Profit like Peter Lynch

How to succeed as a stock market investor? Aspire to be a chameleon. This is not unsubstantiated advice. We are simply asking you to follow in the footsteps of Wall Street's 'chameleon' and investing genius Peter Lynch, who earned this nickname due to his adaptability to different investment styles to suit prevailing market conditions. This adaptability proved to work as the Magellan Fund at Fidelity Investments, managed by Lynch for 13 years, grew investor wealth 27 times from 1977 to 1990. Not only that, the fund reportedly beat the S&P 500 Index in 11 of the 13 years with an average annual return of 29 per cent. Lynch's adaptability is a result of his remarkable ability to identify and distinguish businesses based on their varying growth and risk profiles. His book 'One Up on Wall Street', which serves as an investing bible for equity investors, provides us with such an assortment of businesses into six different categories. Each category grasps the unique tenets of a business and relates it to an investing thesis. Since we at Value Research, like many others, are big proponents of Lynch's agile investment style, we attempted to emulate his categorisation framework in this issue of Wealth Insight. Our goal in this story is to understand Lynch's six stock categories and select those that are ideal for long-term wealth creation. We have also built respective methodologies to help you identify promising stocks that fall in the chosen categories. Towards the end of the story, you will discover 10 stocks that fit the Lynch bill. Let's get started! The Lynch list: Breaking down Peter Lynch's six stock categories Before classifying stocks into his six categories, Lynch would want you to place special emphasis on one parameter: the size of the company. In his words, 'big companies don't have big stock moves'. Simply put, it is difficult for large companies to continue growing at the exponential rates of their yesteryears. Between a company with a market cap of Rs 2,000 crore and another with a market cap of Rs 2 lakh crore, the former has a high probability and legroom to become a compounder. Since the company size affects the growth potential, it is a crucial basis for Lynch's first three stock categories where he has primarily used growth as an identifier for solid stocks. Let's go through each of the six categories one by one: The slow growers Peter Lynch defines these companies as large, ageing and past their prime. They start as fast growers, but as their size grows and their industry matures, their growth rate plateaus accordingly. Their earnings in this phase may grow just on par with a country's GDP growth. Almost every company and even industries exhaust their initial firepower and eventually reach this stage at some point. Since there is little to no room for growth, there is also no avenue for reinvestment for these companies. While some may attempt using the cash to go the inorganic way, many usually just choose to give generous dividends. For instance, FMCG giant Hindustan Unilever's high-teen earnings growth in its early years has slowed to around 10 per cent annually in the last five years. Although it has acquired a few companies over the years like GSK's consumer division, the company is primarily a dividend aristocrat. It has a five-year median dividend payout of 91 per cent! The stalwarts These companies are not exactly fast-growing but are still better off than the slow growers. Their earnings growth normally is in lower teens (between 10-20 per cent). Sometimes, they also dole out a part of their earnings as dividends. Since their growth engine has some steam left, investors have the opportunity to reap good capital appreciation, given they invest at the right valuations. Moreover, these businesses are reliable and provide a cushion during difficult times. Cummins India and Berger Paints are two examples under this category. The two companies grew their earnings at 18 per cent each annually in the last five years. Their five-year median dividend payout was 56 and 36 per cent, respectively. The fast growers Lynch counts this cohort as a goldmine of multibaggers. These are relatively smaller companies that grow aggressively. Their annual earnings growth is usually more than 20 per cent. Generally, these companies are from sunrise industries, but Lynch believes this doesn't always have to be the case. Even in a relatively mature industry, a company can clock high growth rates if it manages to keep grabbing market share from other players. As per Lynch, companies in this category can become 50, 100, or even 200-baggers if held for a long time. But what's crucial to making such returns is catching these companies when they are small. For reference, Dixon Tech's market value five years ago was Rs 2,800 crore. The stock has leapt 26 times since then on the back of impressive net profit growth of 42 per cent annually. As a result, it's now holding a market cap of Rs 74,000 crore! The cyclicals Cyclical companies are those whose revenue and profit expand and contract as the economic cycle changes. During an upcycle, cyclicals perform exceedingly well but during a downcycle, their revenue falls and even profits are wiped off in some cases. Companies in this category are capital intensive and have to rely on both public and private sector capex. Several industries such as automotive, steel, oil and others fall under this category. Tata Steel is an apt example. Lynch also highlights how these stocks are often erroneously grouped with stalwarts due to their large size and established brand. Eicher Motors, for instance, is reputed in the auto sector with a market cap of around Rs 1.3 lakh crore. It is possible to confuse it as a stalwart given that its five-year annual earnings growth has been around 13 per cent. However, doing so would be incorrect since it is a cyclical business whose profitability is volatile and based on demand for premium bikes. According to Lynch, timing is everything in cyclicals, and to make money in these companies, investors need to be able to detect the cycle's turning points early. The turnarounds A turnaround business is the one on the ropes trying to escape a near-collapse or a situation like bankruptcy. Investors can bet on these companies when they expect them to turn the corner. This is because any sign of recovery helps these stocks recoup their lost ground rapidly. Here's a notable example of a successful turnaround - CG Power. The debt-laden and nearly bankrupt company was rescued by Tube Investments, which acquired it for around Rs 800 crore. Tube managed to turn around the business, and voila! CG Power's share price jumped 26 times in five years! The asset plays Asset plays are companies with valuable assets that the market has overlooked. Since these assets are not recognised, the real value of the company is expected to be much higher than what the market estimates. These companies may or may not have smooth operations. So, the core investment thesis for them is the assumption that the market will one day catch up to their true worth. The unidentified assets could be plant, land, investments or even cash. Holding companies are good examples of asset plays. The primary reason they grab investor attention is the expectation that their underlying investments' value will appreciate. The higher the gap between their market value and their assumed intrinsic value (including underlying holdings), the more handsome the returns are. Kama Holdings, the holding company of SRF, has yielded an annual return of 37 per cent in the last 10 years, primarily due to the appreciation seen in SRF. Choosing the right cohort: Zeroing in on the stock categories most feasible for you We have now understood that companies can broadly fall into one of the six categories defined by Peter Lynch depending on their growth and risk profile. The categorisation makes stock selection easy. But, unlike Lynch, who is a seasoned investor, retail investors do not have the same bandwidth needed to work with stocks across all the groups. This is because most of Lynch's categories are tricky to navigate, and the involved risk-to-reward ratio is unsuitable for small investors. So, we decided to e

This article was originally published on August 01, 2024.