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So what sort of stock does Lynch look for, then? He outlines several pointers to find "the perfect stock" in the book. In general he searches for undiscovered small company "gems", great businesses that nobody knows about -- yet. I'll use an example of a company that I have shares in, Latchways (LSE: LTC) that I think suit his sensible criteria. Although I was initially attracted to Latchways through their historic financial performance, I always subsequently put any prospective company through the Lynch criteria. How does Latchways match up?
Those are five of thirteen attributes that Peter Lynch looks for. Overall, anything that keeps investors away from noticing the company's great track record -- dull name, boring industry, no Wise following etc -- must be good news for the enterprising Fool who's prepared to do some digging in the search for "perfect stock". Lack of attention undoubtedly leads to value when considering possible growth prospects.
One of the most enjoyable parts of the book, for me at least, is Lynch's distaste for "hot" stocks. He gives plenty of examples witnessed throughout the last three decades. These hot stocks have usually, but not always, revolved around a variety of technological advances. All go spectacularly up. Then go spectacularly down.
Lynch comments: "If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favourable publicity, the one that every investor hears about... Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there is nothing but hope and thin air to support them, they fall just as quickly. If you aren't clever at selling hot stocks (and the fact that you've bought them is a clue that you won't be), you'll soon see your profits turn to losses, because when the price falls, it's not going to fall slowly, nor is it likely to stop at a level where you jumped on."
It goes without saying that, if Lynch was thinking of investing in today's UK market, he'd be unlikely to be looking at the various Internet and technology companies that have seen tremendous rises of late. An archetypal set of hot stocks, if you ask me. I'm not going to comment any further on these shares -- I'm sure Foolish investors who bought into such issues (and you know the ones I mean) have a deep appreciation of the underlying business model, rather than just anticipation of how the share price will perform over the next month.
What makes the perfect Lynch stock?
The company has a dull name.
You don't have to worry about buying into a speculative froth when the company has a dull name. And Latchways is hardly an exciting name. To catch investors' attention in today's climate, there is a definite need for an eye-catching name. There are three typical choices -- a fancy name, a mysterious acronym and nowadays a "dot com" suffix. You can't get much fancier than 365 Corporation (LSE: TSF), a company with no letters in its main name. Mysterious acronyms? Surely NXT (LSE: NTX) is far sexier than its old name, Verity. And dot com suffixes abound, one example being Globalnet Financial.com (LSE: GLFA).
But some companies mix and match for added excitement. GEO Interactive Media (LSE: GIM) has a fancy name with a mysterious acronym, QXL.com (LSE: QXL) has a mysterious acronym and a dot com suffix, and Scoot.com (LSE: SCO) has a fancy name and dot com suffix.
If the company name sounds exciting, as they usually do in exciting industries, then the company is likely to attract hoards of "trendy" speculators. Encouraged by visions of industry growth, speculators, by their nature, do have the habit of boosting share prices to irrational investment levels. You'll never make long term money buying after the speculators.
The company does something dull.
Dull businesses again don't attract much investor enthusiasm, leaving plenty of time for investors to make rational share purchases. That is until the "dull" news flow becomes too much and the secret is revealed to all and sundry. Latchways design and assemble Fall Arrest Equipment. Basically, that's safety equipment that keeps people who climb up cranes and radio masts secure should they fall off. It's hardly an exciting product, unless you've had the use of one, dangling from a crane. If fact safety equipment is positively mind-numbing compared to the excitement generated lately from RISC microchips, flat loudspeakers and business to business e-commerce software.
And another bonus of being a dullard is that it doesn't encounter much competition. Unlike the e-commerce industry, you don't hear of management consultants leaving their well-paid jobs to become a competing Fall Arrest startup. That would be far too dull. In the book, Lynch says: "Competition is hazardous to human wealth". I agree.
The institutions don't own it, and the analysts don't follow it.
Latchways doesn't score too highly on the institution front, with three on the register with at least 3% holdings. But do the analysts follow it? There's just the one. But as you can imagine, given the size of the company, it's not at the top of the list for Wise investigation. According to Company REFS, it wasn't until June this year that a broker forecast replaced the one from April 1998. Maybe the distance between the City and Wiltshire puts off analysts visiting Latchways? Or maybe they are too busy following Internet shares instead?
In fact, I contacted the Finance Director of Latchways earlier in the year, concerning some straightforward working capital questions. He mentioned that I was the first to specifically mention this situation, ahead, I assume, of any "professional" analyst. In fact, if I paid the company a visit and asked a few questions, I reckon I could probably become Britain's leading investment authority on Latchways (I envisage such a visit next year!). Remember, if an army of Wise men follow a company, you're unlikely to unearth any significant new information that other investors, and the share price, are completely unaware of.
The company has a niche.
One attraction to Latchways is their operating margins -- 30%-plus. It appears to have a big niche in the relatively small safety equipment industry, based on the company's reputation and product patents. Being a big player in a small industry is far better than being a small player in a big industry. In a big market, small industry players tend to be constantly squeezed out by the larger opposition.
Companies need barriers in whatever form -- patents, government licences -- to fend off the competition away from their long term profits. I could imagine it's difficult for a new competitor to suddenly "create" a similar reputation and alternative products. That's assuming they don't already think the industry is too boring to get into in the first place. Having such high operating margins gives me the impression of Latchways having the required niche to keep long term profits to themselves.
People have to keep buying the products.
Hmmm. I'm not convinced that there is a lot of repeat business for Fall Arrest equipment. Once you've bought your safety harness, that's it. They are unlike razor blades, fizzy drinks and newspapers -- constantly being bought day in, day out by the consumer.
But there is a secondary point to make. Latchways products, or similar alternatives, are now effectively mandatory for various occupations. Increasing global legislation has given Fall Arrest equipment sales a real boost in the last few years. So there's no real repeat business, but the legislative impact is a good second best alternative.
In Summary...
Lynch also comments on two other vital points -- the niche and sales stability. Barriers to fend off competitors are all-important for a long term investment. Link the profit niche to the sales growth, and you could be onto a winner.
All in all, I consider the above criteria pretty much mandatory when considering any stock purchase. After seeing, day after day, the latest companies in fashionable sectors continuing their speculative froth, Peter Lynch's book gives some sound advice. If you're starting out on the long road to investment riches, and tempted by the short-term, seemingly easy money on offer in some high profile sectors, One Up on Wall Street and the stock picking strategies outlined in it come highly recommended.
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