Investment Master "hand in hand" teaches you how to select stocks.
Peter Lynch, with an ROI of 29%: Key points for selecting Stocks in 6 categories.
Peter Lynch's investment experience and philosophy.
Investment master Peter Lynch is undoubtedly a legendary figure in the global fund industry, and Time magazine has named him as the 'best fund manager in the world'.
From 1977 to 1990, he created a wealth myth by managing the Magellan Fund (under Fidelity). During his 13 years of management, the fund's size grew from 20 million USD to 14 billion USD, with an annualized return rate as high as 29% (assuming no fund issuance, etc.). If someone had invested 1,000 USD in this fund on May 31, 1977, this amount would have turned into 28,000 USD after 13 years!
How did Peter Lynch initially enter the investment market to achieve such great results?
His investment education can be traced back to his experience as a caddie at the age of 11, where many executives discussed stocks on the golf course, planting the seeds of investment in his mind. Later, during his schooling years, he invested in a cargo airline company called Flying Tiger Airlines, which increased several times, providing enough money to cover all his graduate school tuition.
What kind of investment philosophy does he hold?
Peter Lynch co-authored three best-selling books with John Rothchild: 'One Up on Wall Street', 'Beating the Street', and 'Learn to Earn'. Especially in 'One Up on Wall Street', he condensed a lot of his investment wisdom.
He emphasizes obtaining information from daily life, that is, discovering investment opportunities from the perspective of consumers and the industry he is in. In his book, he says, 'The best place to look for tenbaggers is to start near your home; if you can't find them there, go to a large shopping center, especially look where you work.' One example he cited is discovering a tenbagger due to a medication for stomach ulcers—Merck & Co.
He also emphasizes not investing in companies that are fundamentally not understood, stresses the importance of on-site investigation before investing, emphasizes Fundamental Analysis of companies, and prefers stocks that combine growth with value. He also focuses on differentiation, believing that different types of companies require attention to different Stock Screener Indicators. His idea of 'not pulling out flowers to water weeds' is also quite famous, and he insists on diversified and long-term investments in his portfolio.
Peter Lynch's key points for selecting stocks in six types of companies.
So what reference can Peter Lynch's investment philosophy provide us in stock selection.
The following will be based on 'One Up On Wall Street' (1989), examining the six types of companies he categorizes, the important Financial Indicators he deems significant, and the stock selection key points for different types of stocks.
1. First, let's look at the six types of companies.
1) Slow Growth Type: Typically, these are large, long-established companies that have gone through a period of rapid growth, with subsequent growth rates slightly faster than GDP growth rates (at that time, the USA GDP growth rate was about 3%-5%), such as Electrical Utilities. These companies usually pay dividends regularly.
2) Stable Growth Type: Typically with a Market Cap of several billion dollars, their growth rates are faster than slow growth companies, but not as fast as those of rapid growth companies, such as Coca-Cola and Procter & Gamble at that time. These stocks usually provide better protection during economic downturns or recessions.
3) Rapid Growth Type: Usually small-scale companies that are newly established, have strong growth potential, and an average annual growth rate of 20% to 25%. These stocks are among Peter Lynch's favorites; he particularly favors rapid growth companies in slow growth industries, such as Anheuser-Busch in the Beer sector and Walmart in the retail sector at that time. Attention should be paid to the end point of the high growth period for these companies.
4) Cyclical: Companies whose sales revenue and profits are cyclical, where the company's expansion and contraction alternate, such as those in the Automotive, Aviation, Tire, Steel, and Chemicals industries. These companies need to pay attention to early signs of business recession or boom.
5) Turnaround: Companies that have been severely hit and are on the verge of bankruptcy, but are expected to reverse. Peter Lynch mentioned that he made a substantial profit for the Magellan Fund by buying shares of Chrysler. The price fluctuations of these stocks are least correlated with the market's overall rise and fall.
6) Hidden Assets: Companies that possess remarkable hidden assets. Peter Lynch cited Newhall Land and Farming Company, believing that this company has a large ranch in a certain place with appreciation potential, which local people could benefit from if they capitalize on the local advantages early on.
2. Now, let's look at important financial indicators.
1) The proportion of a certain product in total sales: When interest in a company arises due to a specific product, it is important to know how significant this product is to the company. If the proportion is too small, move on.
2) PE Ratio: Peter Lynch believes that reasonably priced stocks have a PE ratio equal to the earnings growth rate. If considering dividends, look for companies where (long-term earnings growth rate + dividend yield) / PE 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' to derive the PE ratio, it may uncover a company that seems overpriced but is actually undervalued.
4) Debt Factors: Consider the debt-to-equity ratio, which is an indicator that reflects the financial strength of the enterprise. Theoretically, it is the ratio of total liabilities to owner's equity, but Peter Lynch believes that short-term liabilities can be ignored (if the company has sufficient cash). He believes that debt should be less than 25%, and shareholder equity should account for 75%, meaning that long-term debt / owner’s equity ≤ 1/3.
5) Dividends: If buying a stock is intended for dividends, it is important to clarify whether the company can still pay dividends during economic downturns and poor operations. It is best to choose a company with a track record of regularly increasing dividends for twenty or thirty years.
6) Book Value: If a company has significant liabilities and its book value is overestimated, investing in such companies can be risky. Therefore, when attracted by a company's book value, it's necessary to carefully consider the true value of those assets.
7) Hidden Assets: Pay attention to assets that are not reflected on the books but have significant value, such as natural resources owned by the company (e.g., land, timber, oil, Precious Metals) or brands, patents, and franchises.
8) Cash Flow: Focus on free cash flow, which refers to the cash remaining after normal capital expenditures. This is an inflow of cash that does not need to be spent again.
9) Inventory: When the growth rate of inventory surpasses that of sales, it is a very dangerous signal. If a financially struggling company begins to reduce its inventory gradually, this should be the first signal of an improvement in the company's operations.
10) Pension Plans: Because even if a company goes bankrupt and has ceased normal operations, it must continue to support the execution of pension plans. Thus, for companies in distress reversal situations, attention must be paid to whether the company has huge pension obligations that it fundamentally cannot bear.
11) Growth Rate: Under otherwise identical conditions, stocks with higher earnings growth rates are more worthy of a Buy.
12) Pre-Tax Profit Margin: If deciding to hold a stock long-term, it should be a company with a relatively high pre-tax profit margin; if planning to hold a stock during the successful recovery phase of the industry, a company with a relatively low pre-tax profit margin should be chosen (expecting it to grow quickly). The level of pre-tax profit margins only becomes meaningful when compared within the same industry.
3. Finally, let's look at the stock selection points for different types of Stocks.
First, all types of companies need to pay attention to the following information: PE ratio (whether it is high or low compared to itself and peers), the proportion of Institutional Shareholder Holdings in the total share capital (the lower, the better), whether company insiders are Buying the company's Stocks or whether the company is repurchasing its own Stocks (both are favorable signals), the historical situation of the company's earnings growth (whether it is intermittent or has continuous stable growth), the condition of Assets and Liabilities (the ratio of liabilities to owner equity), and Cash position (net cash per share is the bottom limit of the company's stock price).
For slow-growing companies: Focus on whether the company consistently pays dividends over the long term and whether it can regularly increase the dividend level. Also, pay attention to the ratio of dividends paid to earnings; if it is high, it becomes risky if they cannot smoothly distribute dividends during difficult operating periods.
For stable growth companies: Focus on the PE ratio, check the long-term earnings growth rate and whether the same growth momentum is maintained in recent years, check the company's potential diversification (as this may lead to a decline in earnings), and additionally focus on the performance of the company during economic downturns and significant stock market crashes.
For fast-growing companies: Pay close attention to the sales revenue of the focused products as a proportion of total Business revenue, monitor the earnings growth rate in recent years, compare the PE ratio with the earnings growth rate, and consider the company's experience, space, and speed of Business expansion, confirming whether this stock is still relatively unpopular.
For cyclical companies: Focus on inventory changes and supply-demand balance, be aware of the entry of new competitors in the market, and keep an eye on the cycle changes.
For turnaround companies: Pay attention to cash and debt, as well as the improvement in Business and cost-cutting situations.
For companies with hidden assets: Focus on asset values and hidden assets, noting how much debt needs to be deducted and whether there is new debt, as well as whether there are acquirers that could lead to the revaluation and appreciation of hidden assets.
How can we apply this strategy?
So next, following Peter Lynch's thoughts, how can we implement this in actual stock selection? Let's take a look at the representative, quantifiable indicators in the initial screening stage.
1. For all types of stocks, we can derive these quantifiable indicators:
1) (Long-term net income growth rate + Dividend yield) / PE ≥ 2
2) Long-term debt / Shareholder Equity ≤ 1/3
3) Net cash per share > 0
2. For different types of stocks, the additional quantifiable indicators we can derive are:
1) Rapid growth type: Long-term net income growth rate ≥ 20%
2) Cyclical: Inventory growth rate < Revenue growth rate.
Other parts are difficult to quantify, let's set them aside for now and compare them in the next screening step.
How else can this be practically done?
After this, we have obtained 5 Algo Indicators. Taking USA stocks as an example, let's practice using the Futubull Stock Screener function.
Using fast-growing companies as an example, let's first simplify and transform the 4 involved Indicators.
(Long-term net income growth rate + Dividend yield) / PE ≥ 2: This Indicator is difficult to filter directly, but for fast-growing companies, with a long-term net income growth rate of at least 20%, even if the dividend yield is zero, the PE must be ≤ 10.
Long-term debt / Shareholder equity < 1/3: This Indicator is hard to filter out directly, but referring back to the initial description—debt should not exceed 25%, and Shareholder equity should be at least 75%, therefore it can be approximated that the debt-to-asset ratio ≤ 25%.
Net cash per share > 0: This Indicator can't currently be found, but there is an indicator for net operating cash flow per share, we will temporarily use net operating cash flow per share > 0 as a substitute.
Long-term net income growth rate ≥ 20%: It is challenging to filter for long-term growth rates, so at the very least, we should ensure that the annual net income growth rate is ≥ 20%.
Using these four indicators, we selected 38 stocks (based on data from August 17, 2023).
On this basis, further screening criteria can be considered.
For example, consider the non-quantifiable aspects mentioned earlier: observe whether the net income growth rate in recent years has been relatively stable; if there are companies you are familiar with, you can pay attention to the sales revenue of products from those companies that interest you and see what proportion that revenue represents of total sales; or use some fundamental information to determine the business expansion potential of these companies; or check shareholder holdings to see the proportion of institutional holdings.
Of course, in addition to fundamental aspects, you can also incorporate your own technical and financial judgment criteria.
*Note: The images displayed on the screen are for illustrative purposes only and do not constitute any investment advice or guarantee.
Certainly, this is just some practical exercises based on Peter Lynch's thinking, intended for educational purposes only and does not represent investment advice, but it is hoped that it inspires everyone.
