Investment guru “step by step” teaches you to choose stocks
Peter Lynch, with a fund ROI of 29%, shares the key points of selecting stocks from 6 categories.
Peter Lynch's investment experience and philosophy.
Peter Lynch, investment master, is a legendary figure in the global fund industry. Time magazine once rated him as the world's best fund manager.
From 1977 to 1990, he created a wealth myth by managing the Magellan Fund (under Fidelity) and the fund's scale increased from $20 million to $14 billion. The annualized return rate was as high as 29% (assuming the fund issuance is disregarded). If someone invested $1,000 in the fund on May 31, 1977, the money would have turned into $28,000 after 13 years!
How did Peter Lynch get into the investment market with such great achievements?
His investment enlightenment education dates back to his experience as a caddy at a golf course at the age of 11. Many executives discussed stocks on the golf course, which also sparked his interest in investment. Later, he invested in a cargo airline company called Flying Tiger Airlines during his studies, and the stock rose many times, enough to pay for his graduate tuition.
So what is his investment philosophy?
Peter Lynch and John Rothchild co-authored three best-selling books: "One Up on Wall Street", "Beating the Street", and "Learn to Earn". Especially the book "One Up on Wall Street", which embodies a lot of his investment wisdom.
He emphasizes obtaining information from daily life, that is, discovering investment opportunities from the role of consumers and the industry they are in. He said in the book: "The best place to look for a 10-bagger is right in your own neighborhood. If you can't find it there, look in the shopping malls, especially where you work." An example he gave was the discovery of a 10-bagger, the American Schering-Plough Corporation, because of ulcer medicine.
He also emphasizes not investing in companies that he does not fundamentally understand, emphasizes on-site investigation before investment, emphasizes fundamental analysis of companies, and prefers growth-value stocks. He also focuses on distinguishing different types of companies and believes that different types of companies require different selection indicators. His concept of "Don't pull out flowers and water the weeds" is also very famous, and he insists on diversified and long-term investments in his own portfolio.
Peter Lynch's stock selection points for 6 types of companies
So what reference can Peter Lynch's investment philosophy provide us with stock selection?
Based on "One Up on Wall Street" (1989), let's take a look at the 6 types of companies he divided, the important financial indicators he considered, and the selection points of different types of stocks.
First, let's look at the 6 types of companies.
1) Slow-growing companies: usually large and long-established companies, which have had a fast growth period and a slightly faster growth rate than GDP (at that time, US GDP growth was around 3%-5%), such as electrical utilities. These companies usually pay dividends regularly.
2) Stable-growth companies: usually have market values of billions of dollars, with growth rates faster than slow-growth companies but not as fast as fast-growth companies, such as Coca-Cola and Procter & Gamble at the time. During economic downturns or downturns, these stocks usually provide better protection.
3) Fast-growing companies: usually small in size, newly established, strong growth, and an average annual growth rate of 20% to 25%. Such stocks are one of Peter Lynch's favorite stock types, and he prefers fast-growth companies in slow-growth industries, such as Anheuser-Busch in the beer industry and Walmart in the department store industry. This type of company needs to pay attention to the end of the high-growth period.
4) Cyclical companies: companies with cyclical sales revenue and profits, whose expansion and contraction alternate, such as companies in the automobile, aviation, tire, steel, and chemical industries. These companies need to pay attention to early signs of business recession or boom.
5) Turnaround companies: companies that have been severely hit and are expected to reverse. Peter Lynch cited his purchase of Chrysler's stock as an example, which made a lot of money for the Magellan Fund. The rise and fall of such stocks are least correlated with the rise and fall of the entire market.
6) Hidden-asset companies: companies with hidden assets of great value. Peter Lynch cited Newhall Land and Farming Company as an example, believing that this company has upside potential in a large ranch in a certain place, and if local people find out early, they will benefit greatly.
2. Let's take a look at the important financial indicators.
1) Proportions of a certain product in total sales: When interested in a company due to a certain product, it is necessary to know how important this product is to the company. If the proportion is too small, forget about it. 2) P/E ratio: Peter Lynch believes that for a reasonably priced stock, P/E ratio = earnings growth rate. If considering dividends, look for companies with (long-term earnings growth rate + dividend rate) / P/E ratio > 2. 3) Cash position: Net cash per share = (cash - liabilities) / number of shares, actual stock price = current stock price - net cash per share. By calculating the "actual stock price," it is possible to discover companies that appear to have a high stock price but are actually undervalued. 4) Debt: Consider debt-to-equity ratio as an indicator of corporate financial strength. Theoretically, it is the ratio of total debt to owner's equity, but Peter Lynch believes that the portion of short-term debt can be ignored (if the company has enough cash). Peter Lynch believes that debt should be less than 25% and shareholder equity should account for 75%, which means long-term debt / owner's equity <= 1/3. 5) Dividends: If buying a stock to receive dividends, it is important to determine whether the company can still pay dividends during economic downturns and poor operations. It is best to choose a company with a history of regularly increasing dividends over the past 20 or 30 years. 6) Book value: It is dangerous to invest in companies with large debts and overvalued book values. Therefore, when attracted by a company's book value, it is necessary to carefully consider the true value of those assets. 7) Hidden assets: Focus on assets that have tremendous value but are not reflected on the balance sheet, such as natural resources (such as land, timber, oil, and precious metals), or brand names, patents, and franchise rights. 8) Free cash flow: Focus on free cash flow, which is the cash remaining after deducting normal capital expenditures, and which is an inflow that does not need to be used for expenses. 9) Inventory: When inventory grows faster than sales, it is a very dangerous signal. If the inventory of a struggling company begins to gradually decrease, it should be the first sign of a turnaround in the company's operations. 10) Pension plan: Because even if a company goes bankrupt and stops normal operations, it must continue to support the execution of the pension plan. Therefore, for companies in difficult situations, it is important to see whether there is an insurmountable burden of pension obligations. 11) Growth rate: In all other conditions being equal, stocks with higher earnings growth rates are more worth buying. 12) Pre-tax profit margin: If you decide to hold onto a stock for a long time, choose a company with a relatively high pre-tax profit margin; if you plan to hold a stock during a successful industry rebound period, choose a company with a relatively low pre-tax profit margin (expecting it to grow quickly). The high and low pre-tax profit margins have meaning only when compared within the same industry.
2) P/E ratio: Peter Lynch believes that for a reasonably priced stock, P/E ratio = earnings growth rate. If considering dividends, look for companies with (long-term earnings growth rate + dividend rate) / P/E ratio > 2.
3) Cash position: Net cash per share = (cash - liabilities) / number of shares, actual stock price = current stock price - net cash per share. By calculating the "actual stock price," it is possible to discover companies that appear to have a high stock price but are actually undervalued.
4) Debt: Consider debt-to-equity ratio as an indicator of corporate financial strength. Theoretically, it is the ratio of total debt to owner's equity, but Peter Lynch believes that the portion of short-term debt can be ignored (if the company has enough cash). Peter Lynch believes that debt should be less than 25% and shareholder equity should account for 75%, which means long-term debt / owner's equity <= 1/3.
5) Dividends: If buying a stock to receive dividends, it is important to determine whether the company can still pay dividends during economic downturns and poor operations. It is best to choose a company with a history of regularly increasing dividends over the past 20 or 30 years.
6) Book value: It is dangerous to invest in companies with large debts and overvalued book values. Therefore, when attracted by a company's book value, it is necessary to carefully consider the true value of those assets.
7) Hidden assets: Focus on assets that have tremendous value but are not reflected on the balance sheet, such as natural resources (such as land, timber, oil, and precious metals), or brand names, patents, and franchise rights.
8) Free cash flow: Focus on free cash flow, which is the cash remaining after deducting normal capital expenditures, and which is an inflow that does not need to be used for expenses.
9) Inventory: When inventory grows faster than sales, it is a very dangerous signal. If the inventory of a struggling company begins to gradually decrease, it should be the first sign of a turnaround in the company's operations.
10) Pension plan: Because even if a company goes bankrupt and stops normal operations, it must continue to support the execution of the pension plan. Therefore, for companies in difficult situations, it is important to see whether there is an insurmountable burden of pension obligations.
11) Growth rate: In all other conditions being equal, stocks with higher earnings growth rates are more worth buying.
12) Pre-tax profit margin: If you decide to hold onto a stock for a long time, choose a company with a relatively high pre-tax profit margin; if you plan to hold a stock during a successful industry rebound period, choose a company with a relatively low pre-tax profit margin (expecting it to grow quickly). The high and low pre-tax profit margins have meaning only when compared within the same industry.
3. Finally, let's look at the stock picking points for different types of stocks.
First, for all types of companies, attention needs to be paid to the following information: P/E ratio (whether it is high or low compared to the company itself and peers), the proportion of institutional investor holdings in the total share capital (the lower the better), whether insiders are buying shares in the company or whether the company is buying back its own shares (both are favorable signals), the historical growth of the company's earnings (whether it is continuous or intermittent), whether the assets and liabilities are good or bad (debt-to-equity ratio), and cash position (net cash per share is the bottom limit of the company's stock price).
For slowly growing companies: focus on whether the company has been continuously paying dividends for a long time and whether it can regularly raise the level of dividends. In addition, you can also pay attention to the ratio of dividend payouts to earnings. If it is high, it is quite dangerous if the company cannot pay dividends smoothly during difficult times.
For stable growing companies: focus on P/E ratio, check long-term earnings growth rate and whether it has maintained the same growth momentum in recent years, check the company's possible diversification (because this may lead to a decline in earnings), and also pay attention to this company's performance during economic recession and stock market drops.
For rapidly growing companies: pay attention to the sales revenue of the target product in all revenue, focus on the recent growth rate of revenue, compare the P/E ratio with the revenue growth rate, focus on the company's business expansion experience, space, and speed, and make sure this stock is not too popular.
For cyclical companies: focus on changes in inventory and supply and demand balance, pay attention to the entry of new competitors in the market, and pay attention to changes in cycles.
For distressed turnaround companies: focus on cash and debt, pay attention to the improvement of operations and cost reduction.
For companies with hidden assets, focus on asset value and hidden assets, consider how much debt needs to be deducted and whether there are new debts, and pay attention to whether there are acquirers that can lead to a revaluation and appreciation of hidden assets.
How do we apply this strategy?
Next, following Peter Lynch's approach, how can we apply it to actual stock selection? Let's take a look at some representative and quantifiable indicators in the initial screening phase.
1. For all types of stocks, we can get the following quantitative indicators:
1) (long-term net income growth rate + dividend yield) / PE ratio ≥ 2.
2) Long-term debt / owner's equity ≤ 1/3.
3) Net cash per share>0.
2. For different types of stocks, we can get additional quantitative indicators:
1) Fast growing stocks: long-term net profit growth rate ≥ 20%.
2) Cyclical stocks: Inventory growth rate < Revenue growth rate.
Other parts are difficult to quantify, they can be compared and considered in the next screening.
What else can we do specifically?
After this, we have obtained 5 quantitative indicators. Let's take the US stocks as an example and use the stock screener feature on Futubull to implement it.
Let's take the fast-growing company stock selection as an example, and simplify and transform the 4 indicators involved.
(long-term net income growth rate + dividend yield) / PE ratio ≥2: This indicator is difficult to screen directly, but if it is for fast-growing companies, and the long-term net income growth rate is at least 20%, even if the dividend yield is 0, the PE ratio must also be ≤ 10.
Long-term debt / owner's equity < 1/3: This indicator is difficult to screen out directly, but going back to the initial description- debt does not exceed 25% and owner's equity is at least 75%, it can be approximated as an asset-liability ratio ≤ 25%.
Net cash per share>0: This indicator is temporarily unavailable, but there is an operating cash flow per share indicator, so we will use an operating cash flow per share>0 as a substitute for now.
Long-term net income growth rate ≥ 20%: It is difficult to screen for long-term growth rates, so we will at least ensure that the annual net income growth rate is ≥ 20%.
Based on these four indicators, we selected 38 stocks (as of August 17, 2023).
On this basis, further screening criteria can be considered.
For example, for the parts that cannot be quantified as mentioned earlier: see if the net income growth rate in recent years is relatively stable; or if there are companies you are familiar with, you can pay attention to the sales revenue of the products you are interested in for this company and see the proportion of this revenue in all sales revenue; or determine the business expansion space of these companies through some fundamental information; or check the institutional holdings and other situations through shareholder holdings.
Of course, in addition to fundamental analysis, you can also add some of your own judging criteria on technical and financial aspects.
*Note: The images displayed on the screen are for illustration purposes only and do not constitute any investment advice or guarantee.
Of course, this is just some practical exercises based on the Graham philosophy, only for teaching purposes, which does not represent investment advice, but hopefully inspiring to everyone.