What are the types of stocks according to Peter Lynch?
Hapi Pills
9.11.2024 1:04 AM
One of the investors who is always ahead of Wall Street is Peter Lynch. He is recognized for the simplicity of his investment principles and for consistently outperforming the overall returns of the U.S. Stock Market. Among his various tools for analyzing stocks, he developed a stock classification system that helped him identify which companies were truly attractive. Are you ready to learn about the types of stocks according to Peter Lynch? In this Hapi article, we bring you the categories that this investor used to build a portfolio.
The legendary American investor, Peter Lynch, was known for his stock-picking skills. His Magellan Fund at Fidelity Investments delivered a compounded annual return of 29.2% between 1977 and 1990. During that time, Magellan was the best-performing mutual fund in the world. All his knowledge is available in his famous book One Up on Wall Street, a must-read for those looking to start their journey into the world of investing.
In it, he mentions these types of stocks:
Slow growers are stocks whose earnings show flat growth trends, with earnings growing between 2% and 5% annually, below the industry average. These companies are typically in conservative sectors such as energy and railroads. They are in a mature stage and often distribute high dividends regularly.
Since the company's earnings don’t fluctuate much, the stock price doesn’t either. For that reason, Peter Lynch didn't include many of these companies in his portfolio. If you decide to include this type of stock, it's recommended to analyze the dividend's safety.
Examples of slow growers: Exxon Mobil Corp (XOM), Energy Transfer LP Unit (ET), and Shell PLC (SHEL).
Stalwarts grow a little faster than slow-growing companies. They tend to have huge market capitalizations and one or more highly popular products among consumers. Lynch defines them as growing between 10% and 12%, with a very low chance of going bankrupt. To include them in your portfolio, make sure they have an attractive price-to-earnings ratio (P/E).
With these companies, you need to wait a while to see significant returns. Lynch suggests considering selling if these stocks deliver a return of between 30% and 50% in a year or two.
Nonetheless, he advises always keeping some stalwarts in your portfolio as protection against recessions, as their sales are typically stable regardless of economic downturns. However, it’s important to study how these stocks performed during past recessions to determine whether they provide protection. Examples of such companies include:
These are Lynch's favorite stocks because they offer returns of 10, 20, 50, or even 100 times their initial value. Usually, their earnings grow by more than 25% year-over-year, and their earnings graph should have an exponential trend. They already have an attractive business model and traction in more than one country. This category includes various tech companies like social media platforms, e-commerce sites, or fintechs.
As in all investments, higher returns come with higher risk. Fast-growing companies have a higher chance of failing. Therefore, every investor should aim to invest only in those with a strong balance sheet and avoid overpaying for future growth.
To avoid the risk of entering a speculative bubble, Lynch recommends including stocks in your portfolio whose P/E ratio is lower than their earnings growth rate. To find out if this condition is met, look for the price-to-earnings-to-growth (PEG) ratio.
These stocks need their initial growth to continue because if it stops, the market will move on, and the stock will experience a significant drop. This is typical when the company is young, but as time passes, its growth may reach a limit, turning it into a stalwart or slow grower. Thus, consider how much room the company has left to grow.
Finally, to achieve the highest returns, you need to find fast-growing stocks that few institutions hold and that don't yet have much media attention.
Cyclical stocks move with the economy. In times of economic expansion, they deliver excellent returns. Some examples include stocks in sectors such as automobiles or airlines.
When a recession looms, these stocks are hit hard, sometimes falling by up to 50% if you buy at the wrong point in the economic cycle. Ideally, you should buy them after a crisis, not at the peak of a growth period.
For some sectors, these trends last 3 to 4 years. Additionally, the harder the fall, the greater the potential for good returns afterward.
Examples of cyclical stocks include:
These are companies that own a hidden asset of high value that hasn’t yet been recognized by other investors. Often, this asset hasn’t started generating positive cash flows but could do so in the future. The asset could be cash, a patent, a brand, real estate, or inventory.
To invest in these stocks, you must thoroughly understand the asset and patiently wait for its value to be realized. Analyzing debt levels or whether an influential investor is interested in the company's stock is also useful.
Examples from the pharmaceutical sector include:
Turnaround stocks are companies that are close to bankruptcy. However, if this negative scenario doesn’t play out, the stock will soar as it regains investor interest. These companies experience significant price increases when they move from declining earnings and poor financial situations to rising earnings and a solid balance sheet.
The key is assessing the risks before buying these stocks. You need to understand whether the problems the company faces are as severe as perceived by stock market investors. If in doubt, it's best to leave that investment behind.
To better understand the recovery, ask yourself the following questions: What decisions are top executives making to turn the company around? How much debt has the company taken on, and how long could it survive with losses? How much could a significant cost reduction help? Are the declining earnings a short-term or long-term issue?
Past examples of successful turnarounds include:
To summarize, Peter Lynch classified stocks into six categories: slow growers, stalwarts, fast growers, cyclical stocks, asset plays, and turnarounds. All of them can be included in your portfolio if they meet certain important criteria.
Lynch particularly mentions that fast-growing stocks should take most of your attention because they can truly bring significant returns to your portfolio. If you manage the risks, investing in this type of stock is an attractive option.
Remember that all the examples given are not investment recommendations, and there are no guaranteed returns on stock market investments.
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