Growth, value, or quality, is all useless. The road to a 29% CAGR
The brilliance of Peter Lynch
1400
That’s how many stocks Lynch owned at a certain point in time when he ran the Magellan fund.
That’s crazy.
Even if you have a team at your disposal, generating a market-beating return with so much activity means you need a process. Although Peter was known as a growth investor, he looked at everything. His secret?
Putting stocks in buckets.
But we’re getting ahead of ourselves. Let’s start from the beginning.
Growth, value, and quality.
Each investor plays a different game. It’s important to recognize the game you are playing. The universe of possible bets is huge. About 100,000 companies are publicly traded.
What is the lens you are using to look at these?
Overall, there are 3 big lenses that investors use:
Growth: Before 2020, growth investors looked at companies with high sales growth regardless of profitability. That has changed somewhat with higher interest rates
Value is categorized as looking for cheap companies. But that’s the “old” definition. They are looking at more mature companies or companies in decline trading below book value.
Quality: Is looking for companies that are still growing but show operational leverage. Their earnings are growing faster than revenues.
If we look at a company life cycle, it looks like this ⬇️
If a business obeys a typical company lifecycle, then the lens used allows you to zoom in on certain types of companies. There is an overlap between growth and quality and quality and value.
This is an oversimplification, but you know what I mean.
When push comes to shovel, every investor buys a company because they think the price in the market is lower than the actual intrinsic value of the company, regardless of which kind of lens you are using. (unless you trade on momentum, but that’s a different game)
I think it’s important to know what you are searching for, in detail.
That’s what Lynch did.
The Lynch playbook
According to his playbook, he used 6 categories.
Slow growers: Large and aging, growth equals GDP growth
Asset Plays: Focus on NAV and balance sheet
Stalwarts: Growing at 2 times GDP
Cyclicals
Fast Growers: 20-25 earnings growth
Turnarounds
Just like using growth or value, this is a different kind of lens, in my humble view, a better one.
Let’s get back to the chart and look at the 6 categories
The precise placement of each bullet is not the aim. Cyclicals can occur at any stage. The general conclusion is besides slow growers and asset plays, he was all over the place. Although he was known for growth, he did not shy away from other opportunities.
Why oh why Mr. Market?
I’d like to take it a step further. Instead of defining different categories, I’d like to add WHY Mr. Market is providing us with an opportunity.
After all, if the market is efficient 99% of the time, there has to be some reason why we are offered this chance at outsized returns.
Here are 5 categories and their types of mispricing:
Our Yin-Yang strategy currently has a focus on 1,2 and 3. Let’s dive deeper into each one.
1. Illiquid microcap turnaround
Charlie Munger claimed to stay away from turnarounds. And who am I to go against that wisdom? But there are different types of turnarounds.
A company that is in decline, where the board changes management, and they are putting in place a plan to reduce cost and find avenues to invest in growth is on the surface a monumental problem. There is however one situation where it could work:
A structural change in the business model: B2C to B2B or selling a failing business line and doubling down on one that works.
But why illiquid microcaps? Because this is the realm where you can find these, There is less competition. You’re looking for change. Things like this do not go unnoticed by bigger companies.
Example company: Innovative Food Holdings (IVFH)
What can we do? Go through the annual reports and see if you can find something that does not show up on a screen.
2. Quality large-cap growers
Even in big companies, there are huge swings in price. The most obvious example was the tech downturn in 2022. But these situations do not come about often.
Example company: Meta (META)
What can we do? Watch out for sector sell-offs. Which quality companies are thrown out with the bathwater
3. Mid to large-cap wide MOAT companies
The market is underestimating the MOAT of the company. The duration of the MOAT is longer than the market is anticipating. This is a lot more difficult to assess. Categories 1 and 2 are easier.
Example company: Adyen (ADYEY)
What can we do? Create a “buy the dip list” of wide moat companies. For this category, the work is done before. Then we wait for preparation to meet the opportunity.
4. Cyclicals
As Lynch did, but it’s a difficult play to pull off. You’ll need to time the market.
Example company: Most of the current automotive manufacturers
What can we do? Recognize the cycle. Ignore the P/E ratio. Buy when earnings seem at their worst. You make money from worst to better. Estimate normalized earnings.
5. Fast Growers
Continued fast growth can lead to fast price increases. But valuation is difficult.
Example company: Netflix (NFLX)
What can we do? The focus should be on the future. The value will be derived mostly from the future cash flows. Look at runway and potential. Is the company counter-positioning as opposed to an established player?
Summary
It’s important as an investor to know what you're looking for. You don’t use a hammer to drive a screw into wood. You adapt your strategy to the type of stock you’re looking at. That’s the beauty of Lynch’s approach.
Although price is defined by the marginal trade, we must remain humble and ask why Mr. Market is offering us this opportunity.
How do you categorize your investments?
May the markets be with you, always!
Kevin
I also consider Meta a quality large-cap grower. That's why I flagged it 🟩🟩 in my analysis when sentiment was overly bearish in 2022.
I'd also add TEMA/DEMA crossovers and RSI readings to catch optimal entry points in any category, especially for those "fast growers" where timing really matters.