Understanding Peter Lynch’s 6 Types of Businesses

Understand the 6 types of business that one should consider for investing in India from the legendary investor Peter Lynch

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Legendary investor Peter Lynch has identified the six types of business or categories of stocks that an investor should consider for investing.

So let me share each of those stock categories with you and share examples of stocks in each category to help you understand the framework in a much better sense.

A standard disclaimer that the stocks discussed isn’t a recommendation for trading or investment. They are only for us to help us understand Peter Lynch’s six categories of stocks worth investing in.

Slow Growers

Slow Growers are typically large-cap companies that are expected to grow slower than the overall economy.

The growth for such companies depends on the overall economic growth. As the economy grows, the growth in the company improves. However, it remains very close to the overall GDP growth.

The best example of slow growers can be HPCL, BPCL. The overall growth of the company has been around 4 to 5% in the past decade. However, one shouldn’t think that only government-owned PSU companies are slow growers. For example, the sales growth of MNC’s like Colgate-Palmolive (India) Ltd for the five years has been a meagre 5%, or that of Gillette India Ltd has been only 3%.

There can be various reasons for each such company for being a slow grower. However, as an investor, when you invest in such companies, you should expect low returns.

However, one should expect higher dividends or a lot of buybacks. There is little scope for expansion, and the cash generated from the business is returned to the shareholder.

Stalwarts

Large caps companies that grow as per the GDP or slightly better than GDP. Typically, In India, the companies that can grow in the low double-digit are considered the stalwarts.

The best part of investing in stalwarts is that companies can still show growth when the economy isn’t doing well. However, when the economy picks up, the growth for such companies accelerates.

Ideally, sectors like FMCG, information technology and pharmaceutical fall into the stalwarts.

Companies like Marico, TCS, Cipla are growing between 10 to 15% for the past decade and certainly fall into the stalwarts category.

The most important aspect of investing in stalwarts is to buy them at the right price. Ideally, when the market offers correction.

Fast Growers

The companies that can grow in multiple of the GDP growth can be classified as Fast growers. I always prefer to invest in faster-growing companies.

So if GDP grows at 7%, the companies will grow more than 2 to 3 times the GDP growth – aka 14% to 21% or more.

When the companies grow at a faster pace, the valuations are very high as well. So one should be investing in such companies with caution.

However, if you can hold such companies for a very long time (decades) and if they continue to grow, you will see the eighth wonder of the world (aka compounding) happen to your portfolio.

If we analyse Peter Lynch’s portfolio, he preferred to invest in companies that consistently keep growing at much faster rates.

The best example of such companies in hindsight is Asian Paints, Page Industries, etc. The only question is, can they keep growing in the next decade, given the competitive landscape within the sector.

Also read:

One Up on Wall Street – How to Use What You Already Know to Make Money in the Market

One Up on Wall Street is a must-follow book for every investor. My portfolio aligns with the stock-picking ideas from the book to keep it in the green in such a brutal fall of 2019

Cyclicals

The Cyclical companies grow at high speed during their favourable cycle and have slower growth when the tide turns.

In India, cyclical companies have a typical earnings growth from 5-6% in the down cycle and shoot up to 18-20%.

Stock prices show very volatility when the tide turns. Specific sectors for cyclical are automobile, metals, cement etc.

The best example of such stocks includes Tata Steel, Hindalco.

However, as an investor, one should understand when the cycle for the underlying commodity will change. Then, one should time the entry and exit at the right time from the stock to make handsome returns.

I prefer to avoid cyclical stocks.

Turnarounds

I believe turnarounds seldom happen, and the quote from Warren Buffett is worth mention:

Turnarounds seldom turns – Warren Buffett

So, I never consider investing in a turnaround story. However, if an investor can identify turnarounds, they can be very profitable.

The question is can the management turn things around? If you are convinced the management will do it, one can accumulate the stock at a very attractive valuation. However, it is a binary event and what if the management fails?

So your conviction of the management should be the reason to invest in such companies.

The best example in the current market trend has to be Vodafone Idea (VI). I am not smart enough to know if the company will turn things around or not, so I always avoid such investments. I like to invest in profitable companies only.

Asset Plays

The asset plays are those stocks where the market overlooks the total asset (typically the non-core assets) a company owns. So the stock is undervalued.

Typically, if a company owns more assets than the company’s market cap, the asset plays come into the picture.

The valuation metrics in the market considers the earnings growth, the return on capital employed. However, if one can assess the correct valuation of the underlying non-core assets, the company may seem undervalued.

For example, DMart is one of the expensive stocks in the Indian market right now when you are only considering the earnings for the company. What if we can add the value of the properties as well.

Similarly, sometime back in Jan of 2021, SBI was trading around ₹200. If you added the valuation for the subsidiaries, aka SBI Cards, SBI Life, the valuation for SBI looked very cheap. As of today, are the properties owned by SBI part of the valuation?

Many of the PSU can be real estate plays. However, one point to remember is that the government will not fire all the employees and liquidate the properties for the shareholders. For example, BSNL though not listed, has properties in a prime location, but the Government of India was never keen to sell them. So take asset plays in PSU with a pinch of salt.

Final Thoughts

Which category of companies suits you the most? I like investing in high growth companies, but then the valuations are something that one has to be varied off? No investment metrics will ever consider Page Industries, PI Industries, or Pidilite undervalued, yet they are part of my core portfolio.