In a market such as this, when stocks are slipping despite companies producing solid numbers, it is a great time to break out shopping lists and go on the hunt for bargains. It is important to keep in mind what kinds of stocks are worth looking at. Peter Lynch describes six classes of investable stocks in his book “One Up on Wall Street.” Peter Lynch was the fund manager at Magellan from 1970 to 1990. During his time managing the fund, he averaged a 29 percent annual return. He lists stocks from stable no growth stocks with solid dividends to high growth stocks with the ability to go up tenfold aka “ten-baggers” to the turnaround plays of once successful companies that lost their way and are headed for a rebound.
Slow growers
Who could get excited about slow growers? They are companies that have reached their market saturation or are in industries that, while once hot, have now cooled off and grow at a rate just slightly faster than GNP. Their earnings are growing at roughly 2 to 4 percent and frankly; they are only good for the dividend. After all, what’s the point of owning a stock that is growing slowly and producing no dividend? You might as well own a bond or stay in cash. For slow growers, it is important to insure that the dividend is secure. It is important to be sure that the dividend has been maintained over a long period of time, i.e. 10 years or more. You want to make sure that the payout ratio is low and has been low for a long period of time. You can check this information with the interactive chart in GuruFocus to check the historical payout ratio. There is not much use for these stocks in the growth-oriented portfolios of younger investors. These stocks are usually best suited to people who are retired and are looking to maintain the gains that they have banked over the years. Slow growers can provide a little extra income in the form of dividends during retirement.
Stalwarts
Stalwarts are the mega cap stocks. These stocks include but are not limited to Procter & Gamble (PG, Financial), Coca-Cola (KO, Financial) and Bristol-Myers (BMY, Financial). These stocks are the glaciers of the stock world. They grow slightly faster than the slow growers, but they have a solid industry position and usually have healthy dividends. Their stock charts are gently sloping upward and are able to weather turbulent markets and recessions. Typically these stocks have an annual earnings growth rate of between 10 and 12 percent. These stocks are not going to double over night or even in the next year. In fact you should be ecstatic if you see a 50 percent return over two years and might start to consider taking some of your money off the table. The stalwarts don’t appreciate very fast, but they tend to lose less money during market slumps. Sometimes stalwarts can even go up during recessions as they are considered good defensive stocks. They have a place in a defensive portfolio but are only slightly better than cash or bonds.
Fast growers
Fast Growers can be the stuff of legend. They can easily be what Peter Lynch calls 10- 40 baggers. If you are careful you can find stocks that will go up 10 to 40 times. Every once in a while you will find a 200 bagger. This is the stuff that careers are made on. Fast growers are typically small companies that are growing at 20 to 25 percent per year. These stocks are all over the place if you know where to look. They can be in the  grocery aisle in the case of L’eggs by Haines or in the hotel that you stay in the case. They may be the first company to introduce a groundbreaking product or they may just rework a staple product that has a groundbreaking approach. You can also find these stocks in slow-growing industries where one company is gobbling up market share like Anheuser-Busch Inbev (BUD, Financial) did in the beer industry or like Altera has done in the tobacco industry. I like slow-growing industries because they don’t attract a lot of competition. These industries are ripe for one company to grow very fast and gain market share as other smaller companies struggle to survive. In hot industries you may find that the industry is growing at 25-50 percent per year but companies are piling in to try to get in on the action. As a result all the growth is fought over and no one makes much money in the end. The computer industry of the late '90s is a great example of this. The key with fast growers is to get them at a good price. This is not always as easy as it sounds. These stocks can have very high PE ratios and once the growth stops, the stocks will be taken to the woodshed. You don’t want your savings to go along with them. A good rule of thumb is to know what you are buying and pick them up at a multiple less than their growth rate.
Cyclicals
Cyclicals are companies with repetitive cycles of business that more or less follow the cycles of the economy. Cycilicals include aerospace, autos, homebuilders, manufacturing and chemical companies to name a few. With cyclicals, timing is everything. Because of this they can be some of the most difficult to invest in successfully. Making matters worse their PE ratios behave counter-intuitively. Cyclicals will have some of their highest PE ratios at the bottom of a cycle just before they are ready to take off. This is because those in the know will start buying the stock in anticipation of an up cycle and bidding up the stock before they release strong earnings numbers. Conversely cyclicals might look their cheapest just before a cycle ends and business starts to turn south. This is because people will start to sell the stock before the company reports earnings in anticipation of a bad number. Cyclicals are easier to get into than get out of. For example, the auto industry has a replacement cycle of about 2 to 4 years . This is because, as a car wears out, people will need to replace it. In a rough economy, people may put off buying a car for a year or two, but they can rarely put off the purchase for longer than that. If inventories stay high for more than 4 years in the auto industry you can bet that you are about to see a major upswing as people rush to buy a new car to replace the old jalopy sitting in the driveway. But it might be tougher to determine when people decide to stop buying. Cyclicals can be great stocks during a recovery like the one that we are going through now. However it may be difficult to time exactly when cyclicals will fall out of favor. Cyclicals should only be held in a long term portfolio with healthy defensive stocks that move counter cyclically.
Turnarounds
Turnarounds can be the gems of the investing world. These are previously solid companies that have run into trouble. These are no growth companies that are knocking on the door of chapter 11. Typically management has run amuck and driven the company into the ground. Turnarounds might be heavily laden with debt or they may have made too many unwise acquisitions. Instead of diversifying their holdings they have diworsified into business that management knows nothing about and is unrelated to the core business. Some companies have just gotten caught unprepared for the changing realities of the market just as a major recession hits. Take American International Group (AIG} and Bank of America (BAC, Financial) for example. You can find great turnaround plays in cyclical companies with poor management. These companies will sometimes have down cycles that are so big that it looks like they will never come back. Either way management is to blame. If you see a company starting to pay off its debt and sell off non-core segments of its business, it might be a sign that you are in for a turn around story. “Too big to fail" companies can be great for investors. The failure of these companies threatens to have a serious impact on the U.S. economy. As a result the U.S. government may give them a bailout. These companies are great. It is always great to have Uncle Sam vested in your success.
Asset plays
Asset plays are the undiscovered oil wells in your backyard. These companies have large hidden assets that, for one reason or another, you know about them before Wall Street does. It seems farfetched that, with the speed of information and thousands of analysts covering companies, that there could be any hidden assets that Wall Street has not priced into a stock. However, if you look carefully and pay attention to your surroundings, you will find that they still exist. Twentieth Century Fox famously bought out Pebble Beach back in 1976 for $42.50 per share or $25 million. The next day Twentieth Century sold the gravel pit, one of Pebble Beach’s many assets, for $30 million. They essentially got paid $5 million to take control of the golf course, the clubhouse, the adjacent 2,700 acres of old growth forest and the hotel. What a deal! These amazing deals still exist in companies today. If you keep an eye out in the industries in which you work, you may stumble across assets that may be mispriced on balance sheets and overlooked by Wall Street.
There are great companies out there if you know where to look. Take a look at your current portfolio and try to identify under which category each of your holdings fall. This will help you create a better game plan as you try to navigate the life cycle of the businesses that you own. You can do very well sticking in just a few different classes of stock. There are many investors who have entire portfolios dedicated to asset or turnaround stocks.
The importance of diversification in high-risk stocks, such as cyclical and high-growth stocks, should not be understated. Most of all don’t get complacent. Stocks don’t stay in the same category forever. What was once a high-growth stock could easily saturate the market and end up a stalwart or a slow grower. Cyclical stocks can easily turn into turnaround stories and vice versa. In the end know what you own and try to buy stocks with stories that you understand at prices that seem reasonable. If you keep your head about you, there should be no reason that you don’t stumble into a couple of 10 bangers now and again. Best of luck in your investing.
