Value investors come in all styles, shapes and sizes. Fidelity’s Peter Lynch was one famous brand of value investor—looking for growth-y companies trading at a reasonable price.
Who better to find a value investing checklist from than the great Peter Lynch?
Here are some of the items on Lynch’s checklist (“The Final Checklist”) that he shared in his bestseller, One Up on Wall Street. I’ll add some commentary to hopefully provide updated context for today’s world.
Understand what you own
At its core, shares of stock are ownership pieces in a business.
Buying a stock and holding it for the long term means becoming part-owner in a business, and participating in its business performance.
Whether you’re buying a cheap or expensive stock, you can’t get around this fact.
It’s a great idea for value investors to remember this, because buying bad businesses can put you on the fast track to mediocre investment performance.
You might find yourself buying bad businesses often if you never understand what you actually own.
Categorize your stocks
In his portfolio, Lynch tended to group stocks into one of the following general categories: Slow Growers, Stalwarts, Cyclicals, Fast Growers, and Turnarounds.
How you judge a stock should depend on what kind of stock it is.
For example, cyclicals are companies that are very boom-and-bust. They tend to do VERY well when the economy is healthy, and VERY poorly when it’s not.
One of today’s better examples of cyclicals are semiconductors. Building out expansion (fabs) takes a long time, so companies tend to over-expand when things are good which brings the industry crashing down.
When evaluating a cyclical, for most businesses you should not take its most recent earnings and extrapolate that over a long time period.
If you already know the company is in a boom-and-bust industry, then the stock might not be as cheap as it appears, because those earnings are not sustainable.
So be careful. Adjust your price, risk, and rewards expectations depending on the characteristics of the stock you are evaluating.
Avoid hot stocks in hot industries
Industries and stocks get hot usually because they are new and exciting. Oftentimes they promise to take over the world. Oftentimes they end up not.
You have to stay away from these stocks because when they crash, they crash hard.
A stock that has been built on being hot and nothing else will have nothing to fall on when it becomes not hot at all. These are the stocks you will see that lose -80%, -90%, -95%+ when things take a turn for the worst. And coming back from a loss like that takes HUGE future gains (it takes a +1900% return to come back from a -95% drawdown).
Unfortunately, a new crop of investors have to learn this lesson over and over again, with new hot stocks and industries.
Do yourself a favor and don’t be one of those people.
Invest in simple, dull, mundane, and out of favor stocks
Investing is not like the entertainment industry. You don’t get paid for thrills. You get paid for results, growth, and compounding.
Because human beings naturally gravitate to the fun and exciting, many great stock compounders fly under the radar on Wall Street. These can be some of the greatest opportunities because they will tend to be cheaper than everything else.
Buying stocks at better prices makes the compounding much easier and more likely over the long term.
Look for companies with niches
A key part of finding the best companies is identifying those with competitive advantages.
Capitalism can be brutal.
As companies create profits or grow, other companies start to take notice. The more attractive the potential, the more competitors that will be drawn in. Competition can be brutal for profits and growth, as companies undercut each other and steal customers.
As Amazon’s founder Jeff Bezos once said, “your margin is my opportunity”.
It’s only by having a competitive advantage that companies can defend their success against intruders.
Having your own niche is a much easier way to do that.
By being excellent in just one thing, a company can focus all of its energy on dominating that niche and successfully defending its “moat”.
That leaves lots of compounding for investors who buy the stock for the long term.
When buying distressed stocks, avoid those with high bank debt
Value investing can be great for finding turnaround stories that bounce in price very quickly.
However, there’s a huge danger for investors buying the cheapest stocks. And it’s that many of these stocks can become value traps.
The worst thing value investors can do is try to “catch a falling knife”.
It’s the perception that a company has a gloomy future that makes a stock cheap. When that gloomy future includes large debts that will come due, there’s no way for a company to avoid that. It must figure out a way to repay it with cash flows, refinance it, or declare bankruptcy.
That’s a tangible risk you can easily identify and avoid.
Companies do get rescued or “turned around” from time-to-time. But many don’t. And it’s during the worst economic times where many don’t, which can really amplify your losses during a bear market.
As Warren Buffett once said, “We never want to be dependent, not only on the kindness of strangers, but the kindness of friends.”
A lot of money can be made in a turnaround
Taking the other side of this argument, buying distressed stocks can be hugely profitable. This is because when the mood around a stock changes, so does its multiple.
If a stock is considered troubled, it may trade at a 10 P/E multiple. Say it clears that hurdle and is considered an average company. Maybe it then trades at a 20 P/E multiple in a bull market.
Going from a 10 multiple to a 20 multiple is a double: +100% gain.
It’s hard to make that kind of a gain so quickly even for the best business compounders.
Find a story line to follow to monitor a company
One of the hardest decisions for an investor to make is when to sell.
Especially for long term investors.
The truth is, you have to do what Lynch himself once said and avoid “cutting the flowers and watering the weeds.” What he means is don’t invest in the companies whose prospects are deteriorating, and don’t sell the companies that are doing great.
By monitoring the story of a company, you can focus your attention on the business rather than the stock price.
I like looking at revenue growth as one of the nice rules-of-thumb for this. If revenue growth stalls—and the company hasn’t successfully grown revenue for several years—this may signal a company whose business is deteriorating.
By sticking to numbers, which are cold hard facts, you can sift through lots of noise.
Maybe my neighbor Richard had a bad experience with a company I’m invested in; that’s one thing. If the revenue has slowed, the product or service has tangibly gotten worse, and there’s a clear better competitor—that’s another.
And maybe that’s when you think about selling a stock you hold.
Another idea I got from Dave Ahern when it comes to thinking about whether to sell a stock: ask yourself, “Has the business fundamentally changed?”
If not, and you’re a long term buy-and-hold investor… hold it.
Devote at least one hour per week to research
If this sounds daunting to you, you shouldn’t pick individual stocks.
Have someone do it for you or just buy an index fund.
Part of being a value investor means having conviction and sometimes acting against the crowd (“Mr. Market”). It’s hard to have conviction if you haven’t done the research.
It’s hard to find any progress and follow the fundamentals if you aren’t putting in the time.
And the fact of the matter is that business is fluid. Companies change, their business models change, their products and services get better or worse.
You can only really internalize these developments and get the big picture of a business’s prospects by doing enough research.
Oh, and I really like how Lynch put it:
“Adding up your dividends and figuring out your gains and losses doesn’t count.”
Be patient. Watched stock never boils
I’ve been a value investor since 2013. Bought my first stock in 2012. Have evolved my approach and focused more on long-term holding rather than trading in-and-out of companies.
It never failed, the closer I watched the stock, the worse it seemed to get.
It’s funny to watch a stock’s price movements, especially after you first bought the stock, and get those paper losses ingrained in your memory.
Yet time after time, I’ve forgotten about the stock (almost like “giving up on it”) and then became shocked as it roared back.
I think lots of this has to do with being a value investor.
You’re almost bound to pick stocks that have more room to fall when value investing. It can take longer than you might think for the stock (or company) to pick up its momentum again. But when it does, it can happen fast (see “a lot of money can be made in a turnaround” above).
So… be patient.
Buying stocks on book value alone is dangerous. And illusionary
This one might be a tough pill to swallow for traditional Graham and Dodd value investors. Trust me, I’ve been there and know what you mean.
The best way I can make this point is with a simple thought.
Just because you build a factory doesn’t mean it will generate profit.
In the same way, just because a company builds a factory doesn’t make their business more valuable. Yet just by spending the money, a company increases its book value, whether that leads to increased profitability or not.
You might argue that at least the factory has liquidation value…
But who wants to buy a factory that’s struggling to make a profit?
It would probably have to be written down in a fire sale. So, beware of putting too much faith in book value.
In general, Price to Book Value can be very useful in identifying potentially cheap stocks.
But to rely on it solely misses the fact that GAAP accounting is not perfect. Companies’ assets are more-and-more intangible today. And you can’t get around the fact that just because you build it, doesn’t mean they will come.
When it doubt, tune in later
There’s so much wisdom to these 6 simple words.
The stock market and investing are a long game. In fact, you’ll likely be investing in some capacity for the rest of your life (whether selling, holding, or buying).
You should also know that the stock market has created massive wealth for people, but over the long term.
Businesses do not grow to the sky overnight.
They may crash and burn quickly, but most times it takes years (as I uncovered in my Value Trap Indicator research on bankruptcies). For example, in the bankruptcy research, I found that many companies had YEARS of negative earnings before finally succumbing to bankruptcy.
While Mr. Market panics, take your time and find out the real story.
If you want a practical way to do this…
Find some old newspapers if you can. Or, store away some that you have now and report back even in just a few months.
You’ll see that there’s so much noise in newspapers and media that eventually have no impact over the long term for the economy and businesses.
So while uncertainty is playing out in the market, don’t do something impulsively. Rather, tune out and uncover the real story by separating yourself from it. That’s how to make smart interpretations and decisions.
Invest as much time and effort in choosing a new stock as you would in choosing a refrigerator
I like this one and am including it as the last item, as it was Lynch’s too.
Value investing can be attractive because it’s often a numerical approach, and analyses with numbers can be done very quickly these days.
For stock pickers, that can be a death knell.
The more you research, the more you might uncover why a company is trading very cheaply. Many cheap stocks are cheap because they are bad long term investments. Buying those is like buying a ticking time bomb.
So put in the time to avoid those stocks.
Like Lynch once also said, make sure you’re flipping over lots of rocks. If we’re honest, that’s really the only way to find the best opportunities, over and over again.