Courtesy :http://www.csulb.edu/
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No
modern-day investment "sage" is better known than Peter Lynch. Not
only has his investment approach successfully passed the real-world performance
test, but he strongly believes that individual investors have a distinct
advantage over Wall Street and large money managers when using his approach.
Individual investors, he feels, have more flexibility in following this basic
approach because they are unencumbered by bureaucratic rules and short-term
performance concerns.
Mr.
Lynch developed his investment philosophy at Fidelity Management and Research,
and gained his considerable fame managing Fidelity’s Magellan Fund. The fund
was among the highest-ranking stock funds throughout Mr. Lynch’s tenure, which
began in 1977 at the fund’s launching, and ended in 1990, when Mr. Lynch
retired.
Peter
Lynch’s approach is strictly bottom-up, with selection from among companies
with which the investor is familiar, and then through fundamental analysis that
emphasizes a thorough understanding of the company, its prospects, its
competitive environment, and whether the stock can be purchased at a reasonable
price. His basic strategy is detailed in his best-selling book "One Up on
Wall Street" which provides individual investors with
numerous guidelines for adapting and implementing his approach. His most recent
book, "Beating the Street" [Fireside/Simon & Schuster
paperback, 1994], amplifies the theme of his first book, providing examples of
his approach to specific companies and industries in which he has invested.
These are the primary sources for this article.
The
Philosophy: Invest in What You Know
Lynch
is a "story" investor. That is, each stock selection is based on a
well-grounded expectation concerning the firm’s growth prospects. The
expectations are derived from the company’s "story"--what it is that
the company is going to do, or what it is that is going to happen, to bring
about the desired results.
The
more familiar you are with a company, and the better you understand its
business and competitive environment, the better your chances of finding a good
"story" that will actually come true. For this reason, Lynch is a
strong advocate of investing in companies with which one is familiar, or whose
products or services are relatively easy to understand. Thus, Lynch says he
would rather invest in "pantyhose rather than communications
satellites," and "motel chains rather than fiber optics."
Lynch
does not believe in restricting investments to any one type of stock. His
"story" approach, in fact, suggests the opposite, with investments in
firms with various reasons for favorable expectations. In general, however, he
tends to favor small, moderately fast-growing companies that can be bought at a
reasonable price.
Selection
Process
Lynch’s
bottom-up approach means that prospective stocks must be picked one-by-one and
then thoroughly investigated--there is no formula or screen that will produce a
list of prospective "good stories." Instead, Lynch suggests that
investors keep alert for possibilities based on their own experiences--for
instance, within their own business or trade, or as consumers of products.
The
next step is to familiarize yourself thoroughly with the company so that you
can form reasonable expectations concerning the future. However, Lynch does not
believe that investors can predict actual growth rates, and he is skeptical of
analysts’ earnings estimates.
Instead,
he suggests that you examine the company’s plans--how does it intend to
increase its earnings, and how are those intentions actually being fulfilled?
Lynch points out five ways in which a company can increase earnings: It can
reduce costs; raise prices; expand into new markets; sell more in old markets;
or revitalize, close, or sell a losing operation. The company’s plan to
increase earnings and its ability to fulfill that plan are its
"story," and the more familiar you are with the firm or industry, the
better edge you have in evaluating the company’s plan, abilities, and any
potential pitfalls.
Categorizing
a company, according to Lynch, can help you develop the "story" line,
and thus come up with reasonable expectations. He suggests first categorizing a
company by size. Large companies cannot be expected to grow as quickly as
smaller companies.
Next,
he suggests categorizing a company by "story" type, and he identifies
six:
Selection
Criteria
Analysis
is central to Lynch’s approach. In examining a company, he is seeking to
understand the firm’s business and prospects, including any competitive
advantages, and evaluate any potential pitfalls that may prevent the favorable
"story" from occurring. In addition, an investor cannot make a profit
if the story has a happy ending but the stock was purchased at a too-high
price. For that reason, he also seeks to determine reasonable value.
Here
are some of the key numbers Lynch suggests investors examine:
Year-by-year
earnings: The historical record of earnings should be examined for stability
and consistency. Stock prices cannot deviate long from the level of earnings,
so the pattern of earnings growth will help reveal the stability and strength
of the company. Ideally, earnings should move up consistently.
Earnings
growth: The growth rate of earnings should fit with the firm’s
"story"--fast-growers should have higher growth rates than
slow-growers. Extremely high levels of earnings growth rates are not
sustainable, but continued high growth may be factored into the price. A high
level of growth for a company and industry will attract a great deal of
attention from both investors, who bid up the stock, and competitors, who
provide a more difficult business environment.
The
price-earnings ratio: The earnings potential of a company is a primary
determinant of company value, but at times the market may get ahead of itself
and overprice a stock. The price-earnings ratio helps you keep your
perspective, by comparing the current price to most recently reported earnings.
Stocks with good prospects should sell with higher price-earnings ratios than
stocks with poor prospects.
The
price-earnings ratio relative to its historical average: Studying the pattern
of price-earnings ratios over a period of several years should reveal a level
that is "normal" for the company. This should help you avoid buying
into a stock if the price gets ahead of the earnings, or sends an early warning
that it may be time to take some profits in a stock you own.
The
price-earnings ratio relative to the industry average: Comparing a company’s
price-earnings ratio to the industry’s may help reveal if the company is a
bargain. At a minimum, it leads to questions as to why the company is priced
differently--is it a poor performer in the industry, or is it just neglected?
The
price-earnings ratio relative to its earnings growth rate: Companies with
better prospects should sell with higher price-earnings ratios, but the ratio
between the two can reveal bargains or overvaluations. A price-earnings ratio
of half the level of historical earnings growth is considered attractive, while
relative ratios above 2.0 are unattractive. For dividend-paying stocks, Lynch
refines this measure by adding the dividend yield to the earnings growth [in
other words, the price-earnings ratio divided by the sum of the earnings growth
rate and dividend yield]. With this modified technique, ratios above 1.0 are
considered poor, while ratios below 0.5 are considered attractive.
Ratio
of debt to equity : How much debt is on the balance sheet? A strong balance
sheet provides maneuvering room as the company expands or experiences trouble.
Lynch is especially wary of bank debt, which can usually be called in by the
bank on demand.
Net
cash per share: Net cash per share is calculated by adding the level of cash
and cash equivalents, subtracting long-term debt, and dividing the result by
the number of shares outstanding. High levels provide a support for the stock
price and indicate financial strength.
Dividends
& payout ratio: Dividends are usually paid by the larger companies, and
Lynch tends to prefer smaller growth firms. However, Lynch suggests that
investors who prefer dividend-paying firms should seek firms with the ability
to pay during recessions (indicated by a low percentage of earnings paid out as
dividends), and companies that have a 20-year or 30-year record of regularly
raising dividends.
Inventories:
Are inventories piling up? This is a particularly important figure for
cyclicals. Lynch notes that, for manufacturers or retailers, an inventory
buildup is a bad sign, and a red flag is waving when inventories grow faster
than sales. On the other hand, if a company is depressed, the first evidence of
a turnaround is when inventories start to be depleted.
When
evaluating companies, there are certain characteristics that Lynch finds
particularly favorable. These include:
Characteristics
Lynch finds unfavorable are:
Portfolio
Building and Monitoring
As
portfolio manager of Magellan, Lynch held as many as 1,400 stocks at one time.
Although he was successful in juggling this many stocks, he does point to
significant problems of managing such a large number of stocks. Individual
investors, of course, will get nowhere near that number, but he is wary of
over-diversification just the same. There is no point in diversifying just for
the sake of diversifying, he argues, particularly if it means less familiarity
with the firms. Lynch says investors should own however many "exciting
prospects" that they are able to uncover that pass all the tests of
research. Lynch also suggests investing in several categories of stocks as a
way of spreading the downside risk. On the other hand, Lynch warns against
investment in a single stock.
Lynch
is an advocate of maintaining a long-term commitment to the stock market. He
does not favor market timing, and indeed feels that it is impossible to do so.
But that doesn’t necessarily mean investors should hold onto a single stock
forever. Instead, Lynch says investors should review their holdings every few
months, rechecking the company "story" to see if anything has changed
either with the unfolding of the story or with the share price. The key to
knowing when to sell, he says, is knowing "why you bought it in the first
place." Lynch says investors should sell if:
For Lynch,
a price drop is an opportunity to buy more of a good prospect at cheaper
prices. It is much harder, he says, to stick with a winning stock once the
price goes up, particularly with fast-growers where the tendency is to sell too
soon rather than too late. With these firms, he suggests holding on until it is
clear the firm is entering a different growth stage.
Rather
than simply selling a stock, Lynch suggests "rotation"--selling the
company and replacing it with another company with a similar story, but better
prospects. The rotation approach maintains the investor’s long-term commitment
to the stock market, and keeps the focus on fundamental value.
Summing
It Up
Lynch
offers a practical approach that can be adapted by many different types of investors,
from those emphasizing fast growth to those who prefer more stable,
dividend-producing investments. His strategy involves considerable hands-on
research, but his books provide lots of practical advice on what to look for in
an individual firm, and how to view the market as a whole.
Lynch
sums up stock investing and his outlook best:
"Frequent
follies notwithstanding, I continue to be optimistic about America, Americans,
and investing in general. When you invest in stocks, you have to have a basic
faith in human nature, in capitalism, in the country at large, and in future
prosperity in general. So far, nothing’s been strong enough to shake me out of
it."
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