Peter Lynch is remembered as being one of the most successful investors of all time.
Lynch was a mutual fund manager who managed Fidelity’s Magellan Fund between 1977 and 1990.
The Fund averaged 29.2% returns annually, beating the S&P market for 11 out of 13 years.
He was also the author of one of the best-selling investment books: “One Up Wall Street (1989)”, in which he shares his investing philosophies and strategies.
In the book, he categorised companies into six different types.
This classification can be useful for investors who are building their own investment portfolio.
Here’s a brief description of these six categories.
1. The slow-growers
Slow-growers are often companies that are large (i.e. they have a high market capitalisation) and have experienced fast growth in the past.
Currently, they are growing at a rate slower than the growth of the economy.
Some reasons for their declining growth rate could be due to the lack of meaningful investment opportunities.
Because of this, these companies find it increasingly tougher to increase their earnings.
However, slow-growers are more stable since their business has achieved a certain scale, and they are often found in mature industries.
Another defining characteristic is their steady dividend payouts.
The steady free cash flow generated by these companies assures investors that consistent dividends can be paid out.
The best example of a slow-grower is Kimberly Clark Corp (NYSE: KMB).
The company is a personal care behemoth with net sales of US$19.1 billion in 2020.
With such a high revenue base, it becomes more difficult to generate incremental growth.
From 2016 to 2020, the company’s sales increased at an annual rate of 1.1%.
Something to note: if the company is in a sunset industry, it is likely to be a slow-grower as well.
Peter Lynch suggests avoiding such companies as their growth may be sluggish or even negative.
But if you are looking for a stable dividend stream, this might be a low risk option.
2. Stalwarts
Stalwarts are companies that are also large and that possess strong business fundamentals.
How they differ from slow-growers is that their growth rate is appreciably higher.
As such, they have more potential for generating higher profits in the future as compared to the slow-growers.
An example of a stalwart is Polaris Inc (NYSE: PII).
The established motorcycle, snowmobile and ATV manufacturer has fans all around the world.
It possesses the potential to continue growing, but its growth rate is likely to start tapering off soon.
Historically, the company’s revenue grew at an annual rate 8.3% from 2015 till 2020.
Stalwarts are good to include in your portfolio as they remain resilient during recessions and can resume growing once the economy recovers.
3. The fast-growers
As the name suggests, this category of companies possess a growth rate that exceeds the growth of the economy.
Peter Lynch describes them as “small, aggressive, new enterprises that grow 20 to 25 percent a year”.
Fast-growers derive their rapid growth from aggressive business expansion, mergers and acquisitions, and research and development.
Most investors are eager to include such companies in their portfolios because of the potential for stellar capital gains.
An example of a fast-grower is Salesforce.com, inc (NYSE: CRM).
As cloud-based solutions become crucial in many businesses, many software-as-a-service (Saas) companies like Salesforce have also witnessed an increase in demand.
Its subscription revenue grew at an impressive annual rate of 26.3% from 2016 to 2021.
However, it is still important to remember that high returns usually entail high risks.
Salesforce is an outlier in that it has been growing rapidly for many years.
Less mature companies are likely to possess weaker balance sheets and have less access to different sources of funding.
If their debt-fuelled expansion comes to a screeching halt, the company may run into trouble with its bankers and creditors.
Get Smart: Choose your preferred category
Each type of company has a place in an investor’s portfolio.
Depending on your investment objectives, you may choose either a slow-grower, stalwart or fast-grower.
Dividends are the mainstay for slow-growers and this type of company can help you to increase your passive income stream.
Stalwarts are dependable and resilient during crises and allow you to have a good night’s sleep.
Fast-growers are great for long-term capital appreciation but they are also inherently riskier.
Stay tuned for Part 2 where we discuss Peter Lynch’s three other categories of companies.
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Disclaimer: Jia Yi does not own shares in any of the companies mentioned.