Peter Lynch is the world-famous investor who generated 29.2% compound annual returns while running Fidelity’s Magellan Fund.
In his book, One Up On Wall Street, he shares 13 attributes of “the perfect stock.” Today, let’s explore some of these attributes.
Peter Lynch’s 13 Ingredients for the Perfect Stock
1. It Sounds Dull – or Even Better, Ridiculous
Peter Lynch mentions Automatic Data Processing (ADP) and Bob Evans Farms as perfect companies because they sound boring.
Basically, look for companies that are the opposite of Tesla (TSLA). The more boring the better!
2. It Does Something Dull
Again, here we are looking for a company that does NOT build rockets or semiconductors.
We are looking for companies that do very basic things—something that you wouldn’t be excited to brag about at a cocktail party.
The example that Lynch gives is Crown, Cork, and Seal, which made bottle caps.
The idea is that if you find a growing company with a strong balance sheet in a boring business, you will have less competition and may be able to uncover a hidden gem.
3. It Does Something Disagreeable
Think a big tobacco manufacturer like Altria (MO). The cigarette industry has been one of the best-performing industries of all time. Not many people would want to brag about their investments in tobacco stocks, but historically it’s been a very profitable place to invest.
4. It’s a Spin-off
We are big fans of spin-offs as they historically outperform. Peter Lynch is as well. He writes that spin-offs are “a fertile area for amateur investors.”
A spin-off occurs when a publicly traded company separates part of its business into a second public company and distributes its shares in the new business on a pro-rata basis to existing investors.
Spin-offs occur because management thinks their business is undervalued by the market, and believes (with good reason) splitting the business up into a simpler structure will force investors to re-value the spin-off and parent more in line with comparable companies.
5. Institutions Don’t Own It and Analysts Don’t Follow It
Lynch writes, “If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner.”
That’s why we are such big fans of micro-cap stocks. The whole idea is to own a company when it’s too small to be noticed by institutions. Once its valuation expands, you can sell the stock to institutions that can finally buy it.
6. Rumors Abound: It’s Involved with Toxic Waste and/or the Mafia
Lynch talks about Waste Management (WM) stock. The mafia has long been associated with the waste management industry. This taint may have discouraged investors from investing in WM, but those investors missed out. WM has been a hundred-bagger stock!
7. There’s Something Depressing About It
The obvious pick here would be funeral companies such as Service Corporation International (SCI). This stock is up over 1,500% since going public.
8. It’s a No-Growth Industry
Most investors assume that it’s best to invest in a high-growth industry.
The problem with high-growth industries is they attract significant competition. Lynch notes carpets in the 1950s, electronics in the 1960s, and computers in the 1980s.
It’s better to invest in an industry such as bottle caps, coupon clipping or motels.
9. It’s Got a Niche
It’s best to invest in companies with a niche. The pharmaceutical industry is a perfect example. Once a drug is approved, patents protect that drug’s competitive position. Competitors have to spend billions of dollars to find a better alternative and then spend years in FDA trials to provide safety and efficacy.
10. People Have to Keep Buying It
The perfect example here is the razor company Gillette, which was acquired by Proctor & Gamble (PG) in 2005. Razor blades are a consumable product so revenue is essentially recurring.
It’s much easier to stay in business when people return every month to buy your product.
11. It’s a User of Technology
Instead of buying a company that manufactures scanners, buy the grocery stock that can utilize the scanner to save costs. If it’s able to cut costs by 3%, it could double earnings.
12. Insiders Are Buying
Generally, insiders sell 2.3 shares for every share that they buy, according to Peter Lynch. Don’t be too concerned with insiders selling. They can sell for a variety of reasons (buying a new home, going on vacation, paying for college tuition, etc.), but there is only one reason an insider will buy: he or she thinks the stock is undervalued.
13. The Company Is Buying Back Shares
When a company is buying back its own stock, it is reducing its share count, which increases earnings per share. Oftentimes, share buybacks are a much better use of cash than dividends or acquisitions.
When looking for the next great investment, consider Peter Lynch’s 13 ingredients for the perfect stock. You may not be able to generate a 29.2% annual return, but it will help you choose more profitable investments.
How do you look for the “perfect stock”? What characteristics do you prioritize?
*This post is periodically updated to reflect market conditions.