Peter Lynch's Investment Approach
Peter Lynch was fund manager of Magellan from 1985 to 1992 and never experienced negative performance during this period. As well as combining the various elements that we have discussed in relation to Buffett and Graham, Lynch has developed some very interesting avenues.
Moreover, he is highly skeptical about the value of academic theories of finance and has strong doubts regarding the efficient market hypothesis. According to Lynch, it is impossible to forecast market movements and he only believes in “great businesses” . This blog explains Peter Lynch Investing Approach in detail.
For Lynch, “stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide.”
Here his analysis is similar to that of Malkiel, which we will discuss in the following sections. Furthermore, according to Lynch, “the best companies always end up succeeding, the mediocre ones failing, and their respective investors being compensated accordingly”.
By advising to invest only in what is simple and what we know, Lynch echoes Warren Buffett's approach but looks above all for what he calls “ten baggers”, a stock whose value increases by ten times its purchase price.
According to Lynch, there are plenty of these in the world around us and for a small investor's portfolio, one ten-baggers is enough to make all the difference in terms of performance. Unlike for the portfolio of a large fund, which must select many ten baggers to make any difference.
Lynch spends hundreds of hours analyzing companies and speaking with CEOs and financial analysts but, above all, he recommends keeping an eye on the world around you to identify investment opportunities, if possible before anyone else. We can spot them in our workplace, at the mall, during a trip or in the course of conversation.
These unique opportunities can be discovered months or even years before analysts examine and begin to recommend them. Lynch suggests that investors be curious and observe what's going on around them in order to find investment opportunities. “Take advantage of the valuable, fundamental information from your job that may not reach the professionals for months or years.”
He tells of how he discovered Hanes, makers of L'eggs stockings, thanks to his wife and her friends who use the product. After a little research, Lynch invested for the Magellan fund and his initial investment increased six-fold. The analysts did not start to study this company until they noticed a significant increase in its stock price.
As he summarises perfectly, the aim is to discover investment opportunities before Wall Street. Indeed, a financial analyst will only pay attention to security once its price has undergone substantial movement.
However, finding a company is just the first step; the next step is obviously to analyze it. You might find an interesting opportunity in an industry, but you still need to choose the right company. Lynch recommends investing in stocks rather than in the market.
He focuses solely on companies, or individual stocks, and favors relatively small businesses that offer greater growth prospects than large multinationals. Finally, he recommends investing “at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator”.
The first step is to classify the stock in one of the six categories that Lynch has established, although companies may move from one category to another over time. Furthermore, companies have three growth phases and it is important to determine if the company in question is changing phase.
Firstly, there is the start-up phase, then the rapid expansion phase where the company is moving into new markets, and finally the mature (saturation) phase where growth becomes difficult. Here are the different categories.
Slow growth companies develop slowly, more or less at the same rate as the progression of GNP (gross national product). A slow growth stock can generally be recognized by the regular and generous dividend paid to its shareholders.
Electricity companies, for example, belong to this category. When considering this type of stock, it is important to ascertain whether dividends are paid regularly and if they grow over time.
These stocks are faster than slow growth stocks and can reach an annual growth in earnings of 10% to 12%. Companies like Coca-Cola, Bristol Myers, Procter & Gamble, and Colgate Palmolive belong to this category. They have little chance of going bankrupt, but it is important to verify their long-term growth rate.
The potential profit on these stocks depends mainly on when they are purchased and at what price. The P/E ratio is decisive in indicating to investors whether or not they are overpaying for the stock.
During a crisis, people travel less, put off buying a new car, buy fewer clothes, eat out less often, but continue to buy as much cereal and the same amount of dog food. That is why companies like Kellogg's or Nestlé, for example, are candidates worth including in a portfolio.
The Fast Growers
Fast-growing companies develop fast, sometimes at an annual rate of 20% to 30%. Lynch holds them for as long as their earnings are increasing, their expansion continues, and no obstacle is encountered.
The growth rate of earnings is obviously essential for this type of stock, but it is especially necessary to compare the P/E ratio to the earnings growth rate to see if the two curves move in parallel.
When analyzing a product or service, it is also crucial to determine the share of sales in total turnover.
It should be emphasized that this type of stock does not have to belong to a fast-growing industry, as room to continue developing is more decisive for the growth of a company. For example, the hotel industry has an annual growth of almost 2%, while Marriott has developed strongly over the last few years, increasing its market share to 20%.
It is also useful to look at whether the company has been able to replicate its success in other cities or countries, thereby demonstrating its capacity for expansion.
However, if this stock becomes too important, its growth capacity will be limited. So it is best to look for companies with high growth potential, and sell them before this potential is exhausted.
A cyclical stock is a company in which sales and profits rise and fall regularly and in a somewhat predictable pattern. In a cyclical industry, business grows, then slows and grows again, then slows once more and so on. At the end of a recession and in a vigorous economy, these are the stocks that appreciate.
Inventories and the relationship between supply and demand for the products the company sells are the decisive factors in achieving adequate positioning in the business cycle in question.
Automotive companies, airlines, tire manufacturers, steel producers, and chemical companies are cyclical stocks. As most of these companies are reputed multinationals, we often tend to put them in the stalwart category, but the cyclical character of the industry is critical.
These companies are not growing, but in the event of a recovery, they can move back up very quickly. Lynch distinguishes four types of turnarounds. First of all, there are those that are subsidized, whose future depends entirely on a loan guaranteed by the government.
Then there are those that must resolve one or more unanticipated problems, such as operational accidents that will take time to repair. The extent of such a company's losses and debts must be carefully studied.
Next, there are perfectly good companies within bankrupt companies that will be able, after separation, to take off on their own to the delight of investors. There is also restructuring, which lets the company rid itself of unprofitable subsidiaries in order to concentrate on its core business.
Whatever the type of company in difficulty, the number of its liquid assets and its debt level are the essential factors in analyzing its future capacity for recovery. The way in which the company intends to go about this must also be examined, taking into account the outlook for the sector.
The Asset Plays
By “asset plays”, Lynch means a company that's sitting on a treasure that you know about, but that Wall Street has overlooked. The assets may be in the form of a large pile of cash (the famous “war chest”) or real estate, such as land or housing stock managed in parallel with the company's business.
You also find these asset plays in companies operating in the metal, oil, newspaper and pharmaceutical industries and television stations. Companies' losses may also represent value. Indeed, a company in serious financial trouble may, for example, benefit from a tax credit, meaning that future profits will be exempt from taxation.
The aim is, therefore, to identify the existence of these hidden assets and then try to estimate their value, taking the company's debt into account. Finally, investors must consider whether the company is vulnerable to takeover by a third party.
The Perfect Company According to Lynch
Peter Lynch appreciates simplicity. He also looks for other characteristics in a company and has compiled a list of 13 factors to help select them.
The Perfect Company has a Dull, or Even Better, Ridiculous Name For Lynch, the more boring the name, the better.
The Perfect Company Does Something Dull In his opinion, “company that does boring things is almost as good as a company that has a boring name, and both together is terrific”.
The Perfect Company Does Something Disagreeable
The ideal business is one that makes people shrug, retch or turn away in disgust. He gives the example of a company engaged in washing greasy auto parts.
d) The Perfect Company is a Spin-Off
The result of the separation of a division or business unit from a parent company, that then takes its independence, often offers investors exciting and lucrative opportunities. As Lynch rightly notes, parent companies do not want to let their subsidiaries go just to see them getting into trouble, as this may bring them negative publicity.
Spin-offs usually have strong balance sheets and are well prepared to deal successfully with their new independence.
e) The Institutions Don't Own It, and the Analysts Don't Follow It
For Lynch, the lower the percentage of shares held by institutions, the better. The idea is to find a company that no analyst has visited, or that they admit knowing nothing about. As we said earlier, the goal is to discover the company before Wall Street does.
f) Look Out for Toxic Waste and/or the Mafia
According to Lynch, there is no more perfect industry than waste management, and some others such as hotel and casino management reputed to be “influenced” by the Mafia, which may have great prospects.
Rumors about the Mafia allegedly controlling these industries have kept many investors at bay, but Lynch suggests keeping things in perspective; the fact is that hotels and casinos usually appear on recommendation lists.
g) There is Something Depressing About the Perfect Company
Besides the boring or disagreeable nature of a business, being depressing is another key factor for Lynch. He gives the example of Service Corporation International, which is in the funeral business.
The company became a “20-bagger” (twenty times the initial investment) before Wall Street even began to pay it any attention. Since then, it has performed worse than the market.
h) The Perfect Company Operates in a No-Growth Industry
Investors usually prefer to invest in a high growth industry, where there are noise and movement, but Lynch far prefers a no-growth (or low-growth) industry where there will be little competition.
There is no need to worry about potential rivals or to enter a price war because nobody else is interested. The company has a free rein to continue to grow and gain market share.
i) The Perfect Company has a Niche
An exclusive license is obviously the ideal situation, as the company that enjoys these rights can freely increase its prices and, consequently, its profits.
Managing a quarry is one example of such a license, as are pharmaceutical and chemical companies that hold a patent giving them the right to manufacture and sell a unique drug for a given period.
j) People have to Keep Buying the Perfect Company's Product
As Lynch puts it, it is better to invest in a company that makes medicines, soft drinks, razor blades or cigarettes than in a toy manufacturer whose products are often only bought once. Regular sales are essential for ensuring stability, if not growth, of profits in the future.
However, there are also companies that Lynch recommends avoiding, such as hot stocks in a hot industry, those with the best advertising or those that all investors hear about and end up buying simply because everyone else does.
k) The Perfect Company is a User of Technology
It is better to invest in companies that use technology (scanners, for example) to reduce their costs and increase their profits, than in companies that make that technology (scanner manufacturers) and whose products are likely to be made obsolete or outdated by competing products.
l) The Insiders are Buying the Perfect Company's Stock
The best sign of a company's success is to see its executives and managers investing in its equity.
However, it should be emphasized that sales of stock are not necessarily revealing and investors should be very cautious about attempting to draw conclusions. Managers may sell their shares simply to generate the cash to buy a house or send their children to university.
Therefore, it is more representative to see insiders buying shares—driven by the desire to participate in the company's growth—than selling, which can be motivated by any number of reasons. There is only one reason for managers to invest in their company: the feeling that the stock is undervalued relative to the company's growth potential.
M) The Perfect Company is Buying Back Shares
Finally, a company buying back its own shares is a positive sign for Lynch and, more importantly, for investors, because it represents the reward offered by the company to its shareholders.
However, instead of undertaking this kind of buyback or a dividend payout, sometimes companies decide to make often expensive acquisitions unrelated to their core business, which then weighs heavily on their balance sheets and their ability to generate earnings growth.
As Lynch says, “If a company must acquire something, I'd prefer it to be a related business, but acquisitions, in general, make me nervous.
There's a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. I'd rather see a vigorous buyback of shares, which is the purest synergy of all.”
Earnings and Earnings Growth
According to Lynch, although it is impossible to predict future earnings, it is possible to determine whether a company can make them grow. It has five ways of doing this:
if possible, expanding into new markets;
selling more products in old markets;
closing or getting rid of a losing operation.
Investors should focus on these factors to evaluate the company's ability to grow their earnings in the future. They should also find as much information as possible about the company, to understand exactly how it goes about generating profits and thereby analyze its potential success.
For a slow growing stock, dividend stability and growth over time are the essential factors in determining attractiveness. For a stalwart, the analysis of the P/E ratio and the stock price will be decisive. It is also worth considering whether an event may accelerate growth, and if so, which event.
When looking at a fast grower, the question is obviously for how long and by what means the company can continue to grow at this speed. The number of new shops opened, for example, and the development of market share are relevant factors for analysis.
When considering a cyclical stock, industry conditions, inventories, prices and the capacity of production facilities are decisive factors. In the case of an asset play, you need to find out the value of the assets.
Finally, for turnarounds, investors should consider how the company is going to go about improving its situation, and if the measures envisaged are likely to pay off in the future.
It is also useful to recall that stockholders are able to get information directly from companies and their head office. As such, Lynch believes that “nice earnings and a cheap head office are a good combination. Other unfavorable signs include fine old furniture, tapestries, and wood paneling.”
Finally, it is possible to analyze an industry simply by looking around you. A (partial) analysis of the automobile industry can be carried out, for example, in parking lots of ski resorts, malls or other leisure spots.
Most of this information can be found in companies' annual reports. However, Lynch recommends spending no more than a few minutes reading them. In his opinion, “the cheaper the paper, the more valuable the information”.8 He recommends focusing instead on the following criteria.
The Sales Percentage
When we examine a company, the first thing we observe is the products and services it offers. Independently of the profitability itself of a product, it is essential to determine the impact of the product in question on the company's sales and earnings.
For example, a product may sell very well but represent a negligible share in the company's sales and, therefore, have little impact on its earnings.
The P/E Ratio
For Lynch, the P/E ratio of a company valued at its fair price is equivalent to its growth rate. It is, therefore, necessary to find out the growth rate and compare it to the P/E ratio. If the P/E ratio is lower than the growth rate, the investor may have found a good stock.
According to Lynch, book value often has little to do with the true value of a company. Moreover, the closer an investor is to a finished product, the harder it is to predict its resale value.
Examination of a company's balance sheet will show the amount of cash as well as a figure which includes its marketable securities, which together give the overall cash position. The higher this is, the more prosperous the company. It is essential for a potential investor to know whether or not a company has considerable liquid assets.
Subtracting long-term debt from cash and cash equivalents gives the company's net cash position. By then dividing this value by the number of shares in circulation, we get net cash per share.
By comparing this number to the market share price, investors can determine the value of the company's growth potential and of the “true” P/E ratio. In addition, this value can also be interpreted as the lower threshold of the share.
The balance sheet gives us the amount of short-term and long-term debt. When long-term debt is higher than cash and equivalents, the financial the situation of the company is deteriorating.
Conversely, the reduction of debt and an increase in cash and equivalents is a good sign. It is interesting to note that Lynch ignores the short-term debt, considering that the value of the company's other assets is enough to cover this debt.
This factor is crucial for companies in recovery or in the start-up phase, as it will determine which ones will survive and which will go bankrupt. Furthermore, the kind of debt is also important. Bank debt, which is due on demand of the bank, puts the company in a worse position than funded debt, which is not due as long as the interest is being paid.
As mentioned previously, stability, that is, the existence itself of a dividend over time, as well as its growth, is an important criterion for stock selection. The dividend is the first part of a stock's return.
For Lynch, share repurchases by the company are positive, while acquisitions made by forgoing dividend payments to shareholders generally have a negative impact on share price movement.
However, for companies seeking fast growth, dividends are often reinvested, and it is better to favor these stocks above traditionally generous companies without any real growth prospects or outlook.
Companies that own natural resources such as land, forests, oil or precious metals often present assets in their balance sheets at their purchase price although they are worth much more on the market. Moreover, some assets amortized over time disappear from the balance sheet. Investors must take these undervaluations into account.
In general, cash flow is the money a company makes by selling its products or services (revenues), taking account of costs incurred in its activities. Lynch prefers companies that have little or no investment expenses, i.e., those that have a high free cash flow (cash flow after deduction of capital expenditures).
It is also important to analyze inventories and to find out if they are piling up. Growing inventories can lead companies to lower their prices to liquidate them (not to mention the price of storage), which implies a drop in profits. On the other hand, the depletion of inventories is a good sign for the company and consequently for investors.
For Lynch, as noted earlier, a company's earnings growth rate is the most relevant rate in terms of investment and should be compared to price movement.
Finally, Lynch examines gross profits, which represent the company's profit minus costs, including interest but before taxes. By dividing the company's sales by its gross profit, we get the profit margin before taxes that should be compared to that of the industry in question.
Conclusion on Peter Lynch's Approach
Peter Lynch believes that the end of the year usually provides the best opportunities to buy. Opportunities also present themselves during the drops and freefall that occur every two, three or four years, but buying at these times is not for the faint-hearted.
A very interesting approach to stock valuation is suggested above, which will be incorporated into the discussion that is to follow.
It is worth bearing in mind that “the market, like stocks, can, in the short term, move in the opposite direction from the fundamentals”, but “in the long term, the direction and sustainability of profits will prevail”. Moreover, he believes it is impossible to predict market movements over one or two years.
Lynch criticizes all those experts who recommend that their clients systematically sell their positions as soon as they have doubled their initial investment.
The problem is that they will never find a “ten bagger” that way. He indicates that he has never been able to predict which stocks would see their price growing five- or ten-fold, but he held on to them for as long as their story remained intact.
Finally, valuation models are very sensitive to parameters and ultimately only provide estimates. Furthermore, as Lynch reveals, “we all read the same papers and listen to the same economists.
We all come from the same homogeneous mold. Few of us have left the beaten track.” The right direction is therefore off this beaten track and lies in adopting a new, unconventional and even surprising approach.
The idea of value advocated by Buffett and Lynch should be definitively assimilated by any investor, as the selection itself of value is essential in any investment decision.
Warren Buffett's Value Investing Approach
Warren Buffett's approach can be summarised as follows: “Despite these gyrations in the market prices of financial assets, many of them do have an underlying or fundamental economic value that is relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor. In other words, the intrinsic value of the security is one thing;
The current price at which it is trading is something else. Though value and price may, on any given day, be identical, they often diverge.” So Buffett compares the fundamental value of the asset in question with the price set by the market. His process of selection and analysis follows various principles that we will now describe.
First of all, “Buffett will only invest in easy to understand, solid, enduring businesses that have a simple explanation for their success. Look for long-lasting companies with predictable business models.” He invests only in companies and industries he understands and with which he is comfortable.
His advice is to “buy stock in a great company, run by honest and capable people. Pay less for your share of that business than that share is actually worth in terms of its future earnings potential.
Then hold on to that stock and wait for the market to confirm your assessment. He puts his money in easy to understand, solid businesses with strong, enduring prospects and capable and ethical management.”
For Buffett, the product the company offers must be enduring and still exist in ten years' time. As he justly points out, “thirty years of performance makes for a great company. Three years does not.”
“Buffett avoids complex companies that are subject to dramatic change because of their uncertain futures. Earnings and cash flow are two of the pillars of a successful company.”
He, therefore, recommends avoiding companies from developing industries and buying securities issued by companies we understand, whose models and income growth are predictable. He invites investors to look for companies with strong barriers to entry, i.e., those with a product or service that is:
needed or desired;
not overly capital-intensive;
seen by its customers as having no close substitute; not subject to price regulation.
Buffett pays particular attention to the company's management. He wants to know whether it acts in the interests of shareholders to create long-term value or, on the contrary, to get rich to the detriment of shareholders.
With his company, Berkshire Hathaway, “Buffett makes money only when his shareholders make money. He treats shareholders as partners, and every decision he makes is made with the aim of improving shareholder value.”
He suggests buying businesses, not stocks, and he considers that while the price of a stock may be volatile, the price of a company is not. For Buffett, market downturns are buying opportunities and “most of Buffett's greatest investments were made during bear markets when share prices of great businesses had plummeted”.
Furthermore, he believes that a few good investments are enough, and there is no need to make a large number of purchases; “one good decision a year is a very high standard”.
Moreover, it is interesting to note that Buffett suggests ignoring macroeconomic factors and events, and focusing instead on those that affect the company and industry.
He also recommends ignoring stock forecasts and short-term price fluctuations and favoring strong companies likely to succeed independently of market movements. Buffett confesses “that he can't begin to predict the movement of the markets”.
He also recommends that investors “think 10 years, not 10 minutes. Buffett's philosophy is based on patience and a long-term outlook.” So we can clearly see that he is an investor rather than a speculator seeking immediate profit. As for the stock market, he describes it as “a ‘relocation center’—a means whereby money moves from the impatient to the patient”.
As he amusingly notes, “Wall Street is the only place where people go to in Rolls Royces to get advice from people who take the subway.” Buffett does not believe in experts, technical analysis, or any advice on how to make money fast.
He is a proponent of value investing, a slow, laborious job focused on the long-term, whose aim is to “seek out discrepancies between the value of a business and the price of small pieces of that business in the market”. However, this price difference must be significant to justify an investment.
Buffett, therefore, seeks to “determine the discounted value of the cash that can be taken out of the business during its remaining life”.
As we might imagine, Buffett reads for several hours a day to get information on companies he is interested in (annual reports, articles, etc.) but does not waste time studying stock forecasts or financial theories based on formulas.
The rest of the time he spends on the telephone and, especially, thinking about and focusing on what he believes is the essential notion: value.
Although this approach is very interesting, not all investors are able to allow themselves such a long time horizon.
In addition, technological and social developments occur much more quickly than they used to. It has become difficult to guess whether a company's product will still be around in 10 years and if the company will still exist.
Certainly, we admit that this may be the case with “traditional” companies but, for example, with the development of the Internet and free news websites, investing in a newspaper is perhaps a more risky bet today than it once was.
Buffett's approach may sometimes be too limited, but it does have the advantage of focusing on the value of a company, often one which operates in an industry temporarily neglected by investors.
If we look at recent investments Buffett made during the latest crisis, these seem to be focused on the banking and insurance industries, sectors abandoned by investors in the thick of the financial crisis.
For Buffett, it is better to adopt a patient approach, to wait for a strong market correction and buy companies whose listing is clearly lower than their intrinsic value.