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http://businesstoday.intoday.in/story/investment-tips-from-legendary-investor-peter-lynch/1/202660.html
It is not often that I would update an old post. But here in making an exception is perhaps necessary. Just in case if you are more interested in reading the original draft and a cruder version then it's given below.
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Building
a winning Portfolio: The Peter Lynch way
Peter Lynch is like a rock star for many
investors around the world. Perhaps his celebrity status is because he has
written books in a simple language without using many jargons where he shares
his philosophy and details his style of stock picking. To instruct and pass on
his full experience he not only shares about his successes but also of his
failures in stock picking.
Its not that he just wrote books, it is a
fact that under his stewardship as the fund manager of Magellan (1977-1990),
the fund gave an astounding annual average return of 29%. Of the 13 years, his
fund outperformed the S&P 500, its benchmark, in 11 years.
Aswath
Damodaran, Professor of Finance at the Stern School of Business at New York University
Sanjay Bakshi,
Adjunct Professor at Management Development Institute (MDI), Gurgaon, says “In
my view, this is one of the very good books which investors with an interest in
long-term wealth creation should read. Lynch has an excellent track record and
he tells you in plain English without the usage of any jargon how he did it. He
lays out his system of thinking about businesses using common sensical
principles.”
Dr Vikas V.
Gupta, Fund Manager, Alpha L50 (India
To explain this,
Dr Gupta makes an interesting observation, which is, the rate of inflation and
interest rate in US when Lynch was a fund manager was different than what we
have in India India
Peter Lynch’s philosophy
Peter Lynch gives
many pointers for investors on ‘How to research?’ Things to look at and what
should be ignored. He also explains on how to classify a company based on
market capitalization and also based on life cycle of a business.
Most importantly,
he advises investors to stick to their field of competency, an argument also
advocated by another legend – Warren Buffett. Lynch’s argument being that a
doctor would always know more about medicines and hence should be in a better
position to judge pharmaceutical companies than a civil engineer, or a salesperson
with an auto company would understand his company and the competitors better
than others. They will get to know if sales are increasing or decreasing for
them and all others in the industry before analysts would realise.
Part of his
investment philosophy was to place the companies in one of the six categories;
thus defining an expectation from the company. This is crucial as it will also
allow the investor to identify the right focus points.
The first category
of companies is ‘slow growers’. These are large companies that have been in
existence for a long time and are expected to grow slightly faster than the
GNP. This could also be because the entire industry has aged and is growing
slow. The most important sign of a slow grower would be, it pays regular and
generous dividends. Such companies must be included in the portfolio as a
dividend cheque is always good.
Stalwarts are
the second category of companies. These are also large companies but they haven’t
lost all the steam. Here, Lynch has advocated a clear strategy, investors
should aim to buy stalwarts for 30-50% gain and then sell them off and repeat
the process whenever there is an opportunity. These companies are not meant to
be held forever. They should be kept in the portfolio because they offer
protection during recession and hard times, while bringing an upside when the
marker is in positive sentiment.
His favourite
category of companies was ‘Fast Growers’. Peter Lynch advocates them as they can
generate the maximum returns although he also warns that such companies face
greater risk for extinction. The typical characteristic of such companies would
be that they are small, aggressive new enterprises that can grow at 20-25% per
year. Explaining further he says: “This has nothing to do with the industry.
There can be a fast growing company in a slow growing industry as well.” The
second type of risk with such companies is of devaluation once they begin to
falter. According to Lynch the trick here would be to figure out when they
would start getting slow in their growth and what is the correct price at which
one should buy.
Third category
of companies would be cyclicals. He characterizes such companies that it will
witness a rise and fall in its sales and profit in regular if not predictable
fashion. Auto, airlines, tire companies, steel companies and chemical companies
are all cyclicals. Coming out of recession and into a vigorous economy, the
cyclicals tend to flourish and their stock price tends to rise faster. The
caveat here is, if you buy a cyclical in the wrong part of the cycle then it
can result in loss of your portfolio. Even though it is customarily said that
you should not time the market but in case of cyclical companies, ‘timing is
everything’.
Then he has
described two other categories of companies but these are more like special
situations. These are turnarounds and asset play.
Turnarounds’ are
companies that were on the verge of being bankrupt or going out of business and
then they revived. This could be because the government bailed them out, or a
strategic investment is made by another company or group, and the business is
revived. The simplest example would be Satyam.
Asset Play:
These are unique companies, as it would be a dying company or a company that is
so old that its real estate has been completely written-off the books, high
cash with negligible debt. This is the tough part, assessing if it has real
assets and how to value them, most importantly if the company still owns them.
Will the current management allow its liquidation? It requires understanding of
the company’s assets, and once understood it requires patience.
Once a company
has been categorized properly, Lynch’s philosophy requires understanding of the
business and building a story on why one should invest in the company. For this
he recommends investors to use the product of the company, and prepare a reason
why should an investor put their money in it. Though it sounds simple,
practicing this is extremely difficult.
One of the
cardinal rules he recommends was to ‘stay away from the hottest stock in the
hottest industry’, the one that gets the most favorable publicity. This simple
and single test would have saved many investors during euphoric moments. His
argument against such stocks was, “If you are not clever in selling the hottest
stocks then you’ll soon see your profits turn into losses, because when the
price falls, it’s not going to fall slowly, nor is it likely to stop at the
level where you jumped on.”
Another item on
his suggestion was to stay away or exit out a company that diversifies in
unrelated business. ‘Diworsefication’, a
term that Lynch has used many times, he says that any company that tries to
diversify into another non-related business is not diversification but diworsefication and recommends that
investors should re-check the story of the company. Perhaps it’s best to book
profit in this investment.
He also preaches
that investors should invest in stocks only the amount that they can afford to
lose, as stock market can be irrational for some time, and should be invested
for long-horizon like 5-10 years or more. This is an important underlying for
this part of his philosophy clearly abhors leveraged investment and desists
speculation.
Lynch also
suggests that before buying a stock an investor should also check the
historical PE through several years to get a sense of its normal level. But not
limit to this but for an established company with relative history, for a high
PE company, one should also look at the growth rate (Refer to the box ‘PEG’). He also suggests comparing the PE level of
similar companies, but not limiting to that but even check the PE of the
market. (Refer to the box ‘Understanding
market directions’)
It requires
discipline and continuous tracking, since he recommends that if the story has
changed then re-evaluate the stock to see if it should still be a part of the
portfolio. This requires regular monitoring, at least once in six months, Lynch
recommends, “Owning stock is like having children. Don’t get involved with more
than you can handle.” His message being very clear, invest only in so many
stocks as you can follow.
PEG Ratio
Lynch is
credited to use an idea of a test to check if it’s worth putting in the effort
on details of a company. He used to divide the PE of the stock by its growth
rate, popularly known as Price-Earnings Ratio to Growth (PEG).
PEG
= Price-to-Earnings / Per-cent Growth of the company
“PEG is just a
tool, one of many that Lynch talks about in his book. The key is to not
misuse it. Charlie Munger talks about ‘man with a hammer syndrome’ where to a
man with a hammer everything looks like a nail. Investors who using just PEG
and ignore other tools in financial and stock analysis suffer from that
syndrome,” says Bakshi.
Bakshi
explains this further with an example from the era of internet bubble. He
says, “People used PEG to justify overvalued stocks they really wanted to own
because they could not see other people get rich (even temporary) and
everyone was doing it and they did not want to be left out.”
“At the time,
many companies were growing at a torrid pace because they had started from a
very low base. So when growth rates were 200%, people said well if they pay
100 times earnings, the PEG is ‘only’ 0.5 so they bought it and of course
they got killed because that kind of growth was not sustainable,” says
Bakshi.
“The PEG ratio
is an attempt (and a fairly crude one) to incorporate growth into a multiple
and there is no
Dr. Gupta
says, “I would recommend that when using PEG ratio, one should be very
careful to understand Lynch’s principle, everything he recommends. A company
which has historically been growing by 20% year-on-year and it has a PE of 20
will show a PEG of 1. Now another company with a growth rate of 5%
year-on-year with a PE of 5 will also show PEG ratio of 1. But they are not
the same. It is an indicative tool; to use it properly one must adjust the
same for the Indian market.”
“Any investor
must look at other factors that Lynch describes like debt level, if the stock
is hot stock, if the sector is too hot, what is the historical PE of the
stock, etc. All of these factors should be taken into account, before making
an investment decision,” says Dr Gupta.
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Box
– 2
Understanding
markets direction
Peter Lynch also recommends that
investors should look at the market index to determine if it is a good time
to invest. This is a valid point. We checked PE history since 2000, and
checked the median, average, high and low in each year (Refer to table -- PE data
of CNX Nifty 50). In most years the index’s
median and average was between 15-18 times. And in years when bubble had
busted – 2000 and 2008 – the PE had peaked at 28 times. This gives an idea
that when market PE crosses 25 then perhaps its best to move out of equities
or have more investments in defensive stocks. Meanwhile, it is good
opportunity to evaluate the stocks when the market is below PE 15 times.
Example: PE data of
CNX Nifty 50
*Till Nov 8, 2013
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BOX
- 3
A simple checklist
for the story to determine ‘When to sell’
Slow
growers
Stalwart
Cyclical
Fast
grower
Turnaround
Asset
play
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