In my earlier article, “Is an Idiot Running the Business”, I mentioned taking a closer look at the techniques used by one of the greatest investors of all time, Peter Lynch.
Once again, Lynch took the time to organize his stocks into six categories: Slow Growers, Stalwarts, Fast Growers, Cyclicals, Turnarounds and Asset Plays.
Slow Growers are defined as those companies that are large and aging companies and expected to grow slightly faster than the GDP, around 10% or a little less (my estimation). Lynch did not commit a large part of his portfolio with this group; however, he did not shy away either and would invest primarily for the company’s dividend appeal.
Stalwarts are companies growing in the 10-12 (up to 19%) percent range, according to Lynch, and would include companies such as Coca-Cola (KO), Bristol-Myers Squibb (BMY), Proctor and Gamble (PG), Colgate-Palmolive (CL), etc. He recommended keeping stalwarts in the portfolio, especially during difficult times such as recessions.
Fast Growers appear to clearly be Lynch’s favorites; however, don’t let the name fool you into thinking that these do not include stocks that we value style investors hold so dearly. While some Fast Growers might not be considered by all value investors, Lynch’s Fast Growers include Intel (INTC) and Dollar General (DG) which are both owned by Warren Buffett and several other value investors.
Lynch clarifies that a fast growing company does not necessarily have to be part of a fast growing industry and all the company needs is a place to expand. He does elucidate the need for having a good balance sheet and substantial profit margins. Knowing how much to pay for the growth is extremely important.
Cyclicals are separated from Slow Growers and Stalwarts because timing becomes increasingly important. The example given is demonstrated by the difference between companies such as Ford (F) and Bristol-Myers Squibb (BMY). While Bristol-Myers Squibb can lose a great amount of value during a major economic downturn, companies such as Ford, due to their cyclical nature, can get pummeled.
Turnarounds are those that “have been battered, depressed and often can barely drag themselves into Chapter 11.” Lynch breaks them down further into sub-categories:
- The bail-us-out-or else kind of turnaround which would include today’s companies such as GM or some of the banking industry.
- The little-problem-we-didn’t anticipate kind of turnaround. Lynch’s example includes Three Mile Island, which he talks about minor tragedies that are seemingly worse than originally thought and turn out to be good buying opportunities.
- The perfectly-good-company-inside-a-bankrupt-company kind of turnaround
- The restructuring-to-maximize-shareholder-values kind of turnaround. “Restructuring is a company’s way of ridding itself of certain unprofitable subsidiaries it should never have acquired in the first place. The earlier buying of these ill-fated subsidiaries, also warmly applauded, is called diversification. I call it di-worseficatiion”.
- The last category is called The Asset Play and includes any company that is sitting on something of value that Wall Street hasn’t fully considered. It could consist of stocks such as Sears Holdings (SHLD) and the empire of land they possess or the land possessed by the large railroads. Lynch provides us with plenty of examples.
Lynch’s cash position is calculated by adding cash and marketable securities and subtracting long term debt and comparing the result with the price of the stock. As an example, Lynch gives us Ford (F) and his calculations from the 1987 balance sheet.
Lynch adds $5.673 billion in cash with marketable securities of $4.424 billion which is rounded off to $10.1 billion and subtracts the long term debt of $1.75 billion to get a result of $8.35 billion for Ford’s net cash position. With 511 million shares outstanding and dividing that number into the net cash, Lynch concludes that there is $16.30 in net cash to go with every share of Ford
“The $16.30 bonus changed everything. It meant that I was buying the auto company not for $38 a share, the stock price at the time, but for $21.70 a share ($38 minus the $16.30 in cash). Analysts were expecting Ford to earn $7 a share from its auto operations, which at the $38 price gave it a P/E of 5.4, but at the $21.70 price it had a P/E of 3.1… The cash factor helped convince me to hold on to Ford, and it rose more than 40 percent after I made the decision not to sell.”
Lynch points out that it is typical for a stock to have a 10 percent return on cash flow. That is, if you have a $20 stock and $2 per share in free cash flow, one could expect a minimum 10 percent return. A $20 stock with a $4 per share free cash flow and you could expect a 20% return and he advises that if you can find a $20 stock with a free cash flow per share of $10 to “mortgage your house and buy all the share you can find.” The ratios are easy to spot on this website.
Inventory to Sales:
It is imperative that you check if inventories are increasing faster than revenues, especially in manufacturing and retail companies. Take, for example, Wet Seal (WTSLA).
Note that while the revenue has basically been flat, the inventory is trending upward. This may not be a
concern with the small numbers shown, but the trend must be watched or the year over year numbers in order to spot a situation in which the company is forced to liquidate product at a discount.
What are some picks that Lynch would like or pass his screening process that are also owned by our guru value investors:
Here are a few more for consideration:
Omnivsion Tech (OVTI), currently owned by Joel Greenblatt and recently purchased by David Einhorn and Charles Brandes.
Ternium Sa-Adr (TX), recently purchased by Charles Brandes with a P/E ratio of 6.5, P/B of 0.7, P/S of 0.5, PCF of 3.7 and a dividend yield of 6.4%.
Kulicke & Soffa (KLIC). This stock sells for 11.63 and GF’s DCF calculator indicates a value of $28.62 with a margin of safety of 59%
More to come…
Disclosure: I own Dollar General (DG).