Peter Lynch: Buy These 5 Types of Stocks (Rare Clip)

When most people think about investing in stock market, they dream about investing in a fast grower. A company that is growing at over 25 percent a year—at 25 a year a company's profits will double in three, they quadruple in six, and up eightfold in nine years. That's how you get a huge stock in a decade. There's not a lot of these, but they're very powerful, and the best part is you don't have to catch them just as they're taking off.

The beauty of growth companies is you have plenty of time. If they're going to grow for 5, 10, 20, or 30 years, you don't have to be there the first year or the second year. You could have bought Walmart 10 years after they went public and made 30 times your money. What makes a company grow earnings so quickly? Either it is a rapidly growing industry, or it's a rapidly growing company in a slow growth industry. Rapid revenue growth and rapid earnings growth are the hallmarks of a fast grower.

You just can't buy any stock with hot earnings and hot sales. You have to check the balance sheet and make sure the company can keep growing. One way you can look at growth companies is to think of baseball. A normal baseball game has nine innings; you should look at a growth company and say, "I don't want to buy it when they're in the first inning. I want to buy it when they're in the second or third inning." They've got the formula right; they get lots of room to go.

So you want to say, "This is a company that's very early in its cycle," like a McDonald's when they're only in a few stores, or Limited when they're only in 100 stores and they had lots of malls to go to. Microsoft was a company you could have bought three years after it went public and made over 20 times your money. Sales and earnings were growing at several times the rate of the companies in the S&P 500 in an industry that was exploding by leaps and bounds, and it had a lot of potential both overseas and domestically. This was only the beginning of a 15 to 20 year growth cycle. You had plenty of time to get involved.

This amazing company called Superior Industries, I think the stock went up over 100 fold. They were very good at making aluminum wheels; a lot of car companies went to aluminum wheels. The industry for autos wasn't growing, but aluminum wheels were growing dramatically, and they were the best at it. The fast growers get all the attention in the media, but there's nothing wrong with slow-growing stocks provided you get it at a very decent price.

Somebody would say to you, "I'm gonna sell you a business for a hundred thousand dollars, and they're earning fifty thousand dollars a year." You say, "What's the bad news?" Let's say the bad news is the earnings are never going to grow; they earn fifty thousand dollars a year forever. So, this is a price-earnings multiple of two. You pay a hundred thousand dollars for fifty thousand dollars earnings, but they're never going to grow. You say, "I don't care; I'm gonna get a fifty thousand dollar return every year. In two years, I get all my money back and I'm gonna make fifty thousand dollars a year on my hundred thousand investment forever."

So sometimes, even if a company has a very low growth rate in earnings, if the stock is selling at the right price, it may still be a very good deal. A slow to moderate grower will have earnings growth of three to fifteen percent a year. One company that I was very lucky with was Service Corp International. It's a funeral home company that bought up local family funeral homes—a very steady business. Service Corp could grow earnings at 15 a year when I owned it with very little problems.

A slow grower that turns into a no grower is a very bad news situation. So when you start researching a stock, look for these signs: steady earnings growth. You can find annual earnings growth rates in the research section as well as estimates for the coming year. Rising dividends—companies that raise their dividends each year have to have the earnings to do so. A rising dividend is normally a good sign for a stock: room to keep growing. You want slow growers to go on forever. That's one reason I like Service Corp International so much; this was a great stock for me in the 1980s. At that point, it had a long way to go.

Cyclical companies rise and fall with the economy. Typically, they make expensive, big-ticket items that people buy when the economy is good—things like houses, cars, and furniture. When the economy is bad and people are worried about losing their jobs, they don't buy big-ticket items. They're too broke or too scared that they will go broke. Don't try to time a cyclical stock if you don't have intimate knowledge of the business. If you don't have an investor's edge, everyone on Wall Street tries to time cyclical stocks too.

Because the stock market looks forward, you could be left with a sinking stock even though the company's earnings are terrific. You make your best money in a cyclical when earnings go from rotten to mediocre or from mediocre to pretty good. The danger point is when earnings go from great to spectacular. Somewhere between these two points, Wall Street will figure out there's only one way to go, and that's for profits to go down at some point in the future. Just don't buy in the hope; wait for things to get better: prices to get better, capacity to shrink, inventories to go down, scrap prices to get better. Something ought to be happening.

So you just want to wait for something really to happen, and then when it happens, it's going to be big. Let's take a look at Chrysler. In 1990, the company was selling for ten dollars a share. The economy was lousy; people were talking about Chrysler going out of business. But guess what? The economy came back. Everyone's old car was falling apart as people made more money. They started buying new cars, and because Chrysler had great products—the minivan, the jeep, and its first new full-size truck in 20 years—the stock was big. In addition, very importantly, the balance sheet was decent in 1990. This was not a company about to go bankrupt.

If it's a cyclical, you're hoping for a dramatic turnaround on earnings. It's going to happen over two or three years. Earnings are going to go from a loss to a huge profit. The stock's going to go up, and you're going to get out. Make sure you're picking a strong company that can survive when the cycle goes down. That means good cash flow and low debt. If its cash flow is spotty or its debt is high when the downturn comes, the company faces the danger of going bankrupt.

Turnarounds—these are stocks that are battered down or they're hated companies, or they've been forgotten about. They're depressed in price, but you've determined some one thing or a few things that have the potential for reversing this company's fortunes. Independent of the industry getting better or the economy getting better, you always have to do a balance sheet check on any company. This includes turnarounds. Do they have enough cash to make it through the next 12 months? Next 24 months? Do they have a lot of debt that's due right now? These are important questions to answer.

Make sure you understand and believe in the plan to restore corporate profits. It's all internal; they're doing something—either a new product, new management, cutting costs, getting rid of something—something inside the company that allows them to improve themselves. Lots of turnarounds never happen, but a few winners can make up for lots of losers. What's important is to wait for the actual evidence of the turnaround occurring, not just the symptoms.

The turnaround—you had plenty of time, so just don't buy on the hope; wait for the reality. Turnarounds are so big, it's worth waiting to get some real evidence. SS Kresge was a company going nowhere in real trouble. They invented the Kmart formula; they rolled it out across the country. The stock went up over 50 fold. Kmart became a massive stock.

Sometimes, two and two equals eight. How could this be? Because a company has a hidden asset that isn't reflected in the stock price. When Wall Street wakes up to the hidden assets, the stock could be terrific. Want a great example? Let's look at Disney. Walt Disney is an example of an asset play. After they opened up Disney World and after they'd opened up Epcot, the company's growth rate sort of slowed down; they weren't growing very fast.

Then they discovered there was a lot of assets inside the company. There was the name Walt Disney; they started the Disney Channel. They started selling things that they sold at Disney World into Disneyland and started selling them everywhere. They used their licenses for Mickey Mouse and all their characters and made a fortune on that. These are on the books for nothing; the company was loaded with assets. In addition, they had all that land inside of Disney World, and everybody had hotels outside of Disney World. They decided to use their land inside to develop more parks and then even have other companies come in. These companies paid their money to build inside of Epcot or inside of areas of Disney World.

So what are hidden assets? Many companies, particularly old-line companies, companies that have been around 20, 40, 50, or 100 years or more, have real estate holdings whose true market value is not reflected on the balance sheet in the annual report. In many cases, the hidden asset is the company's name and its reputation. Disney is one example of a company with a great name; so is Coca-Cola. That name can be a huge asset when the company rolls out a new product. This name is carried at little or no value on the balance sheet, whereas it is incredibly valuable.

Companies like Intel and AT&T not only make great products, but they have numerous patents for these great products. As long as they have those patents, no one can make the exact same product—that's a tremendous aid in any business. Back in 1987, when the stock market had a major correction, Dreyfus fell to below its price of cash per share. The stock fell from over 50 to under 20. At that point, it was selling for less than its cash. Anytime you buy a stock at less than its cash after subtracting all debt and it has a good business, you're getting something for nothing.