The best lesson I ever learnt about investing came from once-outperforming US fund manager Peter Lynch in his classic investment book One Up On Wall Street.
Making sense of the stock market
Lynch provided his investors with a 2,700% return over just 13 years while running Fidelity’s Magellan Fund from 1977 to 1990. That rate of return works out at a compound annual growth rate of around 29%.
That’s going some and it’s not an easy thing to do, which is why I reckon it’s a good idea to study what Lynch had to say about his approach to stock market investing.
It seems that Lynch outperformed his peers by better understanding the nature of the businesses he owned shares in. He developed a model for thinking about firms on the stock market, and it’s the best and most useful lesson I ever learnt about investing.
Before beginning any analysis of stocks, Lynch sorted companies into six different categories:
- Slow Growers
- Stalwarts
- Fast Growers
- Cyclicals
- Turnarounds
- Asset Plays
He grew to understand and think clearly about shares by categorising their underlying businesses, and the method served him well, as you can see by his investing record.
Businesses that can reverse easily
I find Lynch’s categories can lead to clear thinking about investments and what to expect from them. Take the cyclicals, for example. This unpredictable category is full of businesses that ebb and flow along with the undulations of macroeconomic cycles. Such firms can often seem to go nowhere in the longer term. But they keep wrong-footing investors by going in disguise as something else.
To the unwary investor, forward projections can make cyclicals look like fast-growing companies when they’re on the up-leg of a trading cycle. Sometimes their dividend yields and other value indicators can make them look like bargains when they’re at cyclical peaks — just before the next down-leg. But we mustn’t be fooled by their disguises. Cyclicals’ sales, profits and share prices can reverse back to where they started, and below when the economy falters.
Think of banks, miners, retail companies and housebuilders. Before investing in such cyclical beasts, it’s a distinct advantage to know what we’re dealing with up front. For example, high yields and low price-to-earnings ratios can be more of a warning than an attraction after a period of robust profits with the cyclicals, and when profits disappear and the share price is on the floor, it could be time to buy.
Moving between categories
Fast Growers, Stalwarts and Slow Growers describe different levels of average annual growth in earnings. Generally, a fast grower is likely to be a smaller company with a high P/E ratio. A slow grower will probably be a big company paying a high dividend yield on a lower P/E rating. Peter Lynch was fond of trading stalwarts in the middle ground for gains of 20% to 50% on average.
Companies can move from one category to another and fall from any category to become Turnarounds and Asset plays. So the classifications won’t make investment decisions for you, but I find they’re a good starting point that can lead to clear thinking about stocks.
