One Up on Wall Street - Peter Lynch on Investing

Peter Lynch, Magellan’s former fund manager, suggests that average investors who become experts in their own field can pick winning stocks effectively with a little research. Lynch looks to buy great companies that he believes the market has undervalued and underappreciated. This is a practical approach that many investors can learn from. His investment principles and methods are outlined in his book, One Up on Wall Street: How To Use What You Already Know to Make Money in the Market, which we review briefly below.

Jump ahead

Look for dull and boring stocks
Develop the company growth story
Categorise your investments to ask better questions
Review key financial ratios and numbers
Buy stocks in good companies at great prices
Manage noise and temperament
Further reading

Look for dull and boring stocks

Peter Lynch likes companies that sound dull, ridiculous, boring, depressing or unappealing. He likes spinoffs. He likes companies that institutions do not own, and analysts do not follow. He likes companies that have a niche, where people must keep buying its product and service, and is a user of technology. All this even if it is a no-growth industry.

Ownership and buybacks are good signals

He views company share buybacks and high employee and executive stock ownership as a positive signal. This is because rewarding shareholders becomes a priority when management owns a large amount of its company’s stock.

Conversely, Lynch is careful not to overreact to insider selling as this can occur for a variety of reasons. He may take notice however if most managers are selling most of their shares.

Avoid the long shots and hottest stocks

Peter Lynch prefers to avoid the hottest stock in the hottest industry; stocks that are heralded as the next big something; longshot companies at the cusp of solving the latest national problem; and stocks with the most exciting name. He also dislikes whisper stocks that attract imaginative, complicated and emotionally appealing stories.

Stocks that receive significant positive attention have greater risk of being over-bought and over-priced. High growth businesses in popular industries with low barrier to entry attracts a lot of competition and imitation. The underlying earnings and cashflows of these companies are often something left to be desired.

Beware bad acquisitions and the middleman

Lynch also avoids ‘diworseifications’. These are companies that consistently pursue acquisitions that are overpriced and beyond the acquirer’s realm of understanding.

Such corporations tend to alternate between ‘diworseification’ and restructuring. He may however look at an overpaid target or restructure that expects a successful turnaround. However, this can be difficult to foresee.

He is also wary of the ‘middleman’, which describes a company that sells most of its products or services to a single customer. This can sometimes become a risky position very quickly.

Peter Lynch is also wary initial public offerings of brand-new enterprises. New companies with limited information are inherently risky.

Develop the company growth story

Discovery is not a buy signal. You should spend a couple hours to develop the story of your stock. It is important to understand how the success of a product or service will affect the company’s bottom line.

Before purchasing a stock, you should be able to give a two-minute monologue on the prospects and detractors to a company’s story and its outlook.

Peter Lynch typically devotes several hours to development of a company’s script and checks his story every few months. Chatting with investor relations can be a helpful exercise.

You may learn something out of the ordinary in about one out of every ten calls. If a company is renowned or purchased for a specific product or service, it is important to understand what percentage of sales it accounts for.

A company’s growth cycle consists of about three phases: start-up, rapid expansion and maturity. A company in the first phase is generally regarded as riskiest since its success is not yet established.

The second phase is safer and where money is more reliably made. This is where the company grows through duplication of its formula for success.

Finally, the third phase is troublesome since the company should eventually run into its own limitations and must find new or better methods to grow or maintain earnings.

Peter Lynch likes to ask a variety of general questions to help understand the story of a stock:

What makes the company a good buy now?
Where is the market and industry?
Is the company making a profit?
What is its growth story?
How will they finance reinvestment and/or growth?
Is the P/E ratio high or low relative to similar companies in industry?
What is the percentage of institutional ownership (lower is preferable)?
Is the company buying back its own shares? Are insiders buying its own stocks as well?
What is the size and consistency of earnings growth?
Does it have a strong balance sheet (debt-to-equity ratio) and financial strength (cash position)?

Categorise your investments to ask better questions

Peter Lynch will also compare the size of the company relative to its industry competitors. He will then classify the company of interest into one or more of the following growth categories to guide his analysis: (1) slower growers; (2) stalwarts; (3) fast growers; (4) cyclicals; (5) asset plays; and (6) turnarounds. This helps him to ask the right questions about the company’s outlook and how value might be returned to shareholders.

(1) Slow growers are large and ageing companies that may grow slightly faster than its country’s gross national product. The companies tend to pay a generous and regular dividend.

Example questions to ask:Are dividends consistently paid and growing? Is the dividend payout ratio low to provide a cushion for hard times?

(2) Stalwarts are usually large national or multinational companies. Stalwart growth prospects are somewhere between a fast and slower grower.

Example questions to ask: Is the P/E ratio relatively low (to avoid overpaying)? Is there evidence of poor acquisitions? What is the long-term growth rate? Is it consistent? How has the company fared during downturns?

(3) Fast growers are small, aggressive and new enterprises that grow between 20 to 25 percent a year. Although risky, Peter Lynch likes fast growers with a good balance sheet and have made substantial profits.

Example questions to ask: Is the high growth product a major part of the company’s business? What is the earnings growth rate? Does it have room to duplicate and grow? Is the stock trading at a P/E ratio at or below its growth rate? What is the percentage of institutional ownership (lower is preferable)?

(4) Cyclicals are companies whose sales and earnings expand and contract from period to period. Airline, automobile, steel and chemical companies are common examples here. Timing is critical for successful investing in cyclical industries and companies. Investors will need an edge at detecting the early signs of business fall-off or pick-up.

Example questions to ask: Are you paying attention to inventories? Are there new and significant entrants? Do you have an advantage in anticipating and understanding industry movements?

(5) Turnarounds are no-growers, poorly managed cyclicals and companies near bankruptcy but with some prospect for a comeback.

Example questions to ask: Can it survive creditor raids? How much cash and debt does it have? What is its debt structure and how long can it survive without facing bankruptcy? What is the turnaround strategy?

(6) Asset plays are companies that own something valuable but has been overlooked and unpriced by Wall Street.

Example questions to ask: What is the value of assets? Are there hidden assets? How much debt is there? Is the company borrowing more and devaluing net assets? Is there a raider who can help return cash to shareholders?

Review key financial ratios and numbers

Peter Lynch feels that investing is an art and that attempts to quantify everything rigidly can become a disadvantage. That said, investors should review a company’s financial position to understand the story of their companies.

Lynch shares his reflections on commonly used ratio such as the price-to-earnings ratio and book value, summarised briefly as follows.

Price to earnings

The P/E ratio is a useful measure of fair value relative to the company’s earning potential. It can be thought of as the number of years a company might take to earn back your initial outlay if earnings remained constant. The ratio is generally low for slow growers, high for fast growers, and variable for cyclicals.

The P/E ratio should be compared to historical averages and competitors for context. Investors tend to pay more for stocks when interest rates are low, bonds are relatively less attractive, and/or when optimism is widespread.

A P/E ratio of any company that is priced fairly should equal its growth rate (long-term growth rate plus the expected dividend yield).

Peter Lynch expects a company with a P/E ratio of 15 to grow at around 15 percent a year. A P/E ratio that is less than its growth rate is a potential bargain.

Companies typically have five methods to increase earnings: reduce costs, raise prices, expand into new markets, sell more to old markets, or close and dispose.

Net cash and debt

Net cash position and debt reduction can be a good sign of prosperity. This is the difference between cash (incl. cash items and marketable securities) and long-term debt. An increase in cash relative to debt is an improvement in the balance sheet.

To make it a quick exercise, Peter Lynch makes a simplifying assumption that the company’s other assets (e.g. inventory) are enough to cover short-term debt. The total debt factor is an important consideration. A debt-to-capital ratio of less than 10% is a strong balance sheet.

Debt determines whether a company is more likely to survive crises, turnarounds and/or early stage growth. The type and structure of debt is important too. Bank debt or ‘due on call’ debt, where lenders can ask for their money back at any sign of trouble, is risky. Funded debt is typically more favourable to shareholders since lenders cannot demand immediate repayment.

Buybacks and dividends

The next, a ten-year financial summary can provide a helpful picture of the company’s performance. Share buybacks overtime is usually a positive signal. Dividends can also affect the value and stock price of a company over time.

Many companies that do not pay dividends tend to misallocate capital and overpay for acquisitions. Slow growers that do not pay dividends may lower cash returns to shareholders – a potentially difficult situation.

Book value

Book value may bear little relationship to a company’s actual worth. It can understate or overstate reality. Overvalued assets are misleading and dangerous, particularly if there are high amounts of debt.

Conversely, companies that own natural or hidden assets (e.g. land, oil, metals, etc.) will record book values and not necessarily reflect true market value.

Free cash flow

Free cash flow is the cash left after normal capital spending. A ten percent return on cash should typically reflect the ten percent hurdle that individuals expect from owning a stock long term.

Companies with modest earnings can be great investments on a free cash flow basis. Companies with large depreciation allowances and lower reinvestment needs can enjoy greater tax breaks.

Inventories

When inventory growth exceeds sales growth, it is a potential red flag. Conversely, if inventories of a recently depressed company begin to deplete, it could be evidence of a potential turnaround.

Pension plans

It is important to check that a company does not have large pension obligations that it will not be able to meet.

Growth rate

Growth is not synonymous with expansion. The only growth that ultimately matters is earnings. A company that can raise prices year-on-year without losing customers or market share may be a good investment.

All else equal, a company that grows at 20% per annum at a P/E of 20 is more attractive than a company that grows at 10% per annum at a P/E of 10 (you can check the math yourself).

Profits

Profit after tax is your bottom line but pre-tax profit margin is helpful for cross-company comparisons. A company with a higher profit margin is lower cost operator by definition and better placed to survive industry and economic downturns. It is a measure of staying power during difficult times.

Buy stocks in good companies at great prices

Peter Lynch’s investment philosophy shares similarities with Warren Buffett’s approach. He looks for high-quality businesses at fantastic prices.

Winners tend to raise their bets when the position improves and exit when favourable odds worsen. He feels that a market is probably overvalued if he cannot find a company that is reasonably priced under his investment criteria.

Finding investment bargains

Bargains tend to occur on two occasions. The first is the end-of-year tax selling that often occurs between October and December. During the holidays, brokers and investors like a little spending money for the holidays.

Portfolio managers also like to remove losers for upcoming portfolio reviews. Hence, it is not uncommon for companies to trade at a discount during these periods.

The second bargain opportunity is a market collapse or freefall. These tend to occur every few years. In both the first and second bargain, margin players and margin calls may lead to even greater sales of cheap stocks.

Selling sometimes begets more selling. If you have the stomach during these episodes, you may find opportunities at prices you haven’t seen before.

Know when to sell your stocks

Peter Lynch avoids automatic selling strategies (e.g. selling winners and holding losers) and chooses to stick with companies if the companies’ stories continue to stay or improve.

For cyclicals and turnarounds, he may consider an exit when the company’s fundamentals worsen and its price increases; and entry when the company’s fundamentals improve but the price worsens.

Peter Lynch tends to sell slow growers after a 30-50% appreciation and/or when fundamentals have deteriorated (regardless of price). He may consider selling stalwarts when their P/E moves positively outside their normal range. He may replace it with an undervalued stalwart or consider re-entry at a lower price.

For fast growers, he looks for the second phase of growth or transition into maturity. P/E ratios can reach astronomical levels for fast growers before steep corrections emerge.

Manage noise and temperament

We sometimes confuse cause and effect because Wall Street appears to have an explanation for why the market has gone up or down every day.

When there is a lot of good news and many investors feel confident, the risk of economic under-performance is likely to be higher. We tend to prepare more for the last thing that has happened rather than what might happen next.

Small investors also tend to become pessimistic and optimistic at the wrong times. Unwary investors will move between emotional states of concern, complacency and capitulation.

If the stock’s price is down but its fundamentals are positive, it is probably better to hold on and/or buy more. While new and reasonable concerns merit investigation, we should not allow this to spur snap judgements. It can be self-defeating to time-the-market.

Common sense, patience, self-reliance, pain tolerance, open-mindedness, detachment, persistence, flexibility, humility and independence are invaluable traits for successful investors. The ability to admit mistakes, ignore general panic, make decisions without perfect or complete information, and resist your ‘gut feelings’ are important as well.

Watch for dangerous sayings

A good investment is a gamble with the odds tilted in your favour. In equity markets, it is the company’s earnings that will determine the long-term quality of that company’s stock value.

Investors sometimes confuse current price with value, and their skill with outcome. If you catch yourself making any of the following dangerous sayings, it is important to reassess the quality of your decision making and investment approach, and understanding of the stock’s growth story:

“If it’s gone down this much already, it can’t go much lower.”
“You can always tell when a stock’s hit bottom.”
“If it’s gone this high already, how can it possibly go higher?”
“It’s only $3 a share, what can I lose?”
“Eventually they always come back.”
“It’s always darkest before the dawn.”
“When it rebounds to $10, I’ll sell.”
“What me worry? Conservative stocks don’t fluctuate much.”
“It’s taking too long for anything to ever happen.”
“Look at all the money I’ve lost: I didn’t buy it!”
“I missed that one, I’ll catch the next one.”
“The stock’s gone up, so I must be right or… the stock’s gone down so I must be wrong.”