This is a FREE website designed to give new investors an overview of how to invest like Peter Lynch.
The Amateur Advantage
Being an amateur investor has its advantages. For one, you're not limited to time in the same way a professional is. The professional is usually looking to perform in short periods of time. They're always under the microscope of their clients and their clients have expectations. The amateur has a lot more time. They can ignore the gyrations of the market because they are in it for the long haul.
Professsionals are usually constrained to buying only certain kinds of stocks. The amateur can go anywhere and fill their portfolio with anything that they think is good. It's totally normal to have a portfolio of small caps in India alongside large caps from the USA.
All the math you need in the stock market you get in the fourth grade.
— Peter Lynch
Amateur's also have the advantage of knowing what's happening to a company before the professional. You might work for a company that you know is doing a lot of hiring because they're growing. This kind of information can't be obtained by a professional sitting in their office on Wall Street.
Professional's often wait until the other guy recommends a stock before they themselves recommend it. This kind of behaviour is common in the investing community. Come to think of it, it's common behaviour everywhere. However, this again is where being an amateur has its advantage.
Developing a Story
Lynch suggests that once you begin to consider a stock as an investment, it's a good idea to do some research on the company.
The research doesn't have to be extensive but it should support a hypothesis for buying the stock. This hypothesis Lynch calls "developing the story" of a stock.
The information you collect on the company includes looking at the financial statements, determining the size of the company, looking at its sales and inventory, and a few other items we'll discuss in more deatil in the following passages.
For now, one thing that Lynch suggests as a good strategy for developing the story is to categorize your stock.
Lynch's Six Types of Stocks
According to Lynch, there are six types of stocks. Knowing which type of stock you have helps you understand things like what kind of return you can expect to get.
- Fast Grower
- Asset Plays
1. Fast Grower
This is one of the most popular kind of stocks. Lynch describes these stocks as having the most potential for growing into multi-bagger investments.
Also, he says these stocks have PEG ratios of 1 or less. They will have P/E ratios between 20 - 80. They have growth rates of over 20%.
Stalwarts are characterized as stocks that were once Fast Growers but their growth rates have slowed as they've aged. Their growth rates are in the 3 - 5% range. These are mature companies like Coca-cola or Johnson & Johnson.
3. Slow Growers
These are companies that have been around a long time and are in mature industries. Their growth rates are in the 1 - 2% range. They likely include a dividend. An example might be a utility or railroad company.
4. Asset Plays
These are stocks that have some sort of value that is not included in the valuation of a company. For example, a company that is valued at $10/share and has a price/book value of 1. However, for the last 40 years they've had a portfolio of real estate that's never been updated on the books that is worth another $10/share.
This type of stock is characterized by its predictable up and down pattern. Lynch suggests that by timing investments in cyclicals it's possible to make returns of 50% or more. These are stocks like automobile manufacturers whose sales increase when the economy is good but decrease when the economy is bad.
These are companies that are bankrupt or near bankruptcy. Lynch uses the example of Chrysler in the 1980's.
Chrysler had fallen on hard times but reorganizing itself with new management, better debt terms and improved products the company returned to profitability. Again, Lynch emphasizes timing the entry points to these stocks. It's important to see the turnaround gain traction first.
Features of Great Investments
Lynch suggests that it's a good idea to stick to businesses that are easy to understand. He's not a tech-savvy guy so he avoided companies that made computer chips and stuck to companies that made donuts, like Dunkin Donuts.
Also, he gives a list of qualities that he considers are the makings of a great investment.
- It sounds dull or ridiculous
- It does something dull
- It does something disagreeable
- It's a spinoff
- The institutions don't own it and analysts don't follow it
- It's involved with the mafia or has something to do with toxic waste
- There's something depressing about it
- It's in a no-growth industry
- It's got a niche
- People have to keep buying it
- It's a user of technology
- The insiders are buyers
- The company is buying back shares
It sounds dull or ridiculous
Lynch refers to the name of the company as being an indicator of its investment propspects.
The company Automatic Data Processing is singled out for its boring name. A company that is sure to be ignored by the pros on Wall Street.
Names that are more than boring but also sound ridiculous are favourites of Lynch. Pep Boys — Manny, Moe and Jack is the prefect example. It's the type of name that serious professionals avoid having in their portfolio. They fear the ridicule is contagious.
It does something dull
Lynch describes Crown, Cork and Seal and Seven Oaks International as examples of companies that do dull things. The former makes cans and bottle caps. The latter processes coupons.
Better than boring alone is a stock that's boring and disgusting at the same time.
— Peter Lynch
It does something disagreeable
Here Lynch discusses Safety-Kleen a company that helps gas station mechanics clean dirty auto parts. It has a klunky name as well as does something that most people find disagreebale. That doesn't stop the stocks earnings from growing.
Another company, Envirodyne suffers from the bad name syndrome but has a profitable business making plastic forks. No one would suspect its capacity to grow earnings by judging its name or its business venture.
In the industry it's number 2 in plastic forks and number 3 in straws. It has the lowest costs of production.
Additionally, they bought Viskase from Union Carbide at a bargain price. Viskase makes casings for hot dogs and suasages out of intestinal byproducts. Then they bought Filmco which makes plastic wrap for leftover food.
As a consequence of the acquistions, the company's earnings went from $0.67/share in 1985 to $2.50/share in 1988. Using the increased cash flow, the company paid down its debt from the acquisitions.
Lynch bought the company for $3/share in September 1985. By 1988, it sold for over $36/share.
It's a spinoff
The spinoff is a comapny that was a part of another parent company that has been separated to go its own way. Toys 'R Us was a spinoff from Interstate Department Stores.
Spinoffs can be great investments since the parent company starts them off with healthy balance sheets and managers capable of making good choices.
Lynch lists a few other spinoffs that were success stories.
|Parent||Spinoff||Approx First Trade||Low||High||Oct. 31, 1988|
|IU Int'l||Gotaas Larsen||6||2.63||36.25||47.75|
|General Mills||Kenner Parker||16||13.88||51.50||—|
|Time Inc||Temple Inland||34||20.50||68.50||50.75|
The spinoff company is often not understood by the pros and since they're new companies they postpone their interest in covering them. This leaves you, the amateur, the opporunity to get in before Wall Street.
The institutions don't own it and analysts don't follow it
For Lynch, any company that isn;t covered by Wall Street is a potential good investment. Banks, savings & loans, incsurance companies are not often followed by the pros. He also gets enthused seeing stocks that were once followed by the pros but are no longer. Chrysler and Exxon were examples of companies that were abandoned by the pros just before they started to turnaround.
It's involved with the mafia or has something to do with toxic waste
Waste Management is a company that does what it says. It manages waste of all kinds in countries around the world. Companies that manage sewage and toxic waste aren't popular with professional investors for obvious reasons. It also has the reputation for the type of business run by the mafia. Combined these factors made Waste Management a bargain for those willing to hold their nose.
Holiday Inn and Hilton also suffered from the association of being tied to the mafia when they went into the casino business. Again, this might put the professional off of investing in them but to the amateur who doesn't have anyone to impress, the earnings are hard to beat.
There's something depressing about it
Here Lynch descibes SCI (Service Corporation International). Not only does it have a boring name but its in the funeral business. The combination meant that those who followed the story of the company, could have bought share well before the pros on Wall Street. For those amateurs who did, they were rewarded with a 20-bagger.
It's in a no-growth industry
For Lynch, companies that are in low-growth to no-growth industries make great investments since there are fewer people trying to compete for market share.
He cites the computer industry as an example where, yes, the growth is exceptionally high but so is the competition. Again, he prefers companies like SCI in low-growth industries like the funeral business where it hovers around a mere 1%. A growth rate that low doesn't attract a lot of capital.
It's got a niche
A niche business is another way of introducing the concept of a "moat" made popular by Warren Buffett.
Businesses that don't have competition resist the race to the bottom on pricing. As an example, Lynch uses a rock pit in Brooklyn.
No one else can compete with your rock pit business because the next nearest rock pit might be two cities over in Detroit. The cost of transporting rocks from Detroit to Brooklyn has an immediate negative impact on profits so why do it?
Lynch describes seeing a copper mine in Utah and realizing no matter what the Japanese do they can't create a cheaper copper mine like they would a computer chip.
Brands that are popular have moats. The cost to establish a brand name in the minds of the general public are large and take years to build. Think of Coca-Cola or Tylenol who both dominate their respective niches.
Businesses that have a niche have pricing power. A modern example would be Google who owns the "search" niche. To a large extent they set the rate of advertising on their search results page to their liking.
People have to keep buying it
Drugs, razor blades, soft drinks are the kinds of business that people will keep buying because they're nearly as important as breathing. Unlike kids toys whose product might be popular one day but not the next, businesses that produce necessities have predictable cash flows.
It's a user of technology
When a business, like Automatic Data Processing, buys computers its costs for processing data go down. They profit from using technology unlike the computer makers who compete with each other on price.
The insiders are buyers
The advantages of having insiders like CEO's and Directors buying shares of the company they operate is that you can feel confident the business won't go bankrupt anytime soon. Insiders don't put their money into failing businesses.
Another advantage is if a CEO has a lot of his own money tied up in the business, he or she is likely to make decisions that benefit shareholders. The CEO's who are only there to collect a paycheque don't always have the interests of shareholders in mind.
Seeing insiders like Directors or Vice-Presidents, who make substantially less income than CEO's, buy shares is a vote confidence. If they only make $250,000/year and are buying $25,000 of stock that's a bigger deal than the CEO who makes $2,500,000/year and buys the same amount.
The company is buying back shares
A company that buys back its own shares is saying that it thinks its own company is worth more than what the shares are currently worth. It can be interpreted as a sign of optimism from the management.
Another benefit of the buy back is the company takes shares out of circulation. Reducing the amount of shares from say, 10 million to 5 million increases the value of the remaining shares by 2. The company has doubled the value of your stock.