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Thursday, March 18, 2010

How to Invest Like Peter Lynch - Kabir Ahmed's blog on stock investing

In a previous blog, we have discussed thoroughly the inevitable risk, so far, in the stock market that comes from a lack of knowledge. For that reason risk is contextual, that is depending on a degree of knowledge and also understanding many factors like quantitative, qualitative that are based on under-lying values of a company and psychological movements of shares. The risk needs to be measured and minimized through a learning process, implementing trading evaluation process and varieties of trading strategies. Many of us have already learned the risk minimization process and its importance, now we can begin to explore and experience. (read more)

We have also discussed how to build confidence in the process of screening a list of shares in a stock market investment. This process must be ingrained at a subconscious level to control our minds and create a habit of utilizing a defensive (conservative) approach in a stock selection. Despite many other investment methodologies available, a few people have become highly regarded and popular to global investors because their investment strategies are well-recognized on Wall Street as well as studied in academic circles. Just think about these consummate stock pickers who have run billions of dollars of funds in the last 30 or 40 years with their sophisticated stock screening process. There must be some traits which they are born with and also which they have learned so effectively that they can now trounce the market in order to gain lucrative profits on selected shares. Obviously, there are many questions to be asked. How do they perceive a company, how do they approach studying a company, and what type of investment methodology do they apply for analyzing shares? Does this make you curious at all? It makes me curious for sure. Obviously, their continuous successes are not based on pumping-dumping nor rumor, but rather a solid long-term objective, written on paper, that was followed as a blue-print. What could be more important than studying their investment styles? Old folks believe that there is no need to waste your energy to invent wheels when wheels already exist. These people created remarkable fortune with their great understanding of companies’ future prospect and experiences that can be a course of direction to other investors, in a way, to utilize their investment styles, and adopt their proven attributes and principles that will guide investors to stay on a right course to win on profit-taking.

One of the greatest successful fund managers was named Peter Lynch, who became revered and famous as a money manager worldwide, managed Fidelity’s Magellan fund which is one of world’s largest mutual funds. The remarkable achievement of his career is managing Magellan fund with a cumulative return of 2,703 percent and an average annual return of 29.2%. That small and obscure Magellan fund grew from $20 million in assets when he started managing the funds in 1977 to $14 billion at the time he retired in 1990. Many of his investment strategies and policies have been studied in academic circles around the world. Simplification to a company’s business is one of his mottos, especially understanding and explaining the investment methodology into simple logic—common sense. That was greatly compelling to ordinary people like John or Karim who are neither rich nor well-educated in financial terminology, who don’t have access to sophisticated financial resources, that are only for professional people. Despite all of the financial jargon, you can still do well in the market. He strongly believes that there are some events, news, and business prospect happening that are regularly available to anyone who may attain an investment edge by paying attention to what’s going on around us at the market place or in our society in terms of technological advancement.

For the sake of simplicity, ask yourself what you already know about a company by its products or services, whether they appeal to our society and show a sign of growing in the market place. When you carefully look at these selective products or services-ask yourself how much appealing is taking place to consumers and shaping our society to the advancement. See if these products are essential and integral to our everyday life styles or are they extension of luxuries—imagine you don’t have to depend on clothes, soft drinks, drugs, and also necessary food. All the products we use every day for the rest of our lives that can be sorted to cyclical and non-cyclical products and services. Cyclical represents those products or services that depend on the country’s economy and government’s changes, because they are such products that consumers and businesses only spend on more in an upward turn in the economy. When the market senses bad times coming in the economy, consumers will move toward non-cyclical or defensive stocks due to cyclical changes. Automobiles, vacation/airlines, tire, chemical companies and defense companies are classical example of cyclical stocks. When the economy is good, the middle class is expanding and people are working, so car sales do well. However, if there are layoffs and uncertainties or high interest rates, people may decide to hold off going on vacation or buying a car until next year. In such a cyclical period, some businesses are either falling off or moving up, this can be an early sign for investors to determine the timing to exit, by selling or enter, by buying, certain stocks. Businesses expand during good times or out of necessity. They buy new equipment and build new facilities, so equipment sales and constructions are also early sign for investors. The classic example of non-cyclical stocks is utilities. Everyone from consumers to businesses needs gas, electricity, and also some household non-durable goods such as toothpaste, medicine, necessary foods and others are classical example of non-cyclical stocks. Such common sense, with a little bit of paying attention, can separate the products and services into either cyclical or non-cyclical in order for investors to discover the prospect of certain stocks and decide whether or not they want to enter the market based on the proper timing, because timing is everything when it comes cyclical ones.

Based on the growth rate of earnings per share over the years, many other fund managers as well as Peter Lynch usually use certain methodology to classify stocks into one of these three main categories: fast growers, stalwarts, and slow growers, and also classify stocks to cyclical, turnarounds and asset plays based on other attributes. It is a comparison of PE with growth rate of earning per share per quarter, simple earnings per share, and annual sales to identify if a company is a fast grower, stalwart or slow grower.

Fast growers are companies whose annual EPS’s growth rate was either at 20% or higher in past three years; the growth rate can go much higher. However, a quick growth does not always sound good either because the company may experience trouble with its capacity and managing under a right course. So, it is important to look for at least 3 years of earning records. Some new companies are in the market place with their smaller size of business operation, but aggressive growth, due to new innovative ideas and pioneering in the industry, can achieve a growth rate of 20% or higher in earnings per share. Such a small company with a great deal of success in a small local city can multiply to different cities and different places by duplicating the same business model. Such an expansion of business model can also multiply its rate of earnings growth. Peter Lynch’s idea is to look for PEs that are either less or equal to the growth rate of earning per share then the stock is seen as a fair price. If PE stats are at half or less than the growth rate (say the growth rate is 40% while the PE is 19) that is much better bargain price. It is simply a comparison of how fast earnings growing and how fast PE changing. PEs must be lagging at least; the less it is comparing to growth of EPS, the more gets it attractive to investors. PE ratio to annual sales is when a company manages to have $1 billion ( such a company can be new, any index group but huge revenues growth) dollars of sales per year and the PE ratio is less than 40, then a stock is seen as a fair price. A stock is no longer a bargain price when the PE goes any higher than 40 even the company’s sales are higher than $1 billion (average sales in those fast growing companies listed in DSE).

Stalwarts are companies whose annual earnings per share growth rate exist between 10% and 19% and the PE stats must be half or less than the growth rate plus the yield (say, the growth rate is 45%, a yield is 5% and PE is 20) when the stock is seen as a bargain price. The sales of the company must maintain $2 billion dollars or higher in order to screen a company in a Stalwarts category. Earnings are growing moderately, however, companies in this group are matured and in a highly competitive industry and listed in blue chip categories like DSE-20 or CSE-30. Investors’ expectation from Stalwarts are dividends payments along with a little bit of stock price appreciation.

Slow grower companies are mostly large and aging, and can’t accelerate businesses easily with new business strategies, whose annual EPS growth rate is slightly higher than GNP which would be less than 10% of growth rate. Such companies are extremely stable but earnings growth or capital appreciation or dividends growth are not very noticeable because these Companies already have passed the peak point and are moving away from maturity. Especially utility companies when they have been in the business for decades and providing electricity to limited number of cities.

Turnarounds are companies facing troubles; however they have managed to pull themselves out of serious slumps through bail out money or its own strength. A perfectly healthy company which shows a long history of dividends payments, but currently the stock has created a new 52-week bottom price that can’t be disregarded if you are fishing for the bottom price.

Asset Plays is when the company’s assets exceed its market capital, such companies are commodity based or supermarkets that have been overlooked by Wall Street. Investors can justify the stock based on bargain price opportunity if a company represents a potential of hoard cash, therefore, the company’s price-book ratio might be much more favorable than what has been on the balance-sheet.

What do you get out after reading this article? It means a company can switch several times during its lifetime. Any new starting company starts with fast growing, if no barriers are placed then more companies enter to compete in a free market that pushes companies to stalwarts and then later companies go to further competition that pushes companies to slow growers. When competitors join in or new technology appears, they can become cyclical and then turnaround. If the price sinks far enough, however, they can be an asset play.

--Kabir Ahmed

1 comment:

Kallal Shing said...

Dear Sir,
Could you please help me to explain about RSI and MACD line for share.
Kallal Shing