🔎 6 Stock Types Crucial For Your Portfolio
This simple framework from a legendary investor can save you costly lessons
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Today at a glance:
Legendary investor Peter Lynch defined six stock categories you must know:
The Fast Growers.
The Stalwarts.
The Slow Growers.
The Turnarounds.
The Cyclicals.
The Asset Plays.
Bonus: Lynch’s Favorable Traits in a Stock
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One of the first investing books I read is “One Up on Wall Street.”
It’s a great place for new investors to learn about stocks and what it means to be a shareholder.
The book's author, Peter Lynch, is often considered an investing legend. His tenure as the head of Fidelity’s Magellan Fund from 1977 to 1990 saw the fund soaring with an average annual return of 29.2%, a performance that eclipsed the S&P 500 index by more than double.
Remarkably, Lynch achieved this stellar record not by owning and operating companies (à la Berkshire Hathaway) or indulging in trading activities (à la Rennaissance Technologies) but purely through his exceptional stock-picking and portfolio management prowess.
"Know what you own, and know why you own it.”
Peter Lynch is well known for urging retail investors to invest in what they know.
Why? Because it can save you many mistakes, and you are more likely to stay the course when the inevitable market pullback occurs.
While his 1989 book is rather dated (particularly regarding discussions on technology), it gives insights into his unique investing philosophy that has guided countless investors since.
At the core of Lynch's strategy lies the categorization of stocks. According to him, every stock fits snugly into six distinct categories, with different risks and opportunities to consider.
Since we cover so many businesses in this newsletter, I thought it would be a great opportunity to look at these categories more closely. So let’s dive in!
1. The Fast Growers
This category is Lynch’s favorite.
Some of their traits:
Small: They typically start as small companies (but not always).
Aggressive: Challenge established players or norms in their industry.
High Growth Rate: They grow north of 20%.
Innovative: Fresh perspectives and innovative strategies.
Risk-Prone: Can be financially less stable and need capital.
Potentially Overvalued: The market tends to put a premium on growth.
Can Boost Portfolio Returns: This category has huge winners.
These companies tend to be young and vibrant, and they hold the potential to revolutionize industries. That said, fast-growing enterprises are not exclusive to new, trailblazing sectors; they can also exist in traditional industries, bringing fresh perspectives and innovative strategies.
Fast growers can undoubtedly be alluring for investors, with their promise of hefty returns. However, they can also be some of the riskiest stocks to handle. They are often young companies with grand visions but can lack robust financial backing, making them susceptible to failure before they can fulfill their potential.
Moreover, the market tends to place a premium on fast-growing companies, particularly in low-interest-rate environments, leading to potentially overvalued stocks. If a company fails to meet the high growth expectations even slightly, its stock price can take a significant hit.
Tesla has been the quintessential fast-grower in the past decade. It faced a cash crunch only a few years ago, was often considered overvalued, and grew revenue and earnings at breakneck speed. The company achieved this growth despite its presence in a relatively cyclical industry (automotive).
The Lynch Playbook with Fast Growers:
Lynch’s favorite picks are “moderately fast growers (20% to 25%) in non-growth industry.”
Identifying a genuine fast grower is not an easy task. They often seem overpriced based on trailing metrics due to the premium paid for their growth potential. Cutting through the hype to discern a true fast grower from the duds can be quite challenging.
Nevertheless, snagging a true fast grower in your portfolio can dramatically boost your returns. For example, if you invested in Google when the company went public in 2004, you would have returned almost 50 times your money.
Given the high-risk, high-reward nature of fast growers, Lynch would advise limiting the proportion of these stocks in your portfolio. It's crucial to manage your exposure to fast growers to mitigate the potential impact on your portfolio if any of these turn out to be fast losers rather than fast growers. Remember, hindsight is 20/20, and fast growers are often only identifiable after they've grown for many years.
2. The Stalwarts
Stalwarts are established companies with higher growth potential than slow growers. Their strength lies in their resilience and consistent performance, even within mature, competitive industries.
Some of their traits:
Large: Stalwarts are typically large, established companies.
Stable: These companies have a long track record of stability.
Moderate Growth: Typically single-digit to low double-digit rates.
Recession Resilient: They maintain value during economic downturns.
Dividends: Stalwarts often pay out regular dividends.
Lower Risk: Due to their size and stability.
Portfolio Anchors: Regular returns while minimizing volatility.
An archetypal stalwart is Coca-Cola. Despite being part of the competitive packaged food and drink sector, it has consistently achieved double-digit returns on invested capital over the past two decades. The company's economic moat' includes a universally recognized brand and widespread distribution.
Many fast-growers eventually become stalwarts. A great example is Starbucks. The company grew north of 20% in the 1990s and early 2000s and normalized in the low teens for most of the past decade.
The Lynch Playbook with Stalwarts:
According to Peter Lynch's playbook, stalwarts should hold a permanent spot in your portfolio. In short: Own them, don’t trade them. They demonstrate resilience, maintaining their value during economic downturns when other stocks plummet.
Upon identifying a stalwart at a reasonable price, Lynch would advocate for a 'buy and hold' approach. He'd suggest resisting the urge to frequently check the news regarding your holding or monitor the stock's price action.
However, it's important to note that stalwarts aren't 'set and forget' investments. Lynch would advise checking on your stalwarts occasionally to ensure they're performing as expected.
Warren Buffett bought stalwarts like Coca-Cola and American Express in 1998 and 1993, respectively, and they remain in his portfolio today.
To be sure, while stalwarts are relatively low maintenance, they aren't no-work investments. Lynch's approach emphasizes the importance of routine monitoring to ensure they continue to add value to your portfolio. Stalwart can become slow growers.
3. Slow Growers
This is a group Peter Lynch is not too fond of.
Some of their traits:
Mature: Well-established companies.
Minimal Growth: Often barely beating inflation (or worse).
Regular Dividends: Attractive to income-focused investors.
Lower Volatility: Compared to smaller, growth-oriented companies.
Sector Leaders: But have limited opportunities for further expansion.
Low Risk, Low Reward: Compared to fast growers or stalwarts.
Predictable: Making them easier to analyze and invest in.
Slow growers are corporations characterized by sluggish year-on-year earnings growth. They're often large, mature companies operating in saturated markets where substantial investment opportunities are scarce. Think of slow growers as marathon runners who've settled into a steady, slower pace after an initial sprint.
A typical example today would be Procter & Gamble, in the mature cleaning and packaged food markets, and tobacco companies like British American Tobacco and Altria.
Despite slow growth, these companies often pay regular dividends due to a lack of other compelling uses for their cash flows. However, not all slow growers are permanently stuck; some have made significant strides following strategic business adjustments.
The Lynch Playbook with Slow Growers:
Lynch recommends pruning slow growers from your portfolio, citing their limited contribution to overall portfolio performance.
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4. The Turnarounds
These are the ‘fallen angels.’ The primary reason for investing in these companies is the prospect of buying at the bottom and reaping profits from their recovery.
Some of their traits:
Formerly Successful: Former favorites that have fallen on hard times.
Underperforming: Management issues, market shifts, or financial troubles.
Recovery Potential: Hinging on significant operational or strategic changes.
High Risk, High Reward: Turnarounds are hit or miss but can create huge gains.
Requires Patience: The turnaround process can be long and complex.
Requires Expertise: A deep understanding of the company and its industry.
Volatility: The stock prices of turnaround companies can be highly volatile as they are heavily influenced by news about the company's recovery progress.
Chipotle Mexican Grill experienced a notable turnaround under the leadership of CEO Brian Niccol, who assumed the role in 2018. Before his tenure, the company struggled to recover from a series of food safety issues that had significantly tarnished its reputation. Niccol, previously CEO of Taco Bell, introduced numerous changes, including a refreshed marketing strategy, a focus on digital sales, and new menu additions. Under his leadership, Chipotle regained customer trust and saw its stock price quadruple in the next five years, demonstrating a successful corporate turnaround.
A current turnaround story unfolding is Peloton after expanding too fast during the pandemic. The jury is still out on whether new management can put the company back on track. Similarly, Zillow is still recovering from its investment in a home-buying program that was eventually canned.
Of course, I would be remiss not to mention a high-profile company like Meta that fell out of favor in 2022 due to mounting losses from its investments in Reality Labs before rebounding dramatically after announcing its ‘Year of Efficiency.’ The company laid off 21,000 workers (about a quarter of its workforce), aiming for a flatter organization.
The Lynch Playbook with Turnarounds:
The most profitable turnaround scenarios involve companies on the brink of collapse, revitalized by new management pulling off a seemingly impossible recovery.
Lynch advises against investing in turnaround situations.
Why? Turnarounds seldom turn.
Investors who typically profit from turnarounds do so by actively demanding new management or board seats in return for their investments. This allows them to steer the company's direction and speed up the recovery process. As an ordinary investor, you are unlikely to have this level of influence, making investing in a turnaround more akin to gambling at a roulette wheel. Investing in turnarounds is thus considered risky and not recommended for passive investors.
5. The Cyclicals
Cyclical companies are characterized by their sales and profits following the ebb and flow of economic cycles, hence the name. Industries such as steel and chemicals are classic examples of cyclicals.
When the economy is thriving, the demand for their products escalates due to strong construction and manufacturing activity. Conversely, in a sluggish economy, the sales and profits of these products tend to decline.
Some of their traits:
Predictable Patterns: Growth and contraction in sync with the economy.
Specific Industries: From airlines to manufacturing.
Variable Profits: Earnings can vary greatly based on the stage of the economic cycle.
Timing is Key: Investing in cyclicals requires accurate anticipation of economic trends to buy at low points and sell at high points.
Not for Beginners: Cyclical investing requires understanding the nuances of economic cycles and industry-specific dynamics, making it unsuitable for novice investors.
High Volatility: Due to their dependence on economic cycles.
The Lynch Playbook with Cyclicals:
Despite the seemingly predictable nature of cyclicals, investing in them can be more challenging than it appears. The fluctuations of business cycles aren't perfectly predictable, and getting the timing wrong can lead to substantial losses. Lynch cites the example of Ford, whose stock price swings dramatically in response to economic conditions, potentially losing up to 80% of its value during economic downturns.
Lynch cautions that investing in cyclicals is not advisable for novice or casual investors due to the sector's complexity and inherent risk. It's a playground for ‘smart money’ with a significant presence of seasoned investors who understand the ins and outs of cyclical industries. Unless you have extensive knowledge and experience in these sectors, timing your buys and sells for optimal returns can be challenging.
6. The Asset Plays
Asset Plays are companies that possess assets potentially underappreciated by the market. The assets can include cash, valuable real estate, underutilized investments, or patents and trademarks. The critical point is that the company's stock price does not fully account for these assets, providing investors an opportunity for significant gains when the market eventually recognizes their true value.
Some of their traits:
Undervalued Assets: Possess assets that the market has overlooked.
Real Estate: Often, these assets can be significant real estate holdings not reflected in the company's stock price.
Intellectual Property: Undervalued assets can include patents or tech infrastructure.
Requires Deep Analysis: Spotting an Asset Play requires thoroughly examining a company's balance sheet and understanding all its tangible and intangible assets.
Patience is Key: Investing in Asset Plays often requires patience, as it might take time for the market to recognize the value of the undervalued assets.
Possible Acquisition Targets: Asset Plays could become acquisition targets if other companies or investors recognize the undervalued assets.
A perfect example of an asset play is a company sitting on large amounts of cash and liquid assets. The cash value alone could be worth more than the company's market capitalization. In such a situation, even if the company's operating business is making losses, the undervalued assets offer a margin of safety.
Another example could be a tech company owning an extensive patent portfolio that is not yet monetized or fully appreciated by the market. When the patents are eventually licensed or sold, this could significantly boost the company's value.
The Lynch Playbook with Asset Plays:
Lynch's strategy with Asset Plays is to recognize the hidden value before the broader market does. Once the undervalued asset is identified, an investor should take a position and patiently wait for the market to realize the asset's value. This process could take a long time, even years, and may require further research to ensure the asset is as valuable as initially estimated.
However, this strategy isn't without its risks. An asset play can backfire if the market never acknowledges the undervalued assets or if the company mismanages these assets. Therefore, while potentially rewarding, investing in asset plays requires a deep understanding of the company and patience for the market to catch up.
Bonus: Lynch’s Favorable Traits
Beyond determining the category a stock belongs to, Lynch listed several traits that make a stock compelling:
Earnings: Look for stability, consistency, and an upward trend in earnings growth.
Valuation: The valuation should be in the lower range of its historical average.
Fortitude: The balance sheet should be strong (low bank debt levels).
Cash: The net cash per share should be high relative to the share price.
Unattractiveness: The name is boring, the product or service is in a boring category, the company does something disagreeable or depressing, or there are rumors of something bad about the company (all unattractive traits that keep most investors on the sidelines, creating favorable entry points).
Spin-offs: The company is a spin-off (there is historical evidence around spin-off outperformance).
Peculiar growers: Growing fast in a non-growth industry.
Niche: The company is a niche firm controlling a market segment.
Resiliency: The company produces a product that people tend to keep buying during good times and bad.
Technology beneficiary: The company can take advantage of technological advances but is not a direct producer of technology (less subject to disruption).
Undiscovered: Low percentage of shares held by institutions.
Underfollowed: Low analyst coverage.
Insider Buying: Management is buying shares.
Stock Buybacks: The company is buying back shares (a topic we covered here).
Bottom Line
Undeniably, Peter Lynch's exceptional success in navigating the stock market stemmed from his astute understanding of the unique characteristics and behaviors of various types of stocks.
To be sure, Lynch points out that stocks can fall into multiple categories simultaneously. In addition, companies can move from one type to the next, so keeping track of the story is critical.
By classifying stocks into six distinct categories, he separated the wheat from the chaff and developed tailored strategies for each, significantly enhancing his investment performance. More importantly, he knew what he was buying and why—a process that cannot be overlooked.
However, while Lynch's strategic insights and methods provide valuable guidance for investors, replicating his level of success is a tall order. His knack for identifying potential investment opportunities across a broad spectrum of stock categories is extraordinary and honed through years of experience.
For most investors, staying away from individual stocks and focusing on ETFs and index funds is preferable.
Nevertheless, adopting Lynch's framework can greatly assist investors in evaluating opportunities and making informed decisions. His philosophy of investing in what you know fosters a focus on fundamentals rather than hype. While we may not all reach the heights of Peter Lynch, implementing his wisdom can undoubtedly enhance our investing acumen.
That’s it for today!
Stay healthy and invest on!
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Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.
Disclosure: I am long GOOG, META, and TSLA in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.
I love Lynch. I should have paid more attention to his advice on cyclicals before I dove in headfirst in February of 2020 (really yes, just before the pandemic hit), but his advice continues to pay huge dividends... literal and metaphorical! Wise dude.
One fast grower is Doximity $DOCS
https://heraldofthehudson.substack.com/p/long-doximity-inc-docs