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Peter Lynch is a famous American investor. At 13, he was a caddie in a golf club. For 8 years, he carried the Fidelity President's cart. This has allowed him to be in contact with people at the top of the financial world. Thanks to these relationships, he was able to learn more about the markets and had the courage to buy shares of the air freight company called Flying Tiger. The returns from this first investment allowed him to pay for the rest of his studies, particularly at Wharton Business School, from which he graduated in 1968. At the age of 25, at the end of his studies, he joined Fidelity as an analyst. At the age of 33, Peter managed the Magellan fund at Fidelity for 13 years. Its results were brilliant: the yield was 29.2% per year over this period. How does Peter Lynch invest for the long term with fundamentals? Analyzing your own financial situation before you start is a crucial step (1). Secondly, financial indicators provide an idea of the value of a share in relation to the market (2). Finally, know how to distinguish the different categories of equities to manage your allocation (3).
I. Each person must make a patrimonial assessment of his or her situation
Wealth advisors know what it's all about. To establish this balance sheet, it is necessary to write on paper:
- What you own : investments (securities accounts, life insurance, savings accounts, etc.), real estate (am I a tenant or owner? do I have properties for rent?), exotic investments (crypto-currencies, wine, gold, watches, vintage cars...)
- What you earn : what is my income from my investments? how much is my monthly salary?
- What you owe : do I have a credit to repay? if so, how much is my monthly payment? how much tax do I have to pay per month?
In view of these 3 points, what is my monthly savings capacity or how much can I invest in the stock market? It also implies, how much are you willing to lose? The answers to all these questions are even more important than the investments you make.
“Invest only what you can lose without affecting your daily life or your near future.”
Peter Lynch reveals a plethora of tips for individuals who want to invest:
- Use what you already know,
- Look for stocks that Wall Street or analysts don't watch,
- Buy a house before you buy shares,
- Ignore market movements,
- Try to predict the future and fluctuations is impossible,
- Favour equities because their long-term returns are higher than those of bonds.
Once your financial situation has been analyzed, you must start looking for opportunities. One of the techniques is to be attentive to the local companies you work with and the products and services you see every day. The problem is that most people buy shares of which they do not know the market, the sector or even the companies. As a result, we see doctors buying shares in the luxury sector, sellers in the retail sector buying shares from young start-ups in the biomedical sector or executives from luxury companies buying aerospace stocks. Everyone thinks that the right opportunities are far from their own field while they have an undeniable advantage if they invest in their own sector. Let's take another example; if you sell phones or computers in a specialty store, it's easier for you than any financial analyst to see which brand dominates the sector ? if Lenovo or Apple has trouble selling its new model? if Samsung still makes customers dream or not? Apart from this daily attention, indicators allow you to know if a stock is over or undervalued compared to the market.
II. Indicators are useful tools in the valuation of an asset
Being alert to products that appeal to customers on the shelves of your supermarket is not enough to make an investment decision. Let us therefore distinguish between the actions to be followed and the actions to be avoided and their specific characteristics.
The stocks you must follow must meet certain conditions:
- The company name is not attractive and therefore Wall Street will not be interested,
- Its activity is boring, but it generates large profits and its balance sheet is solid. This allows you to buy at a derisory price and resell once everyone has discovered the rare gem that is this company,
- Investment professionals are turning away from this stock and are not following it,
- Sales must be regular. Some businesses are sustainable, such as the sale of toothbrushes, drinks or medicines, while others are ephemeral, such as toys.
- Managers and executives buy the shares of the company where they work. If these people invest in the company, it is because they have confidence but also because they tend to reward shareholders generously (and therefore themselves).
On the other hand, a stock to avoid would be a company known to all, followed by a number of seasoned analysts, and that everyone talks about, calling it the future Apple, the Airbnb of cooking... Another type of stock to avoid would be a company that makes acquisitions in different sectors of its business. If one company buys another, it is only interesting if their field of activity is close. Finally, if more than 30% of a company's turnover is based on a single customer, then it is dangerous to bet on it because if this contract is lost, the company may go bankrupt. Now that you know what Peter Lynch recommends in terms of buying and selling shares in general, let's look at the indicators to monitor for long-term investment.
First indicator - PER (Price-Earnings Ratio) : this stock market ratio evaluates the cost of a stock. It expresses the number of years it takes to recover the initial amount of an investment if profits remain constant. The PER is useful and relevant for comparing two similar companies operating in the same sector of activity. Thus, comparing LVMH's PER with Kering's makes sense, but comparing Carrefour and Valeo is of no use.
PER = Market capitalization / Net income
PER = Share price / Earnings per share
Example: The Accor share is worth €38. Earnings per share over 12 months were €2. Then the PER is 38/2 = 19.
Note that a low PER is less than 8. A normal PER is between 8 and 14. A fast-growing share PER is between 14 and 20. In the case of Accor, the price is worth 19 times the profits, so the stock is very expensive. It will take 19 years to recover the 38€ invested. Thanks to the general PER of a given market, you can know if a market is overvalued and therefore identify bubbles. You can short the market in question if you notice that all PERs are reaching record highs.
Second indicator - % of sales : if you have identified a new, innovative and highly successful product, you may want to buy the stock of the company that created it. Before that, look at how much this product represents in the company's turnover.
Third indicator - Liquidity : companies with high liquidity need to attract your attention. Such companies will have the means to cope with possible declines in turnover or profits. They will also have the ability to invest in themselves by recruiting people who are recognized and experts in their field, or to buy out their competitors.
Fourth indicator - Debt factor : focus on what companies have in debt. According to Peter Lynch, a normal balance sheet liability has 75% equity and 25% debt. As for bank debt, it is not healthy according to him. Bond debt should be preferred when you are a shareholder of a company.
Fifth indicator - Dividends : Peter Lynch advises small, ambitious and very aggressive companies that reinvest their profits in their own growth. The large companies that make up the indices, on the other hand, pay dividends in an attempt to keep their shareholders because the performance of their shares will no longer be multiplied by 10.
Sixth indicator - Hidden assets : there are companies that own natural resources, land, timber, oil or precious metals but this is undervalued on the assets side of their balance sheets. When analysts realize this, the price of these shares will take off.
Seventh indicator - Cash flow : Cash flow represents what a company collects when doing business. Cash flow can be variable or stable over time. Peter Lynch prefers companies that do not have to worry about the investments they would have to make. MacDonald's or Philipp Morris should not invest in continuous innovation because cash flow is stable.
Eighth indicator - Inventories : Some signs are not misleading and must be detected. If inventories grow faster than sales, it is a signal to sell the company's shares. New products replace old ones, so if a company ends up with a large number of products, it's bad for its cash flow.
All these indicators should help you make investment decisions but be aware that all stocks are different and can be classified into 6 distinct categories.
III. 6 categories of shares
There are 6 classes of shares that characterize the market for corporate ownership securities. Each category concentrates stocks that aim for different benefits that can be; added value, dividends, following economic cycles, stability...
Category 1: Slow-growing stocks
These are mature companies. When an investor has these types of companies in his portfolio, he expects to have relatively low growth. These actions change very little and their graphs show rather flat lines. These "slugs", as they are called, offer regular and substantial dividends.
Questions to ask yourself before buying: Do dividends increase? Are they regular? What % of profits do dividends represent? Does the company have cash flow for difficult times?
This type of share must be divested when the company has lost market share for 2 consecutive years, when it has not developed any new products or when the R&D budget has been reduced. Other signs may indicate that you need to sell your shares, such as the fact that the company has made acquisitions unrelated to its core business. Finally, sell your shares if the price has risen by more than 40%.
Category 2: The pillars ; the sure values
These are stocks that are growing at an average rate. These shares provide protection during recessions and difficult times. With this kind of values, you can expect a gain of 30 to 50% over 5 years. The rationale for detecting these shares is as follows: during crises and recessions, people no longer go on holiday, postpone their car purchase and buy a little less clothing.
However, they still buy the same amount of Purina dog food, cereal or toilet paper. In other words, these are large companies that are unlikely to go bankrupt. Avoid companies that diversify into other activities. Pay particular attention to the long-term growth rate of the companies you select. You have to sell the pillars, if the new products released in the last 2 years have poor results, if the stock has a PER of 15 and companies in the same sector only reach 10, and if managers and executives have not bought any shares this year.
Category 3: Fast growing stocks
The shares in this category come from small, aggressive, often young companies that grow at a rate of 20 to 25% per year. However, a high-growth stock does not have to belong to a high-growth sector. This category of shares concentrates more risks because these companies are younger, and their future is more uncertain. Peter Lynch is looking for those that offer attractive balance sheets and significant benefits. The gains can be very high. The following questions can help you discover high-growth companies:
- Is the company's expansion accelerating or slowing down?
- Has the company already succeeded in replicating its success in other cities or countries?
- What has been its rate of profit growth in recent years?
- Does the new product or service it offers represent a significant part of the turnover or is it insignificant?
Regarding the sale of these high-growth securities, you must act : if 60% of the capital is held by institutional investors because this would mean that it is or is becoming known, if 3 national magazines have flattered the CEO or if 40 financial analysts include this share among their strongest recommendations. The other signs are an illogical and absurd PER, the results of new stores, products or services are disappointing or if managers and employees join the major competitor.
Category 4: Cyclical stocks
“A cyclical stock is a company whose sales and profits rise and fall on a regular basis and in a more or less predictable way.”
These values are found in the automotive, airline, chemical, defense and security sectors. In the aftermath of the crisis, when the economy is strong, cyclical stocks flourish. Their prices rise faster than those of the pillars.
With this kind of values, you can lose 60% of your investment. It is with such values that a reckless investor can lose the most money because in his mind they are safe, because they are large companies. These values are confused with the "pillars" category, but they are subject to much greater fluctuations. With cyclical values, it's all about synchronization and you must be able to detect the first signs of a fall or recovery. To identify cyclicals, keep an eye on inventories, monitor new entrants to the sector, anticipate the decline of the PER and try to predict cycles. Start shorting cyclicals when the end of the cycle is near, if stocks are piling up and the company can't get rid of them, if demand slows.
Category 5: Companies in recovery
These companies are not in a period of growth. But they can recover and regain ground quickly. It is interesting to buy these shares because they are uncorrelated to the market. Several factors can trigger the revival of such companies: they are subsidized by the government, they separate from a branch that is not functioning or they leave the mother company.
The important points to consider are the amount of its liquidity and debt, the structure of its debt to know if the company is able to live without going bankrupt... and also how the company plans to recover. You can also look to see if the sector in which it operates is on the rise again. These companies become too risky when : a) debt has been reduced for 2 years but it increases again, b) when inventories increase twice as fast as the growth rate, c) when the PER is high compared to profit estimates.
Category 6: Asset “games”
Companies in this category hide treasure on the asset side of their balance sheet. If you know it and people don't know it, then you have found the rare pearl. To discover these types of companies, pay attention to local companies, the ones you know. The sectors to be monitored are metals, oil, newspapers, TV channels, medicines with patents... Try to have more details on the real value of the assets, what debt reduces the value of these assets and if the company continues to increase its liabilities.
Finally, you must sell these shares when management announces a capital increase to diversify, if the true value of the assets becomes known to everyone or if the share of institutional investors has risen from 10% to 70% in a few years.
Gifted Trader's advice: "My advice is to stay in the market forever. If you decide that a certain amount of capital invested in the stock market will always remain so, you will avoid general anxiety. Avoid situations where fundamentals worsen, and prices rise and buy stocks for which prices fall and fundamentals improve.”
*Source : Et si vous en saviez assez pour gagner en bourse, Peter Lynch
