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Developing The Story

By Kevin GilloglyHDIC Education Segment

April 2004

Part I

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Understanding The Company“By asking some basic

questions about companies, you can learn which are likely to grow and prosper, which are unlikely to grow and prosper, and which are entirely mysterious,”

Peter Lynch, One Up On Wall Street, Pg. 74.

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“Investing without research is like playing stud poker and never looking at the cards … All you have to do is put as much effort into picking your stocks as you do in buying your groceries.”

Peter Lynch, One Up On Wall Street, pg. 107

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“The drive of a corporation’s management is the single most influential element of growth.”

-- NAIC Official Guide, pg. 21

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“However, a stock has come to your attention… What you’ve got so far is simply a lead to a story that has to be developed… Developing the story is really not difficult: at most it will take a couple of hours… It seems to me that this homework phase is just as important to your success in stocks.”

Peter Lynch, One Up On Wall Street, pg. 106

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Developing The StoryGather Data

About the companyAbout its competitors

Organize InformationOn the SSG & SCG

Apply common senseJudgmentPractice and more

practice!

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Developing The Story Gathering the Data Use at least three sources

Value Line &/ or S&P ‘tearsheets’ Great for both company and industry data

Current news from the internet Yahoo or MSN are the easiest to use

Company itself Best source of data – even after the Enrons

and World Coms Read the Annual Report, esp. MD&A, &

other company news releases.

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Developing The Story1. Understand the economy

Where are we in the economic cycle? How does that impact this industry? Can be done in less than two minutes.

2. Understand the industry What is the long-term direction of this

industry? Demographics Competition Can be done in less than fifteen

minutes.

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Developing The Story3. Understand the company

How do they make their money? What is the competition like? What are the strengths & weaknesses

of the company / industry? What are the threats & opportunities of

the company / industry? Can be done in around sixty minutes.

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Stages of Growth

Break Even Point

BestInvestmentOpportunity

Speculation

Life Cycle ofA Successful

Company

No dividends

Small dividends (Payout ratio <20%)

Large dividends (Payout ratio >35%)

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Stages of Growth The more you understand:

Type of company you are looking Fast growth or steady grower Slow growth or turnaround Cyclical or asset play

Its business model How it makes money Who is its competitors? Threats it faces; Opportunities it has Strengths it has; Weaknesses it has

Then the better your chance to select realistic future P/Es.

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Peter Lynch’s Stages of Growth

Fast growth companies May grow at over 20% per year Have SSG graphs that look like

summit of a mountain peak Walgreens, Lincare, Renal Care Group

“The trick is figuring out when they’ll stop growing, and how much to pay for the growth.” Peter Lynch

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Peter Lynch’s Stages of Growth

Steady growth companies (stalwarts) Look for 10-12% growth per year Have SSG graphs that look like the

foothills of mountains Coca-Cola, Johnson & Johnson, AFLAC

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Peter Lynch’s Stages of Growth

Slow growers Tend to grow less than 6% per year Have SSG graphs that look like the state

of Delaware – flat Clorox, Proctor & Gamble

“Usually large and aging companies are expected to grow slightly faster than the gross national product (3%).” P. Lynch

Cyclicals Have SSG Graphs that look like the

polygraphs of liars Ford, GM, Boeing

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Developing The Story

4. Only after looking at the “big picture” can you begin to evaluate future growth and future P/E in Section 3 of the SSG.

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Developing The Story

5. Look at the 5 year trends Growth comes future EPS

Management is the key Value comes from making educated

guesses about future P/Es. Never want to over pay for growth

NAIC investors look for growth companies that are “on sale” GARP Growth At a Reasonable Price

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Developing The Story

5. Look at the 5 year trends Where is the P/E in relation to its

history? Are the trends for high and low P/E down?

up? Or both? Give greater weight to recent events

Compare to P/Es of the general market Compare to P/Es for its chief

competitors

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“Companies … with long records of above average growth tend to sell at higher P/Es, but their highs

are usually not sustainable.”

-- Handbook, 130

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“Wall Street does not look kindly on fast growers that run out of stamina and turn into slow growers, and when that happens, the stocks are beaten down accordingly.”

-- Peter Lynch,One Up On Wall Street,

pgs. 118-119

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When the growth stops When growth stops, Round I

EPS will slow down Price will drop faster than EPS

because investors won’t pay a premium for slower growth

Causing P/E contraction When the growth stops, Round II

Which can feed more price dropping Which can cause more P/E

contraction

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Review“As soon as sales and/or EPS falter, growing

stocks often react as if their growth vehicle hit a brick wall... Sometimes longstanding growth companies with previously high ratings slow down and the price can fall by 50 percent. They are often referred to as ‘fallen angels’ …they pass our SSG test as if they were the greatest buys in the world (except that the most recent quarterly figures will be down). Many of those fallen companies recover and continue to new highs, but others cease to be growth companies.”

-- Ed Chiampi BI, April 98

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Review A company’s growth prospects and P/Es

are NOT determined in a vacuum. Understand the company’s business

model Understand what the competition is doing What are its strengths and weaknesses? What are its opportunities and threats?

Understanding what a company does will help make your projections more accurate

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“Once you’re able to tell the story of a stock to your family, your friends, or the dog… so that even a child could understand it, then you have a proper grasp of the

situation.”

Peter Lynch, One Up On Wall Street, pg. 174

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Questions