Stock Classification : Peter Lynch’s Framework for Strategic Investment

One of the most heated debates in the financial sector is which portfolio is more efficient: a concentrated or a diversified one. Whether 5 -10 values are enough, and adding more companies does not add diversification and therefore does not reduce risk. That is why here you have a stock classification made by Peter Lynch to choose the best combination of stocks for yours!

Beyond theories or YouTube professors pretending to be Markowitz or Klarman, when you study Peter Lynch, you discover that today he would be labelled as crazy or simplistic.

In his fund he accumulated more than 1500 companies, more than 10% of the total companies listed in the United States. His portfolio would not be efficient according to theorists, but outside the classrooms his profitability made more than one of those university professors rich.

One of the greatest contributions remembered from his book is his vision about how to classify companies in the portfolio.

Next, we develop his classification of companies and what characteristics are associated with each category

Stock Classification according to Peter Lynch

peter lynch stock

Peter Lynch in his book classify stock companies into six groups. These groups include:

1. Slow-grower companies

Those that seem out of fashion but are the favourites of our tax inspectors, due to the juicy dividends they leave to investors.

In this category you should look for companies that grow a little above GDP growth usually between 2-5% above.

This is the category where all fast-growing companies end up when they mature and the sector consolidates. Slow growers are more stable since they have achieved a certain scale, and they often pay decent dividend, and they are good assets during the recession as it's very unlikely for their stock to crash too hard.

Examples of these companies:

  • Utilities: Energy, Railways
  • Industrials

Examples of ETFs to invest in these companies:

ETFISINTICKER
Lyxor MSCI World Utilities TR UCITSLU0533034558LYPQ
iShares S&P 500 Utilities
Sector UCITS
IE00B4KBBD012B7A
Global X Super DividendIE00077FRP95SDIV
SPDR S&P US Dividend Aristocrats UCITSIE00B6YX5D40SPYD

About them, Lynch commented:

“You won't find many of these 2-4% in my portfolio, because if the companies are going nowhere and at no speed, neither will their share price”

2. The Solid Companies

Lynch points out that these companies have an average growth of their profits between 10-12%. This group of companies are also known as the Stalwarts.

He points out that these are companies from which you cannot expect to get several times their price, and you must be tactical when buying them and especially selling them. According to Peter Lynch, investors can get adequate return from these stocks if they hold these stocks for a long time.

👉 Learn how to do this by reading our stock investing guide

If you own a solid company and the stock goes up 50% in one or two years, maybe it's time to start asking yourself if you shouldn't sell

These companies offer excellent protection against recessions and stock market falls. They are good friends during crises.

Examples of these companies would be those in defensive consumption and those with competitive advantages that allow them to maintain their market share without much difficulty:

ETFISINTICKER
VanEck Morningstar Global Wide MoatIE00BL0BMZ89VVGM
Lyxor MSCI World Consumer StaplesLU0533032263LYPB
SPDR MSCI Europe Consumer StaplesIE00BKWQ0D84SPYC
iShares S&P 500 Consumer Staples SectorIE00B40B8R382B7D

3. The Rapid-grower companies

This is the terrain where Lynch liked to fish. Companies that grow their profits at a rate of 20-25%.

They don't have to belong to a growing sector, but it does matter that the company quickly gains market share.

You never escape the profitability-risk binomial. While this group have lot of pros, it also has tremendous downside as the market usually treat fast-growing companies badly when they have any small issue.

Lynch commented in 1989 the following:

There is a considerable amount of risk in fast-growing stocks, especially among the younger ones, with their tendency to exaggerated enthusiasm and scarce financing

When a company fails in financing, it usually ends up in bankruptcy

The stock market does not look kindly on fast-growing stocks that suddenly become slow

If you think it's time for growth and you feel contrarian, these ETFs are for you:

ETFISINTICKER
Lyxor MSCI EMU GrowthLU1598688189LGWT
Amundi ETF MSCI Europe GrowthLU1681042435CG9
iShares Euro Total Market Growth LargeIE00B0M62V02IQQG
Deka STOXX Europe Strong Growth 20 UCITS ETFDE000ETFL037EL4C

4- Cyclical Companies

This is where the paths of Lynch and Paramés, etc meet. Cyclical companies are companies whose sales and revenues fluctuate according to the economic cycle of their industry or market.

The cyclicals differ from the fast-growers as they keep on contracting, repeating the same cycle during it season. They tend to flourish when coming out of recession in most economy. Some of this stock market companies include: automobile companies, airlines, chemicals, weapons manufacturers, steel.

When to buy a cyclical?

Coming out of a recession and facing a strong economy and vice versa for when to sell them.

They are the most difficult companies to understand and the ones that pose the most risk for the untrained investor who does not have a deep understanding of company and sector valuation.

You should not confuse them with a solid company.

Cyclicals have a beta greater than 1 therefore they rise more than the market in bullish environments and fall much more than the market in bearish environments.

This is the fishing ground where several value investors go, while the rest of the copyvalues wait on the shore to be told what was in the lake.

By the time the copiers decide to buy, the price has already risen and their references are at another lake or on the other side of the counter with a smile selling the product.

ETFISINTICKER
Lyxor STOXX Europe 600
Automobiles & Parts
LU1834983394LAUT
iShares Edge MSCI World Value FactorIE00BP3QZB59IS3S
Amundi ETF MSCI Europe Value FactorLU1681042518CV9
Invesco MSCI Europe Value UCITS ETFIE00B3LK4Z20EMSV

5- Turnover or Recoverables

“For you players”

In this type of companies, legends such as Icahn, Ackman and even the beginnings of Buffett have been created. The companies in this group are neither fast-growers nor slow-growers

Lynch categorizes these opportunities in companies that:

  • Pay the bail because if not: companies that depend on a government bailout or some legislative action
  • Who would have thought: recoveries, in which no one believes after strong price drops
  • That little problem we didn't see coming: are companies that have large unforeseen or extraordinary but can recover

6- Those with hidden assets

These are companies that have a very valuable asset, but which analysts or the market do not know in depth.

It could be a holding company like Prosus, a company with concessions or a REITs with undervalued assets.

However, beware of companies with unrelated or inefficient assets and with the famous phrases that you get something for free.

In large companies, these inefficiencies usually do not exist, and these assets are in sight of everyone but not seen by anyone.

ETFISINTICKER
Xtrackers FTSE EPRA/NAREITLU0489337690D5BK
VanEck Global Real EstateNL0009690239TRET
Global X Copper Miners UCITSIE0003Z9E2Y34COP
iShares STOXX Europe 600 Real Estate UCITSDE000A0Q4R44DE

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FAQs

What are the rules for investing according to Peter Lynch?

Peter Lynch's Three Basic Investing Tenets are only buy what you understand, always do your homework, and invest for the ong Run.

What are the categories of stocks according to Peter Lynch?

Lynch created six categories for choosing stocks he was considering: slow growers, solid-growers, fast-growers, cyclicals, turnarounds, and hidden assets.

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