Peter Lynch's six stock categories

'One up on Wall street' by the famous fund manager Peter Lynch is a bible for many stock market investors. In that book, Peter Lynch stated that, in order to know what he is getting into, he classifies the stocks into six categories. While there are many methods and many categories prescribed by many others, Peter Lynch believes these six are more than enough. What are they?

• Slow growers: These are generally large companies that are usually in the maturity stage of their life cycle, and grow in line or slightly more than the country's GNP or GDP. These companies started out as fast growers and eventually became slow growers due to industry slowdown or the absence of space to grow further. High and consistent dividends are a sign of these companies since they do not have many reinvestment opportunities. Glaxosmithe Pharma has grown its earnings at 2.3 per cent per annum and has a median dividend payout ratio of 90 per cent in the last five years with a current dividend yield of 5.9 per cent.

• Stalwarts: These companies grow at a medium pace, at 10-12 per cent a year, around double the country's GDP. Even in these stocks, investors can double, triple, or quadruple their money but the time it takes is longer compared to fast growers. Peter Lynch says these companies are protective investments. They grow steadily and offer a good level of protection in tough times, so 30-40 per cent of his portfolio consists of these stocks. Hindustan Unilever is a great example of this. Its earnings have grown at 14.6 per cent per annum with 16 per cent returns in the last five years. It also pays out good dividends.

• Fast growers: This is the favourite category of Peter Lynch. These small and aggressive companies grow at 20-25 per cent yearly. These need not necessarily be from fast-growing industries as some are also from slow-growing industries. While there is a tremendous upside in this category, there is also an equal downside. The market treats fast-growing companies harshly when they face even a small hiccup. CDSL, which grew its earnings at 29 per cent per annum and posted 100 per cent returns in the last two years, has fallen 26 per cent in the last three months as the company faced a small hiccup in demat registrations.

• Cyclicals: These are companies whose sales and profits rise and fall regularly, mostly in line with the economy. When the economy is doing well, or is in a boom phase, these stocks flourish and when the economy is depressed, these stocks also fall. Examples can be industries like automobiles, steel, capital goods, etc. The timing of buying a cyclical is extremely important. If a stock is bought at the wrong part of the cycle, like an all-time high, it may take years to break even. SAIL is the perfect example of this. Due to increase in commodity prices and infra push, the stock has given 52 per cent returns per annum in last two years but if you had bought it five years ago, then you would have only had 3.7 per cent returns per annum.

• Turnarounds: These companies are neither fast growers nor slow growers. These are beat-down stocks that fell due to various reasons. Success is rare in this segment. While some maybe game-changers, most will turn out to be wealth destroyers. Peter Lynch refers to his investment in Chrysler, a turnaround, which gave him 15-fold returns in five years. An Indian example is CG Power and Industrials which has given a staggering 356 per cent returns in the last two years after the Murugappa group's takeover. Things such as cost control, cash position, whether the business is being pivoted, and dealing with creditors, must be watched closely.

• Asset plays: These are companies that have something valuable in their balance sheet that the market hasn't noticed yet. This can be a company's cash position or its real estate holdings. Peter Lynch refers to the case of Pebble Beach where Twentieth Century-Fox bought the company for $72 million when it was at just $25 million two years before. The jaw-dropping aspect is that Twentieth Century sold Pebble Beach's gravel pit (one of Pebble Beach's assets) for $30 million. Meaning just a couple of years ago, the entire company was valued less than its gravel pit. Right now, Rashtriya Chemical and Fertiliser is a great example of asset play. It has a market cap of Rs 4,314 crore and its management has stated that it has landed a bank worth around Rs 64,000 crore.

Investors have to remember that the stocks in these categories may migrate from time to time. A fast grower may become a stalwart and a stalwart may become a slow grower. The first three categories are based on the business cycle so each company will face it.

We would also like to mention that the examples stated in the categories are not recommendations. Investors are required to do their due diligence before investing.

Alternatively, you can subscribe to Value Research Stock Advisor if you have difficulty in picking stocks and deciding which companies to invest in. We perform thorough due diligence on companies before recommending them to our subscribers.

This article was originally published on July 06, 2022.