Peter Lynch-6 Types of stock to avoid.

Diversification v/s Diworsification

Peter Lynch is a famous fund manager who managed the Magellan Fund at Fidelity Investments who achieved a 29.2% return over a period of 13 years. Stock to avoid means companies one should not invest in for various reasons presented in the article. He is also the author of three famous investing books which according to me everyone should read

  1. One up on Wall Street.
  2. Learn to earn.
  3. Betting the street.

Stocks to Avoid By Mr.Lynch

Charlie Munger Quote on Inversion
Charlie Munger Quote on Inversion

It just means that one should try to invert the problem in order to solve it. Inversion may not solve the problem but can make it easy to solve it.

So according to this principle or quote what not to do is as important as what to do. So what to ignore is as important as what to buy.

That means which stock to avoid is as important as which stock to invest. Do you agree with Charlie Munger?

6 Types of stock to avoid – by Peter Lynch 

1. Hottest stock in the hottest industry.

They are the companies that are favorites of the markets whose revenue is growing at an astonishing pace like technology stock in the USA & finance stock a few months back in India.

They sell at such an extravagant price that it’s difficult to even rationalize the valuations.

Even though they have a good future prospectus ahead of them. Still, it is difficult for them to achieve their goals as new competition will surely entire which will destroy the profitability of the industry.

Peter Lynch says.

“Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there’s nothing but hope & thin air to support them, they fall just as quickly”.

Peter Lynch Example: – Philip Morris & Xerox.

Xerox was one of the famous company known for its photocopy machines. Xerox was one of a kind company of 1960 which had a huge growth ahead of it. It was also one of the Nifty 50 companies, which were the 50 hot stock of that time.

Phillip Morris a cigarette marker, on the other hand, a company operating in a negative growth industry in the USA but they were expanding in other countries.

After a period of time Xerox in its photocopy business attracted huge competition from Japanese companies & other American firms as well.

Which resulted in a huge fall in earnings & that translated to the share price of the company. But in the case of Phillip Morris very there was a negative growth the stock outperform Xerox many times over.

Mr. Peter explains in the following quote:
“Negative growth industries do not attract flocks of competitors” 

2. Beware the next something.

This is the company in which the public or the management itself assume that it will the next big thing.

This type of company fall in two ways first they bring down profits of the entire industry & eventually they fail to the present leader.

In the book, Peter Lynch has discussed a few companies, on being beware of next something.

In the Indian context:- Before the fall of IL&FS there were many small banks who were the sort to be the next HDFC bank but when the crises came everybody know what happened, their NPA increased, they had to raise additional funds, etc.

3. The whisper stock.

These are the stock tips that people receive via phone calls, SMS, E-mails, etc. Usually, brokers do this because their main earning source is brokerage & when you buy and hold they don’t earn money.

Sometimes you may receive phone calls, asking you to buy a stock which also is a pump and dump scheme. Please avoid the calls and assume this stock to avoid while research. Peter Lynch explains it as follows

“Often the whisper companies are on the brink of solving the latest national problem: the oil shortage, drug addiction, AIDS. The solutions is either (a) very imaginative, or (b) impressively complicated”.

What is common besides the fact that you lost money on them is that the great story had no substance. That’s the essence of a whisper stock.

The stock picker is relieved of the burden of checking earnings & so forth because usually there are no earnings.

Instead of buying this hot stock in a hurry, one can wait until these companies establish themselves in terms of profitability as well as its competitive advantage.

For example: – Apple Inc. was once a successful startup but Warren Buffett bought the stake in the company only after when it established its competitive advantage & profitability.

IPO (Initial Public Offering) is built as ‘buy now or never’. But in this case, there is so little information about the company, its track record.

IPO investing is good for traders not for investors as most of the IPO shares go up like a rocket on the day of listing & a few days later they come down.

4. Avoid Diworsification.

This is the company that wants to expand their business left and right, by using debt,  financial engineering, etc. by ignoring profitability.

They spend a huge amount of money on buying unrelated businesses or assets; which in return creates a loss of net worth over a long period of time.

An example of the long history of diworsification is Coca-Cola. Over a period of many decades, they have bought unrelated business & sold them at a loss.

In the Indian context:- In the case of Anil Ambani Group, they tried to diversify in every possible industry & in the end, many of the businesses didn’t perform as expected which resulted in huge losses for the whole group.

Peter Lynch explains that many time’s businesses succeeded due to diversification because of a concept called synergy. “Synergy” is a fancy name for the two-plus-equals-five theory of putting together related businesses & making the whole thing work’.

For example: – When Mothersonsumi Systems buy the same or related auto ancillary business in India & all around the world.

According to him, it is better for the company to just buy-back its own shares in case there is no growth ahead in the existing business. Which will reduce the number of shares over a period of time & increase the per-share earnings.

Diversification
Diversification
Diworsification (stocks to avoid)
Diworsification

5. Beware the Middlemen.

Middlemen here means a single seller or single buyer of a company.

If a company, for example, is a supplier of auto ancillary & its only customer is a single automaker it can be dangerous for the company’s future.

The same applies in the case of a single buyer.

For example: – When Mothersonsumi System Ltd started it had only one customer, that was Maruti Suzuki Ltd, but now they have a wide range of clientele.

Peter Lynch says

“Short of cancellation, the big customer has incredible leverage in extracting price cuts & other concessions that will reduce the supplier’s profits. It’s rare that a great investment could result from such an arrangement”.

6. Beware of the stock with the Exciting name.

Many a time’s companies with fancy names go up in terms of share price but in reality, the fundamentals don’t support it. For example: – When a sector is hot like during the tech bubble the companies with names related to tech went up. In the case of India a few months back finance was a hot sector where all names with finance or related business went up. Peter Lynch explains it, as often as a dull name is a good company keeps early buyers away, a flashy name in a mediocre company attracts investors & gives them a false sense of security. 

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