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Learning From Peter Lynch - Part IPosted by securities on: 2006-10-04 11:08:36
Learning From Peter Lynch By Hari Wibowo Having just read Peter Lynch's "One Up On Wall Street", I must say that this is the one book that I wished I have read earlier. Not that I agree with the whole philosophy. But the book has many different elements that we as investors can learn a lot from. This article will exploit just one of the many things we can learn from Peter Lynch. One of the very few things that Peter Lynch asks before investing in stocks is not the P/E ratio, dividend yield or the growth rate of a company. But rather, it is the: "Do I own a house?" question. Why a house? Peter Lynch beautifully elaborate that regular folks have an edge in investing in a house rather than a stock. Further, investing in houses have many merits that stocks do not have. 1. A house will be a money maker. That may not be obvious but the truth is, in 99 out of 100 cases, you will always make money in house. You won't wake up one day and find that the house that you live in has declared bankruptcy or goes under. This kind of thing may happen with individual stocks. 2. A house is rigged in home owner's favor. Home owners can put 20% down and enjoy the power of leverage. While some brokers will lend you that kind of money to invest in stocks, but if your stock price fell by 20%, you have to put more money into it. Not with a house. You are welcomed to take your time and pay off your mortgage even as your house value goes down in value. Lynch elaborates a wonderful illustration on how nobody will ask homeowners to "come up with twenty thousand dollars tomorrow or else you should sell off your two bedrooms". When this happens to a stockowners, it is called margin call and it does happen a lot of time to leveraged stock investors. 3. Tax advantage. Your mortgage expense is tax deductible. Your stock purchase is not tax deductible. Only when you sell your stock at a loss, you can then a tax write off. Further in your later years, you can decide to sell your house and move into a bigger house, while avoiding tax on your profit. In stocks, what you sell at a gain, you can't escape the taxman (unless illegally) and then when you make another good investment, you will be taxed later on your profit gain. 4. House Put a Roof Over Your Head. That won't happen in stocks. You need to pay rent when you invest in stocks. When you bought a house, you can stay in it and avoid paying rents. Furthermore, you won't likely to sell your house reading the headline: "Home Prices Take A Dive". Also, the afternoon papers do not publish the daily closing price of your house in the classifieds and ten most active house in the neighborhood. 5. Everyone has an edge in house investing. It is handed down from your parents. You naturally knows how to poke around from the kitchen to the garage and ask the right question. You can drive around the neighborhood and see how many houses are being sold and what is being renovated. Further, before you make an offer of the house, you hire many many experts to search for termites, roof leakage, piping, wiring, cracks and others. Imagine that with investing in stocks. Some stock investors even spend more time clipping coupons for grocery than finding a good stock investment. Peter Lynch's "One Up On Wall Street" did not just talk about what we in general are better real estate investors. It talks about stocks too. However, before he goes deeper explaining the way he looks at stocks, he gracefully shared in his book the four stages of stock market cycles which I found to be very very useful. He called it the cocktail theory. Stage one - Everyone avoids a mutual fund manager like a plague. When everyone rather talk about anything else other than stocks, this is the first sign that the market will rise significantly from there. That alone tells you that there is a gloom and doom in the news recently. That, according to Peter Lynch, is the best time to invest. While he confessed that he is not a market timer, this theory is developed over the years. Stage two - Folks linger around a little longer around a Mutual Fund Manager. At this stage, when folk met a mutual fund manager in a cocktail party, he/she will talk briefly with the manager and tell him how risky the stock market is. And then, they will move over to talk with the dentist. By then, the market is already up roughly 15% from stage one but not very many people had noticed. Stage three - Everyone asks a mutual fund manager what to buy. When the market is up 30% from the lows, everyone starts gathering around the mutual fund manager and asks what stock he/she should buy, totally ignoring the dentist. Stage four - Everyone starts giving advice on stocks, even to a mutual fund manager. This is the sure sign of a market top. In a cocktail party, everyone will linger around the mutual fund manager to tell him what stocks he should buy. That sensation is peculiarly true to me about the real estate top in 2004-2005. Folks start telling me and others on how a house is a good investment and how his/her house had risen in value and suggesting me to start flipping real estate. While Peter Lynch had explained the cocktail theory brilliantly, he does not believe in it to make his investment decision. Ultimately, he believes that undervalued stocks will rise while the most insanely overvalued stock will fall, regardless of where the market is. Peter Lynch's "One Up On Wall Street" talk comprehensively about what kind of stocks one should pick. In general, Peter believes that bigger companies tend to make smaller move and vice versa. Therefore, in spotting what he called a 'ten bagger', or stock that has risen ten times in value, it will occur more likely in smaller company with market capitalization of say less than $ 10 Billion. Peter Lynch also divided companies based on six general categories, which has their own unique characteristics. Based on these six categories, investors will be able to know the reason why they invest in such companies and consequently the return expected on each kind of companies. The six general categories are: slow growers, stalwarts, fast growers, cyclicals, asset plays and turnarounds. Slow growers - As the name implies, this is the type of companies that grow slowly, barely above the nation's Gross Domestic Product. Slow grower exists for two reasons. First, they expand rapidly during their early years and had saturated the market or second, they did not make the most of their chances. The book names utilities as slow growers. During the 1950-1970 period however, they are fast growers. As electricity consumption increased (folks installed air conditions, electric heater, refrigerators etc.), power consumption rose and hence their growth rates. That does not happen anymore. Thus, a company inevitably will become a slow grower. A fast grower of the past will be tomorrow's slow growers. Example of industries in this category include: railroad, aluminum, steel, chemicals, soft drink. Stalwarts - These are not fast grower and yet they grow faster than the slow grower. Most stalwarts are huge companies with huge production of cash flow. Due to their enormous size, stalwarts won't move much and Peter always try to take a profit whenever it has run up 30-50% in value in a short period of time. Some stalwarts include: Procter & Gamble, General Electric, Bristol Myers and Kellogg. Fast Growers - The name says it all. These categories are for companies which has high growth rates. This is where the potential of the ten baggers lie. Other five categories will not give you as much chance of finding your next ten baggers. Fast Growers does not necessarily be in the fast growing industry. It can be growing fast in a slow growth industry. For example: WalMart in the stodgy retail industry, Marriott in the 2% growth hotel business, Anheuser-Busch in a slow growing beer market or Taco Bell in a not-so-fast fast food industry. There is however, plenty of risk in investing in fast growers. The trick is figuring out how much to pay for them and when they will stop growing because eventually, the party comes to an end. Cyclicals - Not all companies can profit consistently all the time at every occasions. Generally, cyclicals profit rise and fall in regularly predictable fashion, most often moving in tandem with the economy. Businesses that can be considered cyclicals are : airlines, autos, defense companies or even chip industries. For defense companies, it is cyclical not with respect with the economy but rather with the policy of the white house. For chip industries, it is cyclical with the computer upgrade cycle. Timing is everything in cyclicals. Contrary to other categories, Peter avoids cyclicals trading at a low P/E which generally means that the cycle is currently at its peak. While this rule of thumb does not work 100%, it works pretty well to avoid picking cyclical companies that fall even lower. Turnarounds - These are high risk high reward preposition. Generally, there are specific problems plaguing the company. Further, if the company fails to fix this particular mess, it will probably end up in bankruptcy court. Despite this, there are several appealing reasons for investing in a turnaround. One, of course, is the reward. Once the problem is fixed and solved, the stock price will rise sharply to trade in line with what its peers valuation are. The other beneficial factor of investing in a turnaround is that it is least likely affected by the general market condition. Market goes up, turnaround may stay down and vice versa. A recent example of a turnaround might be involving Altria (MO) in early 2000s. Facing hundreds of billions of lawsuit from smokers, the stock price sank so low that you can buy it at 5 times earnings and 10% dividend yield. Altria also owned a stable Kraft and Miller subsidiary (which was later sold). Turnaround investors will see if the lawsuit problem can be solved, then investing in Altria will be rewarded handsomely. Sure enough, lawsuit problems diminish and its stock price has increased four fold since then. Of course, turnarounds do not always turn around successfully. K-Mart bankruptcy is another past example. Asset Plays - This is the type of companies that normally own a hidden asset that is not obviously listed on its balance sheet. All assets should be listed on the balance sheet, of course. But Asset play company often times do not list its asset at market value. For example, the value of real estate holding which is depreciated under the current accounting rule. Meanwhile, the land itself most likely will be worth more than its purchase price. Also, company that has huge tax-loss carryforward qualifies as asset plays. That's it. All the six categories of stocks according to Peter Lynch. Hope that didn't put you into deep sleep. As boring as it sounds, this will be a valuable lesson that will make your investing journey a lot more exciting and worthwhile. Novice Investing is the online investing guide for beginners. You can also submit investing articles here |
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