Earlier this month I wrote an article called The Cost of Complexity.
In that article, I cited an example used by Clayton Christensen – two different auto components plants of the same company, one burdened with the highest overhead cost but produced the lowest quality product and the other exactly the opposite. The key difference was the lower cost higher quality plant only had two different but well-defined product pathways whereas the higher cost lower quality plant had more than 20 different product pathways and none was well defined.
As I pondered the implications that we can derive from this example and specifically investing-related implications, all of a sudden I bumped into the following observation – isn’t making investment decisions similar to making auto components in that our decision making may either follow a well-defined path like the Maysville plant or a messy path like the Pontiac plant? For instance, some investors claim their advantage is that they consider everything in their valuation for every stock – interest rates, who will win the election, oil price, Brexit, China, potential crisis, the relationship between gold and commodities, EV/EBITDA, P/FCF, etc. I can’t even imagine the unnecessary complexity that is built in this system – isn’t this akin to trying to make all the auto parts possible with the maximum possible pathways?
This led me to Peter Lynch’s category approach – Lynch categorized stocks and used different mental paths with different categories, not unlike the way the Maysville Plant made auto components.
In this video, around the 12:50 mark, Lynch summed it up:
If you start to look at the entire universe of stocks. More than 3,000 stocks on the NYSE alone and over 13,000 public companies total. I break stocks into categories, partly to make the job of researching stocks more manageable. Putting stocks into categories is the first step developing the stories. At least you know what kind of story it’s supposed to be. The categories tell you what questions you should be asking about a company. You simply can’t expect all stocks to behave the same. Basing a strategy on a general maxim like you sell when you double your money or sell when the price fell 10% is absolutely folly. No formula will apply to all stocks. Different stocks behave differently so they require different approaches, different expectations and different kinds of stories. Suppose you’ve made 50% gains on two stocks: one is a fast grower with a long way to go, the other is a big slow growth company that has already saturated 90% of its market, and the market itself is growing slowly. The 50% return is fantastic for the slow grower; the chances are it’s time to sell it. The same 50% return would be just the tip of the iceberg for the fast grower.
In the meantime remember, categories are guidelines, they are not hard rules. Some companies may not fit into a category. Others may seem to fit two categories at once. And almost all companies change their categories at some time throughout their lifetimes.
Lynch rarely owned slower growers. With stalwarts (companies growing earnings 10% to 12% a year), Lynch would buy them for a 30% to 50% gain, then sell and repeat the process with similar issues that hadn’t yet appreciated. With faster growers he looked for the ones that have good balance sheets and are making substantial profits, and he owned them as long as the growth rate continued. With cyclicals he looked for early signs that business is falling off or picking up, and with turnarounds he would wait for evidences that things were getting better. With assets plays he would develop a working knowledge of the company and the value of the assets and wait patiently.
The beauty of Lynch’s approach is that it makes decision making much easier because it reduces complexity. I’ve seen plenty of investors mixing up stock categories when making portfolio-level decisions – for instance, comparing a cyclical company such as Ford (F, Financial) with a stalwart such as Walmart (WMT, Financial). Or comparing the risk-reward ratio of a turnaround with an asset play. The reality is each category requires a different mental path and mixing them up will not lead to the best decisions, just like the Pontiac plan.
I think Lynch’s categorization system is a good one. I would probably add two other categories – (1) what Warren Buffett (Trades, Portfolio) called the “workouts,” which includes spinoff, reorgs and merger arbitrage, and (2) early stage venture capital-type investments.
Buffett and Lynch are probably good at all categories. But you don’t have to be good at all of them. You can pick your category and focus on it. For instance, Chuck Akre (Trades, Portfolio) focuses on compounding machines such as American Tower Corp. (AMT, Financial) and Visa (V, Financial) – a category that may include both stalwarts and fast growers. Donald Yacktman focuses on high quality franchises such as PepsiCo (PEP, Financial) – a category that mostly includes stalwarts. Walter Schloss focused on and Martin Whitman (Trades, Portfolio) focuses on cheap stocks, which naturally would include slower growers, assets plays and cyclicals. They find the styles that fit their personalities, and they focus on being the best in their styles.
The implications are very clear – pick the stock categories you want to be good at and have well defined mental paths for each category. Avoid adding unnecessary complexities by mixing up categories when making portfolio decisions.
Disclosure: No position in any of the stocks mentioned in the article.
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