Choosing What to Invest In

There are so many different businesses listed on exchanges across the globe, for the purpose of trading the shares of these companies. 

The word “stock” covers a diverse range of public companies, which can fit into multiple categories depending on how you choose to classify them. 

Not to mention, many of the categories have overlapping features. 

You’ve probably heard the term “sector”, which defines the type of business the company conducts (I.e. Technology, Cannabis, Psychedelics). 

Market capitalization is another common grouping, which indicates the relative valuation of companies. Think small cap, blue chip, “unicorn”. Categories are extremely useful for creating an understanding of the distinct features within the many possible investment options the stock market has to offer.  

Distinguishing different characteristics of companies that trade on public exchanges is a valuable step towards making a sound investment decision. 

This begs the question: “How should I categorize stocks?”  

Enter: Peter Lynch. 

The legendary stock market figure is an American investor, mutual fund manager, and philanthropist. Lynch managed the Magellan Fund at Fidelity Investments from 1977 to 1990. The fund, under Lynch’s direction, averaged a consistent 29.2% annual return; more than double the returns of the S&P500 stock market index.  

This carved the status of the Magellan Fund as the best-performing mutual fund in the world. 

Lynch identified his stock picks within 6 categories.  

Slow growers, stalwarts, fast growers, cyclicals, turnarounds, and asset plays. 

Let us go over these in detail, so you can use them in your investment strategy. 

Table of Contents 

1. Slow Growers
2. Stalwarts
3. Fast Growers
4. Cyclicals
5. Turnarounds
6. Asset Plays 

Slow Growers 

These types of stocks are typically larger, more established companies. Many blue-chip stocks fall into the slow grower category. 

These types of stocks aren’t usually expected to outperform the overall economy. The appreciation for slow growers, although fairly consistent, is slow, as you may have guessed. The main appeal to investors when choosing slow growers is dividends.  

Since companies within this category tend to be already well-established globally, leftover cash is returned to shareholders in the form of dividends.  

Dividends are widely praised, as they get issued to shareholders regardless of the share price. Often, investors will opt for their dividends to be reinvested as shares, increasing their position in the company long term. This method is often done through a dividend reinvestment plan, also referred to as a DRIP. 

Things to inspect: 

• Find out how long the company has been issuing dividends, and how consistent the payout is. Generally, 20 or more years of dividend history is ideal. This is important to inspect because dividends are never obligatory for common shareholders and can technically be stopped at any point in time. 
• Inspect the book value of the company. This includes their net assets, cash-on-hand, earnings, etc. If the company’s market cap is above their book value to the extent that exceeds the ratio of comparable companies, you may not be at the best entry point for the stock. Dollar-cost-averaging would be a great method to gradually enter your position in such a case. On the contrary, if your Buffet senses go off and you find the stock is undervalued through fundamental analysis, this may be an indication that the stock is at an entry point. 
• Make sure the dividend payout isn’t too high. While it sounds counter-intuitive, a company that issues a comparably high dividend may have a hard time sustaining such a dividend consistently. A lower, but steadier, dividend is often looked at more favourably than a higher, unstable dividend.  

Did you know?  Book value is the true value of all of a company’s assets net of liabilities. Dividing the book value by the number of common shares outstanding determines the book value per share (BVPS), which is utilized in fundamental analysis.

Stalwarts 

Stalwarts are a category of large companies, much like slow growers. However, stalwarts are able to grow faster; around 10-15% annually when they see considerable earnings growth, with the possibility to stay even during periods of economic downturn. 

Market sentiment is market sentiment. Even when a stalwart company is displaying positive financial results, market conditions may dampen the effect. This means that when the market is down, these stocks may stay reasonably stagnant. This can be a good thing in terms of avoiding any major capital loss during periods of bearish market conditions. 

Did you know? Market sentiment refers to the overall attitude of investors toward a particular security or financial market. It is the feeling or tone of a market, or its crowd psychology, as revealed through the activity and price movement of the securities traded in that market.

Stalwarts are known to yield great returns in bull markets, especially after fundamental growth is displayed through financial disclosures. These types of stocks share some characteristics with growth stocks (such as their positive reaction to bull markets and good news) as well as defensive stocks (such as their relative ability to withstand bear markets).

Things to inspect:

• Entry points are crucial for stalwarts, as these types of stocks are typically priced quite high. Using a bit of technical analysis, some dollar-cost averaging, and a pinch of patience can go a long way.
• Be as aware as you can about the market sentiment (and possible upcoming changes in the external environment) as you debate entering a position on a stalwart. Entering in a bull market may result in your position remaining flat or even reducing in value if the market calms down shortly afterwards. 

Fast Growers 

Fast growers are a more aggressive form of growth stock, as compared to stalwarts. These types of stocks are typically smaller to mid-sized companies that are operating in a growth period, seeing returns of around 20-25% annually. 

During certain peaks, under the right conditions and company activity, you may even see these stocks become “multi-baggers”. Growth stocks often have a higher P/E ratio than other types of stocks, due to the future earnings potential being priced in. 

Did you know? A “multi-bagger” refers to a stock that appreciates at a multiple of its original cost. If a stock doubles, it is often caled a two-bagger, while a stock that grows 10x from your initial cost is called a ten-bagger. A stock becoming a multi-bagger essentially means that it has grown to several times its original cost, with no specific indication of exactly how much it has appreciated. 

As much as fast growers can generate great returns, vastly outpacing the market, they also carry a significant amount of risk, especially in the short-term, from volatile swings. It is a common strategy to have 20-30% of your portfolio deployed into these fast growers. 

Things to inspect: 

• Entry points are critical when it comes to fast growers. Buying after a large surge in price (without underlying fundamental change) can almost certainly lead to a small unrealized loss as the share price generally pulls back. Stocks that are trading at a high P/E ratio often experience pullbacks following surges in share price. On the flip side, an entry after a significant pullback can see better gains as the price trends back upward. 
• Similar to stalwarts, market sentiment is a factor in the performance of growth stocks. During times of economic distress or bear markets, these stocks will often sink back to reality. You’ll want to seek out fast growers when a bull market or an economic expansion is likely around the corner. 

Cyclicals 

Cyclical stocks are ones that like to behave in line with the economic cycle, particularly the industrial cycle. 

Typically, a cyclical stock will do great during times of economic growth and do poorly when the economy slows down, or goes through a recession. 

The economic cycle has 4 stages: Peak, Recession, Trough, and Expansion. 

Peak Stage: When the economy is at an all-time high within the cycle. The economy is booming, and inflation is high. This is a popular selling point for cyclical stocks as the market tends to expect things to calm down. 

Recession Stage: The pulling back of the economy from the peak. Typically, the government is restricting monetary policy by increasing interest rates and implementing fiscal policy by taxing a little heavier and decreasing spending, to ease inflation. 

Trough Stage: When the economy hits its lowest point. At the trough, it’s common for investors to buy cyclical stocks, as the economy typically transitions to the expansion stage. The government tends to stimulate the economy by decreasing interest rates and taxation, and increasing spending. 

Expansion Stage: When the economy is on its way to a new peak. At this point, cyclical stocks are experiencing appreciation, jobs are being created, and inflation has been eased. 

Earnings growth for cyclical stocks typically vary 5-6% in the red during economic downturns, and 18-20% in the green during upturns. 

It is common for investors to buy cyclical stocks during economic troughs and expansions, only to flip their positions to slow growers during peaks and recessions, minimizing downside risk, and maximizing upside potential. 

Automobile, metals, construction, industrial, and banking companies are all great examples of cyclical stocks. 

Things to inspect: 

• Evidently, one of the biggest factors when deciding whether a cyclical stock is a good buy, is observing the economy itself. Knowing when a recession turns into a trough, and when an expansion turns into a peak is crucial. The last thing investors want is to buy under the impression the economy is in the expansion stage, only to realize that markets have been peaking for quite some time. Thus, potentially descending into the recession phase. 
• Fundamentals are important here. Knowing how to detect the signs of a company that will take a hit, as well as recognizing when it is going to start to accelerate earnings is a key aspect in successfully investing in cyclical stocks. 

Turnarounds 

We also like to refer to these as underdogs. 

Turnarounds are a category of stocks that have been pounded down in price by the market, but still have potential upside. However, not every stock that takes a beating is a turnaround.  

If a stock has seen a great reduction in valuation due to a lawsuit, poor fundamentals, or any reason that supports the loss of value, chances are it’s not going to complete a turnaround. 

What we are looking for with a turnaround is a poor stock that has dropped significantly in price but has a great shot at… you guessed it, turning around. The goal with these companies is to get supersized returns in a short period of time. 

There are a few aspects that may show significant promise for a company’s stock rebounding. 

• If the share price drop occurred due to poor earnings, yet the company remains fundamentally sound, you may have a turnaround stock. This is especially true if the poor earnings were due to a specific reason that doesn’t carry over to future business. An increase in the cost of a certain good or a shortage of one of the company’s key products is a good example of this. 
• New leadership is brought onto the board of directors or management board after lousy stock performance. Not only can new leadership fundamentally improve the company, but general market sentiment also can be positively enhanced if the leaders have a strong reputation. 
• A market-wide bearish event can often reveal tons of turnaround stocks; a notable example is the COVID-19 pandemic. A vast majority of stocks in the market crashed as much as 30-50%. Plenty of these stocks were great, steadily performing, dividend-paying stocks. Knowing that these stocks had nothing substantially wrong with them except for the fear of a recession, investors looking for a good turnaround stock had a blast. Imagine scooping up shares of a dividend stock at a 30% discount, only to see it bounce right back to pre-covid levels months later; turning around a 45% increase in the short term PLUS regular dividend payments. Score. 

Things to inspect: 

• Cause for depreciation. Careful, your potential “turnaround” stock could have been beaten down with good reason. Perhaps something fundamentally changed for the worse within the company’s business activities, financials, or the board. Be sure to investigate the reason as to why the stock is seeing a dramatic price drop and whether or not it impacts a potential turnaround. 
• Market sentiment. Although you may identify a good turnaround stock, if the overall market conditions are bearish, you may have a tough time achieving the results you desire. 

Asset Plays 

Asset plays have been a Warren Buffett favorite. In fact, according to his biography “Snowball,” this strategy was critical for a great period of his investing career. 

An asset play involves doing a deep dive of the company’s assets. This includes hard assets, such as inventory, land, facilities, and even their cash pile. 

If you can spot a company that has a hefty collection of real estate that hasn’t yet been appraised properly, or a giant reserve of cash that the market hasn’t caught onto yet, you may have found yourself an asset play. 

Patience is key, as it may take time for the market to catch on to the true value of the company. 

First, Buffett would inspect a company’s net assets: their plant, equipment, cash, as well as anything and everything else holding value. This would support the establishment of a company’s book value. 

This number is then divided by the number of shares outstanding to determine the book value per share (BVPS). 

Let’s say Buffett determined that the assets of a company upon liquidation (after liabilities) would equal $30 million, and the company had 10 million shares outstanding. 

This would mean the company’s book value is $3 per share. 

Should the stock be trading above $3 per share, it would be fundamentally undervalued according to Buffett, and he likely wouldn’t take a position. 

However, if the stock was trading at $2 per share, Buffett would be happy to buy up shares of the company, knowing that eventually, the stock would meet its book value levels. As the popular saying goes, investors get “paid to wait.” 

Buffett did, however, have a safety net. 

The reason Buffett saw these asset plays as an asymmetrical bet is because he had a plan. Should the price of our theoretical stock example maintain a price below its BOOK VALUE, Buffett would keep buying more and more shares until he had a controlling stake in the company. 

At that point, he knew that he could theoretically liquidate the entire company for a hefty $30 million, or $3 per share. Not that he would do so off the bat; the Berkshire head would often step onto the board to help turn things around before he would consider full liquidation. 

Things to inspect: 

• Diligence. To find the true value of a company’s assets, it often takes some digging beneath the surface. Recent appraisals of hard assets, up-to-date snapshots of a company’s cash assets, all take time to really dig into. Buffett himself used to show up at the company headquarters and inspect the equipment himself! 
• Market sentiment is important to determine the timing of the market catching on to your asset play. You may catch yourself waiting longer periods for the stock price to meet the book value of its assets in a bear market. 

We hope Peter Lynch’s 6 categories help you manage your portfolio.