stock price, they are more likely to make managerial decisions which will increase the company’s earnings, rather than trying to justify why their salaries should increase.
The Simple Business
Peter Lynch was a master at the art of stock picking and had a simple no nonsense approach. He only considered businesses which he could relate to, with simple products or services.
This was similar to Warren Buffett and Peter would only look for small-caps with businesses which he understood. Peter liked simple businesses which can be run by anyone without any special industry specific knowledge.
He prefers boring type companies with a simple business and a boring name. Good companies with a dull and boring name tend to keep buyers away.
This was exactly what Peter Lynch was after – being a fund manger he had to acquire a lot of shares and this was considerably easier to do if he did not have any competition from other fund mangers.
The types of businesses fund managers tended to avoid included companies that make something boring or something people don’t want to know about or their product is depressing.
Peter liked to buy companies with a consumable product where people have to keep buying the same product.
He generally did not like technology businesses since the technology was quickly outdated and required constant expenditure to remain competitive.
He prefers businesses which are users of technology rather than manufacturers of technology.
Peter Lynch avoided companies where a large portion of their revenue is dependent on a contract with a large company.
The earnings of the smaller contracted company will be hit hard if the contract is canceled. Also the large company can force a lower cost when the contract is due for renewal.
Financial Strength – Earnings
Peter Lynch based his analysis on historical performance rather than forecasts and did not predict the future growth rate as he considered this to be nothing more than guessing.
He looked for smaller companies with a solid history of earnings growth that had not yet been noticed by Wall Street.
Peter determined the historical earnings growth rate over the last ten years and only bought when the PE ratio was less than the growth rate and preferred to buy when the PE ratio was half of growth rate.
He considered the stock to be overvalued once the PE ratio was twice the growth rate.
Exceptionally high growth rates were considered too risky for Peter Lynch and he preferred growth rates around 20% to 25% as these rates were more likely to be sustained in the long-term.
Peter Lynch liked free cash flow and looked for companies where the ratio of stock price to free cash flow was better than 10 to 1 and he particularly liked ratios of 5 to 1.
Financial Strength – Balance Sheet
Peter Lynch carefully checks the balance sheet statement and looks for cash and cash items to increase over the years and long-term debt reducing over the years – to peter this is a sign of prosperity.
He looked at a ten year history as he wanted proven performance.
Since smaller companies are higher risk, Peter Lynch looked for a strong balance sheet with cash and cash items greater than the long-term debt – which helps avoid bankruptcy anytime soon.
Peter’s view was that a company with no debt cannot go bankrupt.
He does not like to see cash and cash items shrinking and long-term debt increasing – he considered this a risky company which is in poor financial shape.
Peter Lynch looked for balance sheets which were better than 75% Equity and 25% Debt – he liked 90% Equity and 10% Debt – this is a sign of a strong balance with plenty of cash to weather any short-term problems.
Peter did not like a lot of debt – assets might be recorded with values that are too high compared to their liquidated value which effectively reduces the true net assets value.
A lower debt level provides a higher level of safety.
Peter did not like a lot of bank debt and instead preferred debt funded by long-term bonds. His reasoning was that banks can demand their money back whereas with bonds the principal only needs to be repaid at maturity.
Acquisitions and Share Buybacks
He prefers companies that do not need to spend money on capital expenditure – to maintain plant and equipment.
Companies that do not need to spend a lot of money on capital expenditures can use that money for other purposes such as reducing debt or share buybacks.
Peter Lynch generally avoids companies that use this money for acquisitions as he prefers that they grow their earnings through their own products or services by financing expansion or reducing debt.
Peter particularly likes to see share buybacks. Companies that buy back there own shares reduce the number of shares outstanding which increases the earnings per share.
He especially likes share buybacks during market corrections, crashes and bear markets.
Buying back shares during these times not only reduces the costs of the buyback but displays that management are focused on increasing stockholder wealth – something that the stock market rewards by paying higher stock prices.
Summary
Peter Lynch’s aim was to buy good quality companies that Wall Street has ignored.
These companies have strong earnings growth with solid balance sheets and sooner or later these growing companies are noticed by Wall Street and their stock price explodes.