This Powerful 'Peter Lynch Chart' Led me to my Next Recommendation

Jun 26, 2018

Tanushree Banerjee, Editor, The 5 Minute Wrapup

I recommend every new investor to read One Up On Wall Street. Not just because of the evergreen investing wisdom that it offers. But also because of Peter Lynch's empathy for investors who do not consider themselves as financial experts.

For instance, can there be a better way to invite lay investors to stocks, than these words?

  • As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who've been trained to rigidly quantify everything have a big disadvantage. If stock picking could be quantified, you could rent time on the nearest Cray computer and make a fortune. But it doesn't work that way. All the math you need in the stock market you get in the fourth grade.

This is a book that can make any new investor believe...If Peter Lynch can do this, so can I!

However, investors fail to notice that Lynch has not just written the book to make investing rules sound simple. But he has also revealed his biggest secret. A secret that fetched him the terrific 29% gains per annum over his 13-year stint at the helm of Fidelity's Magellan Fund.

The secret is a powerful charting tool that helped Peter Lynch simplify his investing decisions.

And trust me, this chart is much easier to read than the ones my colleague, chartist Apurva Sheth often writes about.

The core ingredients of this chart are just two - price and earnings. And like in a race, you need to keep your eyes on the underdog. Whenever, there is a chance of the earnings line pacing ahead of the price line, you must be ready to act.

The way Peter Lynch puts it in the book is...

  • A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you'd do pretty well.

But it is also important to note that the chart could only work for business that are familiar and in a growth phase. Which means, you need to be already convinced about the quality of the business, the management and the earnings visibility. The chart will give you valuation cues and urge you to act.

So, when I was researching my latest safe stock recommendation, I realised that I had stumbled upon an underdog.

The business and the management have been assessed as high quality for years. The balance sheet could not have been better. The consistency and quantum of dividends paid speak volumes about the cash flows. And yet this is a business that has been written off by competition over past few years.

The key competitor, in fact, mocked the company's inability to launch new product variants, in conference calls with analysts.

But it seems all the negativity about the company's earnings potential could do its investors a lot of good.

When I plotted the company's earnings and (adjusted) stock price over past two decades, here's what it looked like.

When Earnings Start Moving Ahead of Price...

The company has already put up sufficient capacity for new products. The strong network in rural areas and specialised distribution of premium offerings could be the icing on the cake. Plus, like its competitors, this business could gain from the rising per capita income.

Even a conservative estimate suggests a big spurt in earnings over next few years.

So, let the competitors bask in their own glory. And let the markets undermine the pace of the earnings. I am urging my subscribers to act on this underdog before it's too late.

Chart of the Day

All eyes are on the trend in India's consumption. The government is worried if GST is killing consumption. The central bank is worried if inflation is killing consumption. The economists are worried if unemployment is killing consumption. The underdog here is the contribution of investments to India's GDP. The ratio, which has historically been a little over 30%, had dipped to lows over past few years. But it has shown signs of steady improvement over the past few quarters. And currently stands at 29%.

Economists believe that the private sector has very little role in the improving investment scenario. They attribute majority of the fixed investment to the public sector. However, even the private sector, which had under-utilised capacity over past few years, is filling the gap.

The Big Upside in Capacity Utilisation Has Started...

Data from RBI and CMIE show that capacity utilisation remains below peak levels. At the end of March 2018, average capacity utilisation stood at 76%, compared to 81% in March 2011. But there is no denying that the utilisation rates are improving dramatically in few sectors. And even as the utilisation level moves closer to the peak, companies will see steady growth in volumes. Companies that can combine the volume growth with pricing power, will have a lot to offer investors.

Warm regards,

Tanushree Banerjee
Tanushree Banerjee (Research Analyst)
Editor, The 5 Minute WrapUp

PS: For over 16 years, members of the exclusive Bombay Investing Society have received safe stock recommendations. These stocks went on to deliver double and triple digit returns with a success rate of 74%. The Bombay Investing Society is accepting new members. You can sign up right away here.

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