Peter Lynch

Next, he suggests categorizing a company by "story" type, and he identifies six:

Slow Growers: Large and aging companies expected to grow only slightly faster than the U.S. economy as a whole, but often paying large regular dividends. These are not among his favorites.

Stalwarts: Large companies that are still able to grow, with annual earnings growth rates of around 10% to 12%; examples include Coca-Cola, Procter & Gamble, and Bristol-Myers. If purchased at a good price, Lynch says he expects good but not enormous returns--certainly no more than 50% in two years and possibly less. Lynch suggests rotating among the companies, selling when moderate gains are reached, and repeating the process with others that haven’t yet appreciated. These firms also offer downside protection during recessions.

Fast-Growers: Small, aggressive new firms with annual earnings growth of 20% to 25% a year. These do not have to be in fast-growing industries, and in fact Lynch prefers those that are not. Fast-growers are among Lynch’s favorites, and he says that an investor’s biggest gains will come from this type of stock. However, they also carry considerable risk.

Cyclicals: Companies in which sales and profits tend to rise and fall in somewhat predictable patterns based on the economic cycle; examples include companies in the auto industry, airlines and steel. Lynch warns that these firms can be mistaken for stalwarts by inexperienced investors, but share prices of cyclicals can drop dramatically during hard times. Thus, timing is crucial when investing in these firms, and Lynch says that investors must learn to detect the early signs that business is starting to turn down.

Turnarounds: Companies that have been battered down or depressed--Lynch calls these "no-growers"; his examples include Chrysler, Penn Central and General Public Utilities (owner of Three Mile Island). The stocks of successful turnarounds can move back up quickly, and Lynch points out that of all the categories, these upturns are least related to the general market.

Asset opportunities: Companies that have assets that Wall Street analysts and others have overlooked. Lynch points to several general areas where asset plays can often be found--metals and oil, newspapers and TV stations, and patented drugs. However, finding these hidden assets requires a real working knowledge of the company that owns the assets, and Lynch points out that within this category, the "local" edge--your own knowledge and experience--can be used to greatest advantage.

When evaluating companies, there are certain characteristics that Lynch finds particularly favorable. These include:

The name is boring, the product or service is in a boring area, the company does something disagreeable or depressing, or there are rumors of something bad about the company--Lynch likes these kinds of firms because their ugly duckling nature tends to be reflected in the share price, so good bargains often turn up. Examples he mentions include: Service Corporation International (a funeral home operator--depressing); and Waste Management (a toxic waste clean-up firm--disagreeable).

The company is a spin-off--Lynch says these often receive little attention from Wall Street, and he suggests that investors check them out several months later to see if insiders are buying.

The fast-growing company is in a no-growth industry--Growth industries attract too much interest from investors (leading to high prices) and competitors.

The company is a niche firm controlling a market segment or that would be difficult for a competitor to enter.

The company produces a product that people tend to keep buying during good times and bad--such as drugs, soft drinks, and razor blades--More stable than companies whose product sales are less certain.

The company is a user of technology--These companies can take advantage of technological advances, but don’t tend to have the high valuations of firms directly producing technology, such as computer firms.

There is a low percentage of shares held by institutions, and there is low analyst coverage--Bargains can be found among firms neglected by Wall Street.

Insiders are buying shares--A positive sign that insiders feel particularly confident about the firm’s prospects.

The company is buying back shares--Buybacks become an issue once companies start to mature and have cash flow that exceeds their capital needs. Lynch prefers companies that buy their shares back over firms that choose to expand into unrelated businesses. The buyback will help to support the stock price and is usually performed when management feels share price is favorable.

Characteristics Lynch finds unfavorable are:

Companies (particularly small firms) with big plans that have not yet been proven.

Profitable companies engaged in diversifying acquisitions. Lynch terms these "diworseifications."