The first investing book I ever read was One Up On Wall Street. I was in middle school when I first read it, and to this day, it remains my favorite investing book. Written by Peter Lynch in 1989, many of the book's examples may appear outdated. But the central ideas remain as strong as ever.
Lynch advocated grassroots observations paired with fundamental financial analysis. Let's take a deep-dive look at how Lynch's approach worked in practice and apply it to three companies which have been making headlines in financial news as of late: Shopify (SHOP 0.14%), Target (TGT 1.28%), and Walmart (WMT -0.65%).
Image source: Getty Images.
Lynch's approach
At his core, Lynch was a growth investor who looked for companies that could compound their size over time and produce monster earnings. Lynch was famous for fully experiencing a company: He talked to its employees, called up investor relations desks, and did everything he could to gauge the pulse and health of the underlying business.
From there, Lynch looked at financial statements to determine if an asset was mispriced or had hidden value. If the business felt promising in person, sounded solid based on what other folks were saying, and its financials checked out, he deemed it a good buy.
Applying Lynch's lessons today
In today's ruthless bear market, it's more important than ever to make calculated risks and ask important questions. With Lynch's investing philosophy in mind, we might start by asking ourselves:
- Does this company have cash on its balance sheet or the free cash flow (FCF) needed to outlast a period of negative growth?
- In a weak enviornment, will this company take or give up market share?
- How has this company fared during past economic downturns?
Many of the companies that have suffered from plus-80% stock plunges as of late are shaky on all three points. They don't have a lot of cash relative to their projected spending and are FCF negative, meaning there is more cash going out of the company than coming in. To the second point, many such companies may be swallowed up or lose their competitive advantages during the current downturn to larger players with more resources. Finally, many newer struggling companies have not been around long enough to prove their mettle in a rising interest rate environment; rather, they enjoyed the majority of their growth while interest rates were low, financing was cheap, and growth was easy.
So, how to find a good buy in today's market? The real bargains right now are companies that have seen their stock prices crash due to broader market conditions, but that only fail on one -- maybe even two -- of the these questions.
The creative move: Shopify
Shopify fits that bill. The e-commerce company isn't consistently FCF positive, but it does have a lot of cash on its balance sheet and is well-positioned to take market share even during a recession. However, it lacks the track record of persevering through past downturns.
In terms of grassroots Lynch-style reconnaissance, Shopify definitely checks out. Shopify has excellent reviews and feedback from folks that use its services. Whether on message boards or social media platforms, Shopify stands out as a fan favorite among small and medium-sized businesses. It also has an excellent 4.1-star rating on Glassdoor, meaning its employees are generally satisfied. Shopify is also a founder-led company, suggesting its management has a significant stake in the success of the business.
Shopify's business model is structured so that it benefits as its customers do. The majority of revenue comes from gross merchandise volume, a fancy way of referring to the sales that pass through Shopify. Therefore, it is in the company's best interest to help its customers grow their sales and achieve their goals.
All told, Shopify is the kind of high-risk, high-reward potential 10-bagger that Peter Lynch would likely say deserves a look.
The simple route: Target and Walmart
Risk-averse investors may be better off applying Lynch's methods to companies with which they are more directly familiar. Let's take a look at household names Target and Walmart, both of which released first quarter earnings earlier this spring.
Both of these big-box retailers are easy-to-understand businesses. Given that they are discount retailers, their margins are inherently low, which leaves little room to raise prices during times of high inflation. In their recent earnings calls, both management teams reported having absorbed a lot of the cost pressures from higher freight and fuel costs, supply chain constraints, and the higher costs for goods. The result of that, though, is billions of dollars in headwinds that these companies normally don't have to deal with. It is no wonder why both stocks took a beating after reporting weak guidance after the release of their first quarter results.
Applying what we've learned, though, let's find out: would Peter Lynch consider the stock drops of these companies to be threats or opportunities? The famed investor would likely approach the situation by going into stores and getting an up-close look at factors like quality of service, consumer habits, available inventory, employee sentiment, and discounted goods. Lynch would then follow up by looking at each company's financial statements.
Especially as inflation persists, Target and Walmart stocks could continue to fall. But both companies have positive FCF and large cash positions as well as low price-to-earnings ratios. They're positioned to take market share from smaller retailers during a recession, have been through several economic downturns in the past, and are both Dividend Aristocrats, meaning they have paid and raised their dividends for over 25 years (50 years for Target and 46 years for Walmart).
In sum, it doesn't take a financial expert to realize that Walmart and Target are great companies that are caught in a moment where it is hard to offset inflation with price hikes. That's not the end of the world for either company. It just means they will probably report some bad quarters for the time being.
Thinking long term
As a long-term investor, Lynch was famous for finding companies with issues and scooping them up at a good price. Shopify relies on small and medium-sized businesses that are more vulnerable to a recession than big businesses. Therefore, its growth is probably going to slow, which is reflected in its falling stock price. But nothing has changed about the company's long-term thesis.
Seeing businesses in action for yourself instead of just looking at a stock chart reminds investors that there are real companies behind the stock price. By going on message boards, forums, reading reviews, and talking to folks who use Shopify, it becomes clear that most folks love the service. As for Target and Walmart, it's easy to go inside those stores and use their e-commerce services to see that both are doing perfectly fine and aren't going away anytime soon.
I would expect the short-term situation to get worse before it gets better for all three of these companies. But thinking long term, all three stocks seem like great buys right now that Peter Lynch himself would be proud of.
