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Beyond Peter Lynch: 6 Types of Stocks You Need in Your Portfolio, Pt. 1

Peter Lynch's "One Up On Wall Street" is a classic of the investment genre. In the book, the legendary manager of the Fidelity Magellan Fund presented a taxonomy of stocks that has informed many investors' thinking.

In their second-quarter 2019 investor letter, published in July, the team at Mar Vista Investment Partners decided to do something similar:



"To understand better what he owned and why, Mr. Lynch classified stocks into six categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. Each group represented differing levels of expected returns and risk and his exposure to each helped him profile the portfolio. Similarly, our team recently worked on an exercise to categorize our businesses based on a variety of common characteristics."



Mar Vista came up with six categories of their own that, while similar to Lynch's taxonomy, offer a unique and valuable perspective on how to classify attractive investment opportunities. I have summarized two of these categoris in this article.

Cyclical compounders

Mar Vista is interested in value plays, but that does not mean it eschews cyclical businesses or industries. The key is to identify stocks that are cyclical compounders:


"Cyclical Compounders' near-term results may gyrate unpredictably as macroeconomic drivers influence demand but, over a full cycle, these companies generate progressively higher economic profits at the nadirs and peaks. Our favorite Cyclical Compounders exploit weaker competition during the downturns and, through faster share gains or smart acquisitions, further extend their competitive advantages. Knowing where industries are in their cycle is important to generating alpha and protecting capital when investing in Cyclical Compounders. The businesses appear least expensive later in the cycle when profits are robust and most expensive when demand and profits are at a nadir. Perversely, the stocks present the least risk at the bottom and the most risk at the top."



Choosing the right companies to back is key to success when dealing with cyclical industries. Being at the end of the cyclical bullwhip gives some players the ability to invest in themselves, or steal a march on competition during times of industry weakness. Thus, long-term financial strength and management with a track record of full-cycle execution are key factors in identifying a potential cyclical compounder.

Mar Vista's favorite cyclical compounders reflect a couple well known cyclical industries, including electronics and microprocessors. Mar Vista has a particular liking for Honeywell International Inc. (HON), Microchip Technology Inc. (NASDAQ:MCHP) and Sensata Technologies (NYSE:ST).

Cannibals

Mar Vista also sees profound opportunities in companies with powerful, consistent cash flow that engage consistently in buybacks of undervalued stock. In essence, these companies expand shareholder value by decreasing share count in an efficient manner. Hence, Mar Vista views these so-called cannibals with a favorable eye:


"Our favorite Cannibals enjoy secular growth tailwinds such as a sizable and growing addressable market, share gains, pricing power and high incremental margins but with one added benefit -- growth requires very little incremental capital. All things being equal, a dollar of operating profit from an asset-light business adds more value than a dollar of profit from a more capital-intensive business. Cannibal management teams throw accelerant on per share intrinsic value growth as profits expand over an ever-declining number of shares. Mathematically, the Cannibal model has a finite life as shares outstanding shrink to one but patient shareholders enjoy an increasingly larger slice of a growing pie."



Many companies like to engage in stock buybacks with their free cash, but it is not always economically sound to do so. The key feature of a good cannibal is that its stock is undervalued when it is repurchased, whether due to lack of a following, small size or other factor. Really, these are classic value investing opportunities, powered further by a slow process of essentially taking themselves private.

Mar Vista's favorite cannibals are Mettler-Toledo International Inc. (NYSE:MTD), Moody's Corp. (NYSE:MCO) and O'Reilly Automotive Inc. (NASDAQ:ORLY). Mettler and O'Reilly are of particular note for their aggressive buybacks in recent years. Since 2005, Mettler has bought back 42% of its outstanding shares. O'Reilly has been buying back stock at an even more blistering pace, retiring 44% of shares since 2010.

Disclosure: No positions.

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This article first appeared on GuruFocus.