Applying Peter Lynch’s Categories to Investing

“Know what you own, and know why you own it.” – Peter Lynch

This quote has become such a mantra of my own that I had forgotten that it came from Peter Lynch.  Lynch’s book, One Up on Wall Street, is one of my favorite investing books and has heavily influenced my own investment approach.  This is one of the first books I recommend to beginning investors as there are great insights for amateurs and pros alike.

Lynch is particularly skilled at distilling complex ideas into simple concepts.  In a chapter entitled “I’ve Got It, I’ve Got It – What Is It?” Lynch outlines six categories for classifying stocks.  There are many possible ways to break down stocks into categories, but the key is categorizing helps an investor analyze the stock, develop and test the thesis, and know when to buy and sell.  In short, it helps you know what you own and know why you own it.

My well-worn copy of One Up on Wall Street

Here are the six categories Lynch identifies:

Fast Growers

Fast growers are typically the most desirable stocks in the market and their prices are usually high.  Many fast growers are smaller companies, but these days, mega-cap tech firms like Facebook, Amazon, Netflix and Google (the “FANG” stocks) certainly qualify.  Stock prices can be volatile and will suffer if growth slows.

Stalwarts

Stalwarts are large, well-established companies with their fast-growing days behind them but still see their profits grow faster than the economy.  Lynch puts the earnings growth rate for stalwarts at 10-12%, but I think the high single digits would qualify.  Stalwarts produce consistent cash flows, which are regularly used for stock buybacks, growing dividends, or acquisitions.  Stalwarts don’t always offer spectacular returns, but often come with a high degree of safety.  In a market correction they tend to hold up better than other stocks under market stress as their products and services are typically those that consumers buy no matter the economic situation.

Slow Growers

As the name suggests, slow growers grow slow, likely just keeping pace with the economy (perhaps 2-3% per year).  Slow growers often pay dividends which can provide a steady stream of income, and occasionally a slow grower gets really cheap and can be a worthwhile investment if you believe the business is more durable than the market thinks.

Cyclicals

Cyclicals are companies whose sales and profits rise and fall with the economic or industry cycle.  Cyclicals see their profits rise rapidly coming out of recession but suffer significantly when the cycle turns (and risk bankruptcy if they carry significant debt).  Understanding the industry and seeing the signs of a turn for better or worse is critical.  Lynch warns that many “blue chip” stocks are really cyclicals and unwary investors may mistake them for stalwarts or even fast growers.

Turnarounds

Turnarounds are companies whose business and stock price have been beaten down, often to the brink of bankruptcy.  Turnarounds are tricky, as the companies are facing real and severe problems that are difficult to fix.  Profits in owning turnarounds can be huge, but there are many more failed turnarounds than successful ones.

Asset Plays

Asset plays own an asset usually unrelated to the core business that is overlooked or unappreciated by investors.  The best examples are non-operating real estate, equity in an entirely different business, or excess cash or investments.  Because the asset typically is not producing cash flow for the business, investors may not include it in their valuations.  However, the value can often be difficult to realize (or management may be unwilling), leaving investors to wait indefinitely for something to happen.

Applying the Categories to Investing

Categorizing stocks in this manner helps solidify the investing thesis and know when opportunities arise.  Fast growers and stalwarts are almost always timely if the business is strong, but the best opportunities to buy may come from market corrections or weakness in their industry as babies are thrown out with the bathwater.  For cyclicals, timing is critical as they should be shunned at the top and purchased in times of industry downturns (easier said than done!).  Asset plays and turnarounds can be found almost anytime, but the true successes are few and far between, so you may go long periods without owning either.

I apply Lynch’s model in my own strategy, but I first divide my investments into two classes – Core and Opportunistic – before further breaking them down into categories.  This helps prevent thesis drift as I keep focus on why I own a stock and what role it plays in a portfolio.

Core holdings are generally fast growers or stalwarts with excellent business fundamentals, strong management, solid long-term prospects.  My holding period for these stocks is indefinite, as expect to own these companies if the business is strong unless the price gets utterly irrational.

Opportunistic holdings can come from any category.  The common thread is a divergence between price and value, often with a catalyst to close the gap.  The holding period is much shorter than for Core holdings – typically 1 to 3 years.  Cyclicals, turnarounds, asset plays, and temporarily-depressed stalwarts and slow growers will all fall under Opportunistic holdings.

Dividing my portfolio into these top-level categories helps with one of the toughest questions investors face: when to sell.  Core holdings will be held as long as the business fundamentals move in the right direction, even if the stock exceeds my estimate of fair value.  Opportunistic holdings will generally be sold as the business achieves fair value, the catalyst is realized, or the thesis is disproven.

Using both Core and Opportunistic holdings also provides an additional level of portfolio diversification.  Core holdings frequently move up and down with the broader market (indeed, they are often market leaders that make the headlines) and are frequently priced close to their 52-week highs.  Opportunistic holdings – especially those with catalysts – often move independent of the broader market and are regularly found on the 52-week low list.  Too many Core stocks and you become a momentum investor.  Too many Opportunistic stocks, and you may find your portfolio completely out of step with the market, particularly in strong bull markets.

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