Legendary American investor Peter Lynch shared nine characteristics about companies that he finds very favourable and four which he finds unfavourable.
Lynch is one of the world’s most successful value investors, with the fund he managed averaging a 29.2% annual return. He achieved the best 20-year return of any mutual fund ever.
During his 13-year tenure, the Fidelity Magellan Fund that he managed increased assets under management from US$18 million to $14 billion.
Lynch has written three books on investing – One Up on Wall Street, Beating the Street, and Learn to Earn.
In these books, he gives advice to individual investors, whom he believes have an advantage over institutional investors when using his approach.
One of the biggest benefits of being a retail investor is that you have more flexibility because bureaucratic rules and short-term incentives do not restrict them.
Maria Crawford Scott, the former editor of the American Association of Individual Investors (AAII) Journal, summarised Lynch’s investment approach.
Lynch advised people to invest in companies that they know well and where the stock has good growth prospects and is trading at a reasonable price.
Financial data to assess include year-by-year earnings, the price-to-earnings ratio (P/E) relative to historical and industry averages, debt-equity ratio, and dividends and payout ratios.
Lynch has also given characteristics he finds particularly favourable when evaluating companies, including:
- The name is boring, the product or service is in a boring area, and the company does something disagreeable or depressing. Rumours of something bad about the company can also help. He likes this because their nature often means the share is trading at lower levels than what they should.
- The company is a spin-off.
- A fast-growing company in a no-growth industry. Growth industries attract too much interest from investors and competitors, which leads to high share prices.
- The company is a niche firm controlling a market segment and that would be difficult for a competitor to enter.
- The company produces a product that people keep buying during good times and bad. Typical companies include drugs, soft drinks, and razor blades.
- The company is a user of technology. Taking advantage of technology creates a competitive edge but does not have high valuations associated with tech stocks.
- There is a low percentage of shares held by institutions and low analyst coverage. Bargains can be found among firms neglected by Wall Street.
- Insiders are buying shares. It is a positive sign if directors feel confident about the firm’s prospects.
- The company is buying back shares. Lynch prefers companies that buy their shares back over firms that choose to expand into unrelated businesses.
Lynch has also provided a few characteristics that he finds unfavourable in companies that he analyses, including:
- Hot stocks in hot industries.
- Companies with big plans that have not yet been proven.
- Profitable companies engaged in diversifying acquisitions.
- Companies in which one customer accounts for 25% to 50% of their sales.
Lynch also advised investors to invest in several categories of stock for diversification. However, he warned against diversification simply to diversify, particularly if it means less familiarity with the firms.
Instead, he encouraged people to invest in companies that are large enough to fully research and understand them.