How We Pick Winning Stocks

"Good artists copy, great artists steal"

When it comes to investment advice, Peter Lynch is considered an expert on the subject. His approach to investment has been successful in real-world endeavors. Plus, Lynch firmly feels individual investors will benefit significantly over the large and Wall Street money managers with his approach. Why is that?

According to Lynch, the reason is that individual investors have greater “flexibility” as they are not tied to official rules or have concerns with short-term performance.

Lynch came up with the investment philosophy while working at Fidelity Management and Research, gaining notoriety for managing The Magellan Fund. He started his career in 1977, and the fund remained one of the highest-earning stock funds during his time. It ended when Lynch retired in 1990.

It’s a bottom-up approach, meaning investors choose from companies they are familiar with and conduct a thorough research about the company, its competitive environment, forecasts and if the stock is reasonably priced to buy.

He lays out the strategy in the 1989 book “One Up on Wall Street” – a best-seller that provides individual investors tips on how to use the approach. In 1994, he wrote “Beating the Street,” which touches more on the first book’s theme and offers examples of the approach and applying it to certain companies that he invested in.

“Invest In What You Know”

Lynch is considered a “story” investor. This means every stock choice is made on the researched expectation about the growth possibilities. It comes from the company’s story – what it will do, what will happen, etc. - to ensure results.

The more familiar investors are with the company they want to invest in, the better they understand its operations and competitive background. This helps investors to find a story that becomes a reality. Lynch strongly proposes investing in companies people are familiar with or who offer easy-to-understand products/services.

According to Lynch, he’ll make investments in pantyhose before communication satellites or motel chains before fiber optics.

Lynch promotes investment in multiple kinds of stocks, as long as the “story” approach offers positive outcomes. He recommends investors look to companies growing at a moderate pace and still have a reasonable price for purchase.

How To Choose Your Investments

With a bottom-up approach, investors are advised to pick stocks and review stocks one at a time. Research of the companies will determine the type of story that reveals itself. Using the information they’ve uncovered and their own experiences, they can decide if the investment is sound or not.

Investors need to get “intimate” with the company to learn what kind of future it may have. There is no way investors can forecast actual growth rates – something Lynch expresses is essential for investors to understand. He is also wary of any analyst earnings estimates.

What can you do to determine the possible growth of a company?

The suggestion is to look at the plans the company has and then answer the following questions:

1.) How will it plan to boost earnings?

2.) How are they fulfilling those plans?

Lynch said there are five ways a company can improve its earnings:

  • Lower costs
  • Increase prices
  • Revitalize, sell or close losing operations
  • Grow into new markets
  • Sell more in the old markets

Lynch said the story is revealed with how the company is planning to increase its earnings and fulfill the plan. The more investors are familiar with the business and industry, the better off they will be to learn and determine its plan, capabilities and possible drawbacks.

According to Lynch, a storyline can be found by classifying the company. This classification will also help investors develop reasonable expectations about the company’s future.

6 Ways To Classify Companies’ By Their Story Type

Lynch’s first recommendation is to classify companies by their size. It can be safely assumed that a large company is unlikely to grow at the same speed as a smaller company. From there, investors need to determine what classification a company falls under.

Slow Growers

For the most part, the established companies may grow just a bit more than the U.S. economy but do rake in large dividends regularly. Lynch doesn’t really favor them.

Stalwarts

Large companies that can grow still may see yearly earnings and growth rates of up to 12%. Proctor & Gamble, Coca-Cola and Bristol-Myers are prime examples of this. If an investor buys at a reasonable price, they can see a good return. Nothing extravagant and usually less than 50% in the first two years.

He recommends investors rotate companies – to sell when they’ve reached a moderate gain and going with companies that have yet to see appreciation. If a recession hits, the companies offer some protection.

Fast Growers

These will be firms that have yearly growth earnings of 20% to 25%. Lynch suggests these companies not be in rapidly-growing industries but does recommend fast growers, as they will ensure the biggest gains of the investor’s portfolio will derive from the stock. But, he warns, they do come with some risks.

Cyclicals

Lynch is wary of companies that look like stalwarts and urges investors to be mindful of them. Cyclical companies have profits that fall a particular economic cycle – rising at one point and falling at another. This pattern is commonly seen in steel, airlines and auto industries. It’s all about timing if you invest in these businesses, and you need to know when the company is facing a downturn.

Turnarounds

These are companies Lynch dubbed “no growers” because they have been battered (Penn Central, General Public Utilities and Chrysler). Successful turnarounds have stocks that quickly bounce back. According to Lynch, turnarounds are usually linked to the general market.

Asset Opportunities

These are companies with assets Wall Streeters have missed. Lynch highlights a few general area assets – patented drugs, newspapers and TV stations, and metals and oil. The real goldmine for investors is to find the hidden assets, which means comprehensive learning about the business that owns the assets. The best advantage with this classification comes from an investor’s own experience and information.

8 Tools Investors Should Use To Measure A Possible Investment

The approach Lynch uses is based on research and investigation. When looking at companies, the key is to understand their business and good and/or bad prospects (competitive advantages and look at possible adverse outcomes that could affect a potential positive story). Investors need to be mindful of the price they buy at. If a price is too high, the investor won’t make any real money, even with a happy ending.

Lynch suggests looking at the reasonable value. What are some of the critical numbers investors should consider?

Year-by-Year Earnings

Look at the history of the company’s earnings, as this will give you a good idea of its reliability and stability. Stock prices are usually aligned with the earnings level, even though they deviate from time to time. If you can see a pattern of earnings growth, you can learn just how robust it is. For the record, you want earnings that continue to grow.

Earnings Growth

When it comes to a company’s earnings growth, it should be aligned with its story. For instance, fast growers “should” have a quick growth rate than any slow growers. If an earnings growth rate is too high, it lacks sustainability and will factor into its price. Investors and competitors will pay much attention to those companies with a high level of growth.

Price-Earnings Ratio

A company’s earnings potential will be a leading indicator of its value, but there are instances where the market moves too quickly forward, and the stock is overpriced. With the price-earnings ratio, you can keep a level head. You’ll need to compare the current price to the company’s most recent reported earnings. Stocks that have good prospects will have higher price-earnings ratios than poor prospects stocks.

Price-Earnings Ratio Compared With Historical Average

Looking at the history of the price-earnings ratios the last few years to find the company’s “normal.” If you see the price getting ahead of its earnings, you know not to buy into the stock. You can also see it as a warning sign that you should sell the stock.

Price-Earnings Ratio Compared To Industry Average

If you compare the price-earnings ratio to the industry the company is in, you may learn if it’s a good company to invest in. It would beg to question why the company’s price is so different. Is it neglected or a poor industry performer?

Price-Earnings Ratio Compared With Earnings Growth Rate

Companies with good prospects tend to have higher price-earnings ratios. However, the ratio between them uncovers overvaluations or good deals. If a price-earnings ratio is half the previous earnings growth, this is good. If it’s more than 2.0, then it’s not worth it. According to Lynch, the measure is learned by adding the dividend yield with the earnings growth and dividing it by the price-earnings ratio.

If you get a ratio of 1.0 or higher, it’s not good. Less than one is ideal.

Ratio of Debt to Equity

What’s the balance sheet say about a company’s debt?

With a robust balance sheet, it gives the company some maneuverability to expand or handle problems. Be mindful of any bank debt that banks can call in whenever they want.

Net Cash Per Share

This is determined by adding cash and cash equivalent levels, deducting the combined level from the long-term debt and dividing it by the number of outstanding shares. A high level is an indicator of financial strength and backs the stock price.

Dividends and Payout Ratio

Larger companies pay dividends, which is why Lynch suggests investing in smaller growth companies. He said investors who want the dividend-paying companies should look at those who will still pay during a recession and have a 20 to 30-year history of increasing dividends.

Inventories

Is the company you’re considering for an investment have a stockpile of inventories? If so, this is a warning sign that they’re not making the sales that warrant the inventory. A depressed company experiencing a turnaround will see its inventory deplete quickly, so this is something to be mindful of.

Favorable Company Characteristics

When looking at companies, Lynch said there are several favorable characteristics to be mindful of:

· Ugly Duckling – Companies with boring names, their product/service is boring, the company is depressed or does something distasteful, or rumors are circulating about something bad tend to offer the best bargains. Waste Management (toxic waste clean-up company) or a funeral home operator are good examples of ugly ducklings.

· Spin-Off Company – Lynch said Wall Street pays little mind to these companies and recommends investors look at them later to determine if they are getting snatched up.

· Rapidly Growing Company In No Growth Industry – Companies growing quickly in a no-growth industry often catch competitors’ and investors’ attention, which can cause the high prices.

· Insiders Buy Shares – When insiders are buying stocks, you can take it as a good sign that they feel assured in their prospects.

· Company Buys Its Shares Back – Companies who have matured often do buybacks and have cash flow that surpasses their capital needs. According to Lynch, companies that do buybacks are better than those that grow into a different business. The buyback aids the stock price, and the management sees a favorable share price.

· Company Uses Technology – These businesses are using the technology available but don’t see the tech company’s high valuations.

· It’s a niche firm company that controls a segment of the market, making it harder for competitors to get in.

· The company creates an in-demand product during good and bad times, making them more stable.

· There is minimal investor coverage, and the share percentage with the company is low. Wall Street can offer a lot of bargains due to its inattentiveness.

Unfavorable Company Characteristics

· Hot stocks of that industries

· Companies with unproven big plans

· Profitable companies involved with differentiating procurements

· Companies with a single customer that accounts for a quarter or more of their sales

How To Build and Manage Your Investment Portfolio

Lynch, when he was Magellan’s portfolio manager, was holding onto nearly 1,400 stocks. He may have been successful at juggling them, but some problems come with managing so many at one time.

While individual investors are unlikely to handle 1,000 stocks, they need to be mindful not to diversify so much. Diversifying just to do it could be costly, especially if little is known about the company. Investors, Lynch said, can own any number of exciting stocks they want after they conduct a thorough examination of the companies. He recommends investments be made into several stock categories to reduce the risk and never invest in just one stock.

According to Lynch, prospective investors need to be committed to the stock market. He’s against market timing because it’s not possible to happen. He also said investors don’t need to hold onto one type of stock forever. Better, investors need to examine their portfolio every couple of months, reinvestigating the companies’ story to determine if anything noteworthy has changed.

When Should You Sell Your Stocks

According to Lynch, the why you bought a stock is tantamount to knowing when you need to sell it. This should happen when:

  • The company’s story has come to fruition, and the price reflects the ending. For example, the stalwart’s price is as high as it will go.

  • The story has changed, something unexpected takes place, or there is deterioration in the details. For example, a smaller business begins another growth stage or the inventories of a cyclical begin to increase.

Lynch feels a drop in price is a chance to purchase more of a good thing but at a lower price. He said it becomes difficult to stay with a great stock when the price increases, especially with the fast-growers where people sell sooner rather than later. Lynch said it’s best to hold onto the stocks until you see if the business goes into another growth stage.

Lynch doesn’t fully recommend selling the stock, but rotating it – sell that stock and buy one with a similar company story, but has healthier prospects. With this rotation method, an investor stays committed to the stock market and is attentive to the important value.


How Does Lynch See The Market?

Lynch uses a real-world approach to investments that any investor can learn from and use to their benefit. It doesn’t matter if you want to invest in the fast growers or if you’d rather stick with stable investments. While it does involve getting into the nitty-gritty of a company’s business, the advice he provides includes what to look for and how to see the market.

What does Lynch say about the outlook of stock investing?

Despite the number of mishaps, the level of optimism in investing by Americans in America continues to grow. When you venture into the stock market, you must have some faith in human nature, entrepreneurship, the country and its future. For him, there hasn’t been anything powerful enough to break his confidence in the market.

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