Tue Dec 23 2014
Live Index (1447 articles)

Peter Lynch – The Perfect Stock

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If my memory serves me correctly, “One Up on Wall Street” was the first investment book I ever read. To this day, it remains among my favorites. In the book, Peter Lynch consolidates his investment philosophy (with countless examples) into a few hundred pages; it’s a great “how to” book for starters, while at the same time a good reference book for more experienced investors. Considering that Mr. Lynch managed the best performing fund in the world during his 13-year career (Fidelity Magellan Fund from May 1977 to May 1990), he’s worth listening to.

In “One Up on Wall Street,” Mr. Lynch lists 13 attributes that he looks for in the perfect stock. I’m going to add some commentary on the few points where I think I have something useful to say (or even better for you, quote Mr. Lynch directly). With that, let’s get started:

(1) It Sounds Dull – Or Even Better, Ridiculous

Pep Boys – Manny, Moe and Jack (PBY) is the most promising name I’ve ever heard. … Who wants to put money into a company that sounds like The Three Stooges?”

(2) It Does Something Dull

“A company that does boring things is almost as good as a company that has a boring name, and both together is terrific.”

(3) It Does Something Disagreeable

(4) It’s A Spinoff

Anybody interested in spinoffs should read Joel Greenblatt (Trades, Portfolio)’s “You Can Be a Stock Market Genius” (a reasonable subtitle could’ve been “Why You Should Invest in Spinoffs”). The book lays out the rationale for considering spin-offs (historical outperformance, on average, in the few years after the spinoff), and why that’s the case (mainly behavioral biases and incentives that impact both the investment community and the new management team of the spin-off).

One example of those incentives is quoted by Mr. Lynch: “Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents.” As such, they’re unlikely to set off on their own without sound financial footing. At the same time, there’s a lot of early selling pressure that’s driven by individuals uninterested in the new company (“dismiss these shares as pocket change or found money”), as well as institutional investors who may face certain constraints to holding the new stock (too small, outside “value” / “growth” mandate, not in the S&P 500, etc). Add in the incentives for the new managers, and it starts to become clear why these situations can potentially be intriguing (especially if those new managers go out and directly buy some shares in the new company).

One friendly suggestion: if you don’t have Greenblatt’s book, buy yourself a copy and read it – you won’t regret it.

(5) The Institutions Don’t Own It, And The Analysts Don’t Follow It

“When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm.” Companies that are not covered by a bevy of analysts or a third party research firm like Value Line or Morningstar are often avoided for the simple fact that many investors aren’t comfortable acting alone without a vote of approval from others. If you’re one of a handful of people that intimately knows a company, that’s likely to work out well over time.

(6) The Rumors Abound; It’s Involved With Toxic Waste or The Mafia

(7) There’s Something Depressing About It

(8) It’s A No-Growth Industry

Before discussing no-growth industries, let’s start with investing in “growth” industries. The problems with doing so, as I see them, generally come from three areas: (1) growth rates often prove to be overstated with hindsight; (2) competitors and new entrants are constantly looking to get a step ahead of the competition, and will spend aggressively / lever up accordingly; (3) the stocks are priced for perfection. That doesn’t sound like a recipe for success.

Compare that to a no-growth industry, particularly for a company with a dominant position: (1) you can wrap your head around the competitive threats, as new entrants are unlikely; (2) the market leaders have an opportunity to buy smaller competitors and build scale at reasonable prices, or grow slowly by taking market share organically; (3) there’s no interest in the companies in the sector and they’re potentially misunderstood, often resulting in too much pessimism and (every once in awhile) an attractive investment opportunity.

That sounds like a great place to start looking for cheap stocks…

(9) It’s Got A Niche

The importance of a niche ultimately comes back to building a sustainable competitive advantage – “Once you’ve got an exclusive franchise in anything, you can raise prices.”

Warren Buffett (Trades, Portfolio) hit this point in his interview with the FCIC: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising prices by a tenth of a cent, then you’ve got a terrible business.”

(10) People Have To Keep Buying It

Mr. Lynch makes the case for consumables like soft drinks, razor blades and cigarettes, as opposed to a wonderfully popular toy (“every child gets only one… eight months later that product is taken off the shelves to make room for the newest doll – manufactured by somebody else”). I agree with this concept for another reason (but along the same lines): low cost items are likely to have more meaningful brand equity. The difference between a 10% savings on a pack of gum and a large ticket item is substantial. Most people will stick with Wrigley’s rather than risk it on a pack of no-name gum to save 15 cents; those same people will seriously consider the alternative offerings before paying a 10% premium for a new TV or an airline ticket.

(11) It’s A User of Technology

“Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war?”

(12) The Insiders Are Buying

“There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it.”

I’ll point you to a company that I’m interested in that has had significant insider buying as of late: WPX Energy (WPX). The company named a new CEO in May; since that time, he has purchased 44,000 shares on the open market. Due to the fact that oil companies have been routed in recent market trading, his cost on those purchases has totaled ~$ 836,000, or an average of ~$ 19 per share; that is nearly 100% higher than where shares recently traded. His most recent purchase was last week.

In the past two weeks, three directors have also purchased more than $ 100,000 of shares on the open market (each), in addition to purchases back in May; of those directors, none had purchased shares in any size over the prior two and a half years. Directors and managers (namely the CEO and CFO) have purchased 50,000 shares, at a cost of more than $ 550,000, in the past 10 days.

When the people who know the company most intimately are willing to directly invest in the stock in a big way, that’s a good sign that the company warrants closer inspection. As Mr. Lynch notes, “when insiders are buying like crazy, you can be certain that, at a minimum, the company will not go bankrupt in the next six months… I’d bet there aren’t three companies in history that have gone bankrupt near term.”

(13) The Company Is Buying Back Shares

This is a point I’ve harped on numerous times lately. Unfortunately, intelligent repurchase activity seems to be the exception, not the rule. A company with a solid repurchase track record is FLIR Systems (FLIR); they buy the stock in size when it gets cheap, and then pull back the reins if the stock starts to run higher – simple as that. While repurchasing shares is generally a good sign, I’d add the caveat that management should be judged on their results over time – and that outsized repurchases may actually be a bad signal, particularly for cyclical companies: look no further than Deere (DE) in the period leading up to the financial crisis (here).

For a lot of the companies I’ve looked at, there needs to be a significant change in the approach to share repurchases (at least based on their historic results); CEOs and CFOs would get a leg up on their corporate peers if they started by reading Will Thorndike’s “The Outsiders.”

About the author:

I’m a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don’t have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question – which if I’ve done my job properly, should be very attractive over many years.

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