Introduction: Our articles frequently refer to legendary investors like Peter Lynch. Talking about such legendary investment advisors brings out a snarky response from new investors that goes like "Did he not retire 2 decades ago. How is he relevant still?" However, in his best seller "One up on Wall Street," Peter Lynch has given out more helpful suggestions to investors in one book than one could gather from watching news channels and listening to the newly minted experts all year long.
The Six Categories: This article focuses on Mr. Lynch's 6 major stock categories: Fast Grower, Slow Grower, Stalwarts, Turnaround, Cyclicals, and Asset Plays. Some stocks can fall into two or more categories at the same time. And as Lynch says, some stocks have been in each of the 6 categories at some point.
Why do we need to know these categories?
- Investing is all about expectations. If you do not know what you own, you will not know what to expect. If you do not know what to expect from your stocks, you do not have a goal. This translates to not having a buying or selling rule if you do not know what to expect from your stock.
- Lynch even suggests structuring your portfolio around these categories, in addition to the usual known rules of diversifying by sector.
- Once you have made a decision to buy a stock, putting it into one of these 6 categories is going to make your follow through and sell process easier.
- With the introduction and the "why" out of the way, let us get into the details
What Is It: Let us get the easiest one out of the way first. These are usually small and aggressive companies (though not always) that grow at least 30% each year. Companies like Vringo (VRNG) fall under this "small and aggressive" category. Vringo is a an aggressive play on the growth of smartphones. However, remember even companies like Google (GOOG), which is actually being sued by Vringo, can still be counted as a fast grower in spite of being around for a long time.
What To Expect: This is the place where you can expect multi-baggers but it does carry more risk than some of the other categories mentioned below. The risk comes from the market's expectations of growth and any slight disappointment would plummet the stock.
When To Sell: The obvious sell signal is the growth slowing down. It sounds easy to say but is actually difficult to spot. Some signals can be the entry of strong competitors and the earnings growth falling to the level of the market average.
What Is It: These are mature companies like AT&T (T) that you own primarily for the dividends. They are expected to grow just slightly above the Gross National Product.
What To Expect: What you can expect here is the same as what you expect from a high interest paying savings account. Dividend growth and capital appreciation are rare events in this category. You hold them mainly for a steady dividend payment.
When To Sell: Since these stocks are held mainly for their dividends, a dividend cut is the obvious sell signal. Shrinking earnings and ballooning payout ratios could be used as indicators.
What Is It: Stalwarts are companies like Coca-Cola (KO) and McDonald's (MCD). These are relatively "slow" growers but are usually faster than the market in general. You need these stocks to cushion your portfolio during down times.
What To Expect: You can expect these companies to perform fairly steadily through good times and bad. Their returns will not as good as the growth companies during a boom nor will they suffer terribly in a bust.
When To Sell: Lynch suggests selling the stalwarts if they suddenly present you with a huge unexpected gain, say 50% or if the fundamentals deteriorate and the company starts to "diworsify."
What Is It: Turnarounds are companies that were once well respected high flyers that now have their wings clipped. Lynch uses Chrysler as an example in his book. In today's terms it could be Nokia (NOK) or Research In Motion (RIMM). Of course these companies have not turned around yet and the chances look slim at the moment.
What To Expect: If you own these stocks you have to realize that you are making a risky bet and that it could totally burn out. So you can expect either high rewards or losing almost your entire capital.
When To Sell: This is the toughest category to spot a sell-signal. Using the examples of RIMM and Nokia, if their depressed PEs return to their pre-fall level, that is your sell signal.
What Is It: These are companies that rise and fall mainly due to macro-economic and sector specific conditions. If there is a recession, they struggle and they flourish during a boom. Auto-companies, Airlines, and most Materials fall in this category.
What To Expect: Everyone knows about cyclicals but what is not commonly understood is these are very volatile. You cannot own, say Freeport McMoRan (FCX), and expect to have a smooth ride up (unless you picked it right at the turn of the cycle). The ride is going to be bumpy with nasty falls and scintillating rises. If you do not have the stomach for it, do not get into cyclicals. A lot of people complain about how these stocks fall violently, clearly showing they do not know what type of stock it is. The key to owning cyclicals is timing the economic cycle. For example, you do not want to be holding copper stocks if you expect China to slow down.
When To Sell: Buildup of inventory is the main sell-signal in this category according to Lynch. With cyclicals so strongly dependent on inventories and the associated costs, you may want to stick with companies like Potash Corporation (POT), which has 70% of its cost as variable - meaning it's tied to the demand volume.
What Is It: These are companies that have something valuable (gold, cash, oil etc) that you have recognized but the analysts and investors in general have overlooked. Some times, their market cap is lesser than their net asset value, making them attractive for value investors. Seeking Alpha contributor Bret Jensen is someone who seems to have a fair knowledge of these kind of companies that are overlooked. Here is a sample article.
What To Expect: These companies are undervalued for one reason - not many know about them. So, expect these to remain undervalued for a long time, as this is not the place for quick profits.
When To Sell: The basic sell signal is when the company is valued at least equal to its net asset value.