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r4mangf
r4mangf
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6 Useful Categories of Stocks

When searching for GARP and ten-bagger opportunities, it's worth using a mental framework to categorize any stock into. This is something Lynch described in his book One Up On Wall Street.

A couple of considerations before categorizing your stocks:

Small companies can make bigger moves than larger companies, all else being equal.

For a large company to grow rapidly and become a ten-bagger, it eventually has to defy the law of gravity.

Apple (NAS: AAPL) has been a fantastic investment for those who got in early, or even throughout the re-birth engineered by Steve Jobs. But currently, full year revenue for 2013 is $171 billion, and net income is $37 billion. As great as the iPhone and iPad are, it's a big ask to expect net income to grow 10 fold, or even 5 fold (allowing for very generous share buy-backs). It just takes too much to move the needle.

Compare this to the last 10 years of AAPL growth – with revenues growing from $8.3 Bn (2004) to $170.9 Bn (2013); net income growing from $266 M (2004) to $37 Bn (2013). This has been coupled with split adjusted share-price growth from $3.40 to $100 over the same period – a 29 bagger. Fantastic growth, but much, much harder to replicate going forwards.

If a specific product is driving growth, how much does this contribute to the company's overall bottom line?

AAPL's growth has been driven by the phenomenal success of the iPhone and iPad. If you were able to anticipate this ahead of time you would have done very well with growth in the company's value and share price.

But what about companies like Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG)? Each of these has product lines in non-core business areas. Microsoft has Xbox and Windows phones; Google has an array of products, from office tools and maps to finance and news sites. For each company, these have an almost insignificant effect on the bottom line from core products – Windows PC software for Microsoft, and search for Google.

If a company you are considering for rapid growth has a new product or service that looks like it will fly, it should have a meaningful impact on the overall revenue and profits to affect the EPS and stock price.

The six categories of stocks

Here's the mental framework Lynch used while managing Fidelity's Magellan fund. It includes 3 categories based on growth rate, and 3 others:

1. The Slow Growers

These are slow growing and well-established companies that are growing slightly faster than the gross national product, perhaps 2-4% per year. They would have started off as fast growers to become so established, but eventually settle down.

Perhaps they've saturated their particular niche, innovation has stifled, the market has moved away from them, corporate focus moves towards preservation rather than growth – or any other number of reasons. This may also occur when it's overall industry slows down.

Slow growers also tend to pay generous dividends. This will be to maintain the steady shareholder base they have, attract income investors, and because management cannot find more effective uses of shareholders capital.

As a whole, this is category I want to be aware of to avoid. Nothing wrong with them; just in the absence on earnings growth, unlikely to be a place you will find significant returns.

2. The Stalwarts

Typically, companies with around 10-12% annual earnings growth. These can be a good place for strong steady gains, certainly faster than slow growers, but upside may be limited to 30-50% over a couple of years. You're unlikely to find multi-baggers here.

A recent example from my own portfolio that nearly fits this is Microsoft. The last 5 years of earnings growth has been around 9% CAGR. The company is well established, a leader in its field with a well defended niche and steady increasing revenue and earnings. I bought in early 2013 for around $28 per share for a 60% gain at today's price of over $45 per share.

Contribution to the gain included: steady earnings growth; stock buy-back to improve EPS; and a small PE multiple revision (from around 15x to 17x). These are great additions to any portfolio since they give good gains while adding some stability and staying power in more challenging markets.

Best to wash, rinse and repeat with these stocks.

3. The Fast Growers

This is the prime hunting ground for multi-baggers. Generally these are smaller, growing enterprises with a validated business and model, but still early in their growth potential. Growth rates for earnings are more like 20-25% per year (I'm happy to go as low as 15% per year).

Fast growth in a company doesn't have to come from a fast growing industry (though it can). It can also appear in a slow growing industry where the fast grower has growing space – this can be by winning market share, say with an innovative product or service within an established industry, or other means such as consolidation. It's all about scaling and replicating a winning formula for business growth.

Other things to look out for are a solid balance sheet, early strong positive cash flow (so the business can fund its own growth) and a simple business with an economic moat and well defined niche.

Fast growers do have there fair share of risks. With larger fast growers, the growth can eventually slow and they become re-rated as slower growers. For smaller fast growers, the risk is stiff competition from other companies, or internal challenges with scaling – either of which can lead to its collapse.

But the quest is worthwhile; a couple of these can make a career for a private investor.

4. The Cyclicals

In a growth industry, business just keeps on growing. In a cyclical industry it moves in waves – growing and contracting, growing and contracting.

The big challenge with cyclicals is seeing them for what they are, and not confusing them with growth industries. Examples include autos, chemicals, metals, agriculture, shipping, oil and gas. These all move in line with general business expansion and contraction. Compare this to steadily growing industries like ethical drugs or staple foods which broadly grow even in recession.

The other challenge is figuring out where you are in the cycle. Cyclicals tend to do best coming out of a recession when spending picks up again.

Going into growth mode is fairly simple to spot just by tracking the previous slump and growth metrics. But figuring out when a down phase will happen from the middle of a cycle is much harder. This is where industry insiders specific knowledge pays because they can see signs before they're reported in the financial press.

5. The Turnarounds

These aren't slow growers – they're the no growers in the middle of an imminent collapse where earnings often go negative. The news is all bad and no respectable investor would touch them.

What makes them interesting is the potential upside when the turnaround works out. They're much riskier than other categories, because you really need to understand and believe in the turnaround play to commit a purchase. It's not as simple as just following a nice history of earnings growth and buying at a modest PE ratio.

Lynch colorfully describes several types of turnaround in his book:

The bail-out-or-else – usually dependent on a government loan or guarantee. Recent examples include the financials sector following 2008 collapse – Fannie Mae (FNMA), Freddie Mac and American International Group (NYSE:AIG) in the U.S., and Royal Bank of Scotland (RBS) and Northern Rock in the UK. Investing in these is not always straightforward (for example, through debt instruments) but rewards can justify the effort.

The who-would-have-thunk-it – Lynch describes a utility, Con Edison – where stock price fell from $10 to $3 by 1974 then recovered from $3 to $52 by 1987. Unusual behavior for an utility.

The little-problem-we-didn't-anticipate – such as the Three Mile Island, described as a minor tragedy that was considered to be worse for the owner than it was. Such minor tragedies can be the source for major opportunity. But he does warn to stay away from situations where the liability and outcome is unmeasurable.

The perfectly-good-company-inside-a-bankrupt company – such as Toys R Us spun out from Interstate Department Stores, with a resulting 57x return.

The restructuring-to-maximize-shareholder-values - these often occur when large diversified companies (which usually bought unrelated divisions in previous booms) spin-off divisions into separate operating companies.

The idea is that out-sized returns can be gained – with a renewed focus, unhindered by a slower growing parent or sibling, and management incentivized to make the stand-alone work. Balance sheets in the spin-off are usually bolstered too in order to enhance success. Joel Greenblatt (Trades, Portfolio) covers these in much greater detail in his book, You Can Be A Stock Market Genius.

A good current example includes Hewlett-Packard (NYSE:HPQ), where as part of a turnaround including plans for a spin-off, share price has gone from $12.35 in Nov 2012 to $34 now.

6. The Asset Plays

These are companies where underlying owned assets have significant value that is not reflected in either the balance sheet or the earnings picture. Balance sheet anomalies arise since true value versus recorded value may differ (e.g. purchase price for real-estate vs. market value); Earnings based valuations do not directly reflect held assets.

Some common examples include undervalued inventory, real-estate, and leases (e.g. oil and gas, minerals).

A couple of current examples include BP - downgraded because of the Deepwater Horizon spill (this also qualifies it as one of the groups in turnarounds above), while the oil and gas assets are undervalued compared to most other oil and gas majors.

Another is Bob Evans Farms Inc (NASDAQ:BOBE) – currently the subject of an operational turnaround, but where the company owns the real-estate for 480 restaurants, and two farms of 937 acres and 30 acres. The restaurant locations could release value through sale and leasebacks, potentially freeing up several hundred $millions.

The trick with asset plays is understanding why the true value differs from what's reported and patience for the value to be unlocked.

Lessons...

So there you have it. Six broad categories against which you can frame any stock. Of course, you still have to look in detail at each opportunity and understand why there is value. But using the categories helps you think about each company in the right way. It also stops you from using the same valuation criteria across the board - which I've found to my detriment can lead you out of good situations.

If you're looking for GARP opportunities, it's also a good way to know which categories fit and which don't. Broadly speaking, I'm interested in Fast Growers, Stalwarts, Cyclicals, Turnarounds and Asset Plays. True GARP will arise in Fast Growers and Stalwarts, but you can still get worthwhile multi-baggers in the other three categories.

And finally, for a slice of humble pie, before I started using the six categories here are a few stocks I missed out on:

Amgen (NASDAQ:AMGN) – a stalwart where I recognized the upside but was impatient for the value to out with continuing earnings growth and a PE multiple upwards revision

Hewlett-Packard – being too down on the turnaround opportunity

Medtronic (NYSE:MDT) – another stalwart where I was impatient for the PE multiple upwards revision, despite strong and steady growing earnings.

Gilead (NASDAQ:GILD) – a fast grower where I was scared off by paying a slightly higher multiple despite rapid earnings growth, with strong franchises and new approvals for HIV and Hep C drugs.

Raman Minhas writes about investing using Growth At Reasonable Price to find interesting and profitable opportunities. If you enjoyed this article, join his free newsletter.

Disclosure: Long MSFT, BP at time of writing

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