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Lessons from Peter Lynch - IV

May 17, 2013

In our previous article on Peter Lynch investment philosophy, we spoke about how one can use specific edge /common knowledge to get an investment idea.

Got the idea? Now develop the story...

Once a company/stock has your interest, it is important to develop the story, a story convincing enough and that you are confident will not be affected by short term blips, competition, economic downturn or other out of control factors.

Since you are picking up the stock based on a the popularity of a product/service, it is important to find out what is the contribution of that product /service to the company's topline and bottomline and thus the stock valuation . For e.g., Revive, a Marico product, is the market leader in fabric starch industry. However, basing Marico story around this brand will hardly work for an investor since it is just one of the many consumer product brands offered by Marico and there is a lot more to analyze as far as the topline, bottomline and the valuations of the company are concerned.

Understand the business

Ratios and numbers without the correct interpretation and understanding mean nothing. Mr. Lynch suggests that if you don't understand the industry and the business, don't go further. Otherwise, you may end up comparing apple with oranges and making some flawed assumptions. For e.g., a high debt to equity ratio is generally undesirable. However, there are some capital intensive industries such as construction that have inherently high debt on their balance sheets, purely because of the nature of the business they are in. Hence, comparing FMCG or service based company with construction based on this parameter will make little sense.

Similarly, if you are thinking of a pharma based company and have no knowledge about patents, competition and different market and regional /geographical dynamics, you might end up burning your hands.

Annual report - your best friend

These days, lot of websites are available that give a decent snapshot of financials. As Mr. Lynch suggests, investing in stock markets is a matter of hard work and not gambling. It you want to be confident and convinced about your story, you cannot ignore the annual report. Infact, it can be your best friend as far as research and building a story is concerned.

Unfortunately, not many people give it due importance. As such, they are likely to miss important factors. For example, the bottomline may include extra ordinary / nonrecurring items leading to inflation of profits. If the investor just gets the financial data without looking at the notes to accounts (given in annual reports), he might end up getting the wrong impression and making a wrong investment.

Another important data that is likely to be found mostly in annual reports only is the data on contingent liabilities and off balance sheet items. Lot of behemoths have fallen, the symptoms of the upcoming doom reflected only in off balance sheet items that was unfortunately ignored by the investors. Further, an annual report gives us an idea of not just the performance in the past year, but also management's outlook and comments that give valuable insight on where the company is heading.

Know the category ...

Research is an open ended concept. Hence, unless you do it in a systematic way, you can feel totally lost. While annual report in itself offers a lot of data, investors are better off following a systematic approach not to get bogged down by the sheer amount of information. As such, placing stocks in broad categories helps. Mr. Lynch has divided stocks into various categories that make their analysis relatively easy. We will elaborate on these categories in our next article.

Lessons from Peter Lynch - Series - Previous article | All articles

Richa Agarwal

Richa Agarwal (Research Analyst), Managing Editor, Hidden Treasure has over 7 years of experience as an equity research analyst. She routinely scours the small cap universe for fundamentally strong companies trading at attractive prices. Having degrees in both finance as well as engineering has served her well in analysing business models across the small cap space.

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