Peter Lynch: Understand the TYPE of stock you’re investing in

How do you pick the right stocks? It seems intuitive that companies with popular products make for great investments. But Peter Lynch says we should categorize stocks based on their growth rate to understand which types suit our needs.

Slow-growers are large and ageing companies that run out of new avenues to invest their surplus cash into, and are able to provide generous dividends. These are good for income, not so good if we want our portfolio to get more valuable over time.

Medium-growers like Coca-Cola and Procter & Gamble don't grow explosively, but still perform better than the slow-growers. We can make sizeable profits from them by investing at the right time.

Fast-growing companies are small but aggressive and grow at 20-30% per year. They may not belong to a fast-growing industry as they only need room to expand within their industry.

The investing risk is high with young companies that are overzealous and under-financed. When they do stop growing, Wall Street batters their stocks.

Companies that deal in automobiles, tyres, steel, chemicals, and airlines see a regular pattern of rise and fall in their sales and profits and are cyclicals. You can lose more than 50% of your investment very quickly if you buy cyclicals in the wrong part of the economic cycle.

Of all the categories of stocks, the performance of turnarounds, or stocks that went through a phase of weak financial performance and then went up, are the ones least affected by the general market. However, they are a waste of time if you want long-term growth.

Sometimes, companies restructure by ridding themselves of unprofitable subsidiaries. There’s a chance their stock price will suddenly leap. But unless you have some expert knowledge of the situation, these companies are usually a bad bet.

Asset plays are where a company is sitting on a valuable asset, like a pile of cash or real estate that the Wall Street crowd overlooks. These can yield great rewards. All it requires is a working knowledge of the company and some patience.

Bottom Line: Spotting good investments compatible with our portfolio requires a smart and solid understanding of the market, the relevant industry, and the companies themselves. It is hard work, but the only way to long-term outperformance if you are investing for yourself.