Thursday, December 17, 2009

Peter Lynch's 6 Stock Archetypes

View of Wall Street, Manhattan.Image via Wikipedia
Peter Lynch classifies all stocks into roughly 6 categories: slow growers, stalwarts (mid-growers), fast growers, cyclicals, asset plays, and turnarounds. Later, he also gave some human equivalents.

Why human equivalents? Human beings are a lot like businesses. Businesses, like human beings, even if they haven't earned anything, have the POTENTIAL to earn. A 12-year old child has more potential to earn (mow lawn, lemonade stand, etc.) than probably some 80 year old in a nursing home, even though the 12-yr old has no history of earning, while the 80-year old have a very long record. Add up the assets, and the liabilities, and you end up with book value (or in human terms, "net worth").


Slow Growers

Slow growers are extremely stable, like utilities are now (they were fast-growers back in the 1960's). If it pays a generous and regular dividend, it's probably a slow grower. Figure, 2-5% growth per year, right about rate of inflation. [In general, companies pay dividend because the managers can't think of a way to expand their business using their profits, but it doesn't want to buy back its own stocks either, so they give the profit back to the stockholders as dividends to enhance the company prestige and goodwill instead.]


Utilities do NOT grow because it takes too much capital expenditure and bureaucratic red tape to get a power plant approved and built nowadays. Cheaper to buy power from a different state that has a surplus, or even Canada. Watch for signs in an industry that requires HUGE amount of initial expenditure, but those have VERY long life, and thus now has just simple operating expenses.

Slow growers are the stuff you buy when you can't find anything else. Frankly, if you ran that low, you should go buy some Treasury bonds instead.

People-wise, they have slow and steady, but secure jobs. Think teachers, librarians, and so on.


Stalwarts

Stalwarts (or mid-growers) are companies like Coca-Cola, Proctor and Gamble, Bristol-Meyer, etc. They are huge, but they either buy market share or they have retail oomph that they can generate 10-12% annual growth in earnings. If you hold them long enough, they provide decent returns. Not great, just decent, but it sure beats treasury bonds. They usually have a nice brand-name to rely on and sell consumable necesities (i.e. stuff that you need over and over again). They may periodically launch new products, usually they're big enough that one new product doesn't affect them that much.

Stalwarts should be bought and sold as they yield a decent profit, like 30 to 50%. Think of it this way: if your company was going merrily along at about 15% a year, then sudden it yielded 50% over 2 years, don't you wonder if the up cycle is about to end? Thus, shift the money around when you run into stalwarts. On the other hand, they provide a handy hedge against soft economy. Most have VERY few down quarters, if any.

People-wise, think mid-level managers in a corporation... good salary, good raises, but won't be mega-rich either.


Fast Growers

Fast Growers are smaller aggressive companies that can do 20-25% growth in earnings per year. Pick the right one, and in a few years it'll grow multi-fold. It doesn't have to be in a fast growing industry. The right amount of marketing and acquisition savvy can improve earnings as well.

The primary risk in investing in fast growers are 1) overzealous and bit off more than they can chew, or 2) underfinanced, ran out of cashflow. The former would cause it to run out of momentum. If the growth slows, the stock price will get hammered. The latter usually means Chapter 11 bankruptcy.

Fast growers need good clean balance sheets, and steady nice profits, for you to invest in. The trick is figuring out when they will slow/stop growing, and how much will you pay for the growth.

People-wise, you're looking at actors, inventors, small businessmen, musicians, athletes, and so on. They have the potential to make it big.


Cyclicals

Cyclicals are industries / companies that are affected by cyclical changes, such as economy, government elections, and so on. Travel industries like airlines and auto companies and tire companies are affected by the economy a lot. When times are good, travel is up, everything goes up. When economy is down, everything goes down. Defense industries are often affected by national policy and elections (change of administrations). Semi-conductor makers like AMD, Intel often have to make MAJOR infrastructure expenses to upgrade their technology every few years, affecting their earnings for that year or so.

In a sense, cyclicals are the riskiest investments you can make... If you bought in at the wrong time. They appear to be big and steady... Until they hit the downturn. They are often regarded as a stalwart, until their true colors show.

Timing, when it comes to cyclicals, is everything. You need to watch the company for signs of upturn, and get in then. This is where "buy what you know" comes in.

People-wise, you're looking at those with seasonal income, like amusement park workers, summer camp workers, Bering Sea fisherman (3 months out of a year, i.e. "Deadliest Catch"), even writers and actors (they get paid only when a project is on).


Asset Plays

Asset play is when the company's assets exceeds its market cap. So you KNOW you're getting a good deal. The question is... Are you sure you evaluated the assets correctly?

Lynch's example is Pebble Beach. At end of 1976 it has 1.7 million shares outstanding, and stock is trading at 14.5. So the market cap for the whole thing is about 25 million. Less than three years later, Twentieth-Century Fox bought the whole thing for 76 million, then sold off the gravel pit (one tiny part of Pebble Beach) for $30 million. In other words, that gravel pit was worth more than the entire property three years ago. It's like getting the rest of the property for free (two world-famous golf courses, the hotel, a TON of land, 300-year old forests, name recognition, PGA tournament, steady cashflow...)

Keep in mind that assets may not be all tangible, and value of an asset will vary depending on the appraiser / appraisal method. And book value is NOT a reliable indicator of true network, as it can be over- or under-valued.

People-wise, you're looking at someone who inherited a family fortune. Think of it as "what will be left after all the debt have been settled" kind of scenario.


Turnarounds

Turnarounds are companies that either pulled themselves out of a serious slump, or got bailed by by the government. Chrysler is one such exmaple, but that's during the Iacoca era, not the 2009 bailout. In fact, if you buy at at the depressed, price, it may be your biggest movers. However, it is a major risk betting on such company, as it CAN actually sink out of sight in the river of time. There are several subtypes, according to Lynch:

Bail us out or else: Chrysler, Lockheed, would have gone Chapter 11 if they didn't get a government loan way back then. Now, GM and Chrysler DID went chapter 11... AND got the loan... and a government takeover of sorts. A lot of the savings and loans and investments and banks are now in the same boat, weighed down by the wave of foreclosures when the interest rate hiked. You should wait a few months and see if the company can dig itself out before investing in it as a turnaround.

Who would have thought: Con Edison went from 10 to 3 in a year, then 3 to 52 in 12 years. They didn't need any one to help them turnaround. And it's a UTILITY, normally a no-growth/slow-growth industry! Con Ed's edge is that it finally figured out they can buy power from Canada instead of building their own plants. They can continue to earn money instead of investing in infrastructure and grow. If the price went down for no particular reason, or the company found a solution to its problem, then it's time to buy.

Where did that came from (or little problem we didn't anticipate): Three Mile Island was a problem for General Public Utilities. It took 7 years for GPU to climb out of its hole of 3.375 in 1980. In 1988 it went up to 38. However, TMI was more sensational than it looks. When there's a huge disaster, such as Bhopal disaster at Union Carbide plant in India, where THOUSANDS died, Union Carbide isn't really going to climb much out of that. GPU had government and other help in cleaning up the TMI mess, so their fundamentals are sound, thus, their recovery is almost inevitable. It's the timing, and help, that will determine whether it will turn around or not.

Spin-me-out: Toys R Us was a part of the moribund Interstate Department Stores. Once it got spun off, it went up 57 times its initial price. In fact, most spin-offs are worth considering. In fact, spin-offs are often a good sign for investments.

Restructure: a lot of companies, in their spurt of growth, got sidetracked into "diversification", what Lynch called "di-worse-fication". For example, Coca-cola, for a while, invested in fish farms and other stuff. Then during the down times, it sells off those extraneous stuff in "restructuring". Both were applauded by Wall Street when they happened. Fortunately, after a restructure, the parent company may become a turnaround, while the spun-off companies often become fast growers.

People-wise, you're looking at down-and-outers, bankrupts, laid-off workers, and so on. They have the potential of turnarounds... If they can get out of the doldrum.


So what does it all mean?

A company can switch categories several times during its lifetime. When a company starts, it is a fast grower. Then it sinks to stalwart, then slow grower. When competitors join in or new technology appear, they can become cyclical, then turnaround. If the price sinks far enough, they can become asset play. Don't "pigeonhole" a stock just because it "was" in a category.

A stock market want to know what are the chances of a company earning a lot of money. If the chances are good, stock prices go up. Else, it comes down. Thus, for very good growth, you pretty much have to bet on a relative unknown. In human terms, maybe s/he is an actor/ress that has worked in bit roles before moving to the big screen.

Harrison Ford was a carpenter before he got picked by George Lucas to be Han Solo. Who would have thought he'd be the superstar he is today? That's about finding "potential". It is NOT easy, but then, that's because humans don't have to lay their lives bare, like a company does. That's where all the P/E and P/S and balance sheets come in.


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