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Stock Analysis, IPO, Mutual Funds, Bonds & More

Peter Lynch’s 5 types of stocks & how to make money in them

Stock picking cannot be learnt overnight, everyone has an inherent skill, says Lynch.

, ETMarkets.com|
Aug 13, 2019, 01.07 PM IST
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The American investor fund manager and philanthropist managed the Magellan Fund at Fidelity Investments between 1977 and 1990.
Legendary investor Peter Lynch believes investing in the stock market should not be intimidating and it does not really require any advance level of education. To amass stellar returns from the stock market, all that an investor needs are intelligence, awareness, patience, a bit of skill and the ability to do some research.

The American investor fund manager and philanthropist managed the Magellan Fund at Fidelity Investments between 1977 and 1990. Till the time Lynch retired in 1990, his fund delivered 29.2 per cent average annual returns, more than doubling the returns on the S&P500 index and making it the best performing mutual fund in the world. During his tenure, assets under management of the fund increased from $18 million to $14 billion.

Invest for the long term


Lynch says stock picking cannot be learnt overnight, everyone has an inherent skill to pick stocks, which they are unaware of. He say in order to generate huge returns from the stock market, it is important to invest for the long term as the power of compounding can make a huge difference over time.

“When you put away a certain amount every month, earning 6 per cent every year, the returns over say, 30 years, may seem attractive. But after your investment is taxed, your returns are reduced. So if you don't need that money until retirement and you don't need pay taxes on the money until it is withdrawn, the power of compounding provides the best return. The longer the money compounds, the better the returns," he told investors in an address, whose video is now available on YouTube.

Lynch is known for devising a number of modern individual investing strategies and has co-authored a number of books and papers on investing. Nowadays he spends most of his time mentoring young analysts and sharing his investment philosophies with budding investors.

Choose stock market for better returns


Lynch says the stock market provides better returns over other forms of investments, like bonds and treasury bills which can only give average return of around 3-5 per cent.

But if an investor is not willing to invest in the stock market for a long time, it is best to keep away as the market can be volatile and there is a lot of risk associated with stock investing, says he.

"A good stock can take several years before it really pays off. Give your investment time to grow. No one can tell you when the right time is to sell a stock. You need to have patience. If you are averse to risk, the stock market is not for you," he says.

Pick stocks after full research on company

Lynch says investors should pick stocks based on their direct exposure to the companies as a consumer or as a professional. He feels picking stocks whose products or services are highly recommended may provide stellar returns over the long run. “Research the company and its products and services. Ask people why they are using a certain product versus another. Ask them what they think of the product and if they would continue using it for years to come. Check what they like about it. Look for products and services that are the best, those who provide the best value," he says.

Focus on only a few companies

Lynch says it is essential to focus on only a few companies and research them well before buying their stocks, as it is not possible to keep an eye on all the companies in the stock market.

Crediting McDonald's and Coca-Cola for their many-fold growth through decades, Lynch says it is their out-of-the-box thinking and innovation that led to their success over time.

It is necessary to spot a good opportunity to buy great companies at great prices, as the stock market is very volatile and factors like wars, elections, rising interest rates, or bad economic conditions can push the market down anytime, he says.

Each stock has a different story to tell

According to Lynch, each stock has a different story to tell and no two stocks behave in the same way and, hence, there is no particular formula that can be applied to all stocks before investing in them. As each stock exhibits different qualities, it is essential to research properly before zeroing in on a stock.

Five stock categories

Lynch breaks down stocks into categories that can serve as guidelines to assist investors make the right decision before picking one.

"There are basically five categories. One would be fast growers, two would be slow growers, three would be cyclicals, four would be asset players and the fifth one would be turnarounds. Companies may not always fit neatly into a particular category. Many are known to have changed categories at some point in time,” he says.

1. Fast Growers

Lynch says investors should look out for stocks with companies having steady earnings growth and rising dividends, which he refers to as 'fast growers'.

He says fast growing companies that expand at over 25% a year aren't many in number. They have a knack for defying their size and finding new and exciting ways to grow earnings and give investors plenty of time to get involved.

"The beauty of investing in these powerful companies is that you have plenty of time. You don't have to be there in the first, second or third year. They continue to grow – for five, 10, 20 and many more years. Revenues and earnings that grow rapidly are hallmarks of a fast grower," he says.

Categorising Microsoft as a fast grower, Lynch says in the three years since it went public, it made 20-times the investment and grew by leaps and bounds in its 20-year growth cycle.

2. Slow Growers

Lynch says some companies have the scope of growing forever at a steady pace as external factors like wars, elections and rising interest rates do not affect them.

Giving the example of Service Corporation International as a slow grower, Lynch says the company, which is into the business of providing funeral goods and services grew at a steady rate of 15 per cent year after year.

3. Cyclicals

Lynch advises investors to exercise caution while buying stocks of companies that are directly connected to the economy of a country. Lynch calls them cyclicals, whose earnings can go from spectacular in one quarter to non- performer in another if the economy does not perform well.

Lynch advises investors to pick a strong company having good cash flow and low debt while investing in cyclicals as they can survive when the cycle goes down.

4. Turnarounds

Lynch says there are companies whose stocks have taken a severe beating in the past and have been forgotten by investors but have the potential for reversing their fortunes.

Terming them 'turnarounds', Lynch says investors can check balance sheets of these companies to predict whether they can reverse their trends. "If the companies are doing things to improve themselves – coming up with new products or have been taken over by a new management, or they're cutting costs, it is a good indication that they have the potential for bouncing back. Many turnarounds don't happen, and there are more losers than there are winners. The important thing is to wait for evidence of the actual turnaround to happen. Don't act on the symptoms," he remarks.

Giving example of Kresge, Lynch says that it was in real trouble and going nowhere till it introduced K Mart. After its introduction, the stock went up fifty-fold, making K Mart a massive stock.

5. Asset Players

Lynch is of the view that many companies have a hidden asset which is not often reflected in the stock price. When the stock exchange gets the indications of this hidden asset, the stock can become a runaway hit.

Giving example of Walt Disney as an asset player, Lynch revealed that when Disney World and Epcot opened up, they weren't doing too well. Then they discovered their hidden asset was their name ‘Walt Disney’ which went on to become a great success.

"A hidden asset is a name – like Disney or Coca-Cola. It's the reputation an old time company has built up over the years. Though not reflected on the balance sheet, it has incredible value and can be a huge asset when these companies roll out new products. No one can duplicate their products as long as they have those patents," Lynch affirms.

Things to look out for before investing in a company

According to Lynch, investors while evaluating a company for investment should find out whether it has good growth prospects. Companies having a long history of increase in earnings and dividends, introducing new products, cutting costs and showcasing a great balance sheet coupled with a terrific brand name is what investors should look out for.

Also, investors should focus on what the company’s products are and where its money is coming from and what it is competing against. In case the stock of the company is behaving differently from the expectation, it is wise to find out the reason for it.

Pick the right time to buy a stock


Lynch further urges investors to pick the right time to buy a stock and look for times when the potential upside is high, and the potential downside is reduced.

“Understand that balance is a key to successful stock investing. Stock picking is a risk-reward trade-off. You have to know how much you're going to lose if you're wrong and how much you're going to make if you're right. The skill is to minimize your risk and maximise your reward," he feels.

Mutual funds as an Alternative


Lynch says until investors are comfortable with the stock market and researching companies it is better not to pick stocks themselves and invest in equity mutual funds which are managed by experts. This way investors can diversify their investments and are also protected from the dangers of a few stocks dropping sharply.

He warns that equity mutual funds are volatile, and proper research is essential before choosing them.
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