The legendary mutual fund manager Peter Lynch wrote a popular investment book called One Up on Wall Street in which he argued that individual investors can use common sense and everyday experience (along with some hard work and diligence) to find great investment ideas. The book is a convincing and enjoyable read that gets you excited about investing, but is the advice accurate? The Wall Street Journal recently questioned Lynch’s advice that you should “buy what you know.”
One problem according the Journal is that this approach tends to lead people to invest mainly in retail companies, an industry that most people feel as though they can understand. Retail investing, however, is prone to fads and boom and bust cycles. The article mentions a few cases in which this theory has worked, including one adviser’s pick of Williams-Sanoma (WSM) after his family started to frequent the company’s stores. The story also mentions another winner Under Armour, which is a long-time holding in our small cap fund. On the losing end the author mentions Crocs (CROX), a stock that has languished after its footwear fad fizzled out.
There are lots of dangers to the Lynch approach, says the Journal. For a large retail company, your own experience may be simply a local anecdote and not a national or international trend. Also, you may have an emotional attachment to the company that makes you overly optimistic, overlooking the company’s flaws. Often by the time a trend is on your radar the stock is already expensive.
So is “buy what you know” bad advice? Yes and no. I don’t think that you can manage a whole portfolio based on that method, but every once in a while it can produce a great idea. For us Under Armour (UA) and Chipotle (CMG) were this way. My personal experience with these companies helped me identify and decide to buy the stocks. Other times, I will find a stock through screening or some other source, but then verify it with everyday experience. This was the case with Calavo Growers (CVGW), an avocado distributor that is riding the Guacamole craze.
“Buy what you know” can be a great strategy but, usually it does not paint the whole picture. Rather, it is just one tile in the mosaic that comes together during investment research.
My recent experience with the wedding industry illustrates the opportunity and also the limitations of “buy what you know”. I got engaged in December and quickly realized that the wedding industry was a highly profitable business. I came across the Knot, which is a hugely popular wedding website and, as it turns out, a publicly traded stock. The Knot, which recently changed its name to XO Group (XOXO), went on a tremendous run last year almost doubling between March and the end of the year. Another wedding-related stock is Blue Nile (NILE) which is a popular, online ring retailer that is disrupting the traditional jewelry stores. Both of these stocks are already very expensive, so despite my insight, I may be too late to profit a great deal from these trends.
“Buy what you know” is a useful investment tool, but its unlikely to produce enough good ideas to build a whole portfolio. Instead it should be combined with a wide range of other sources of ideas such as screening, reading the financial press and following the picks of other top investors. More important than where the idea comes from, of course, is doing your own due diligence, something that Peter Lynch also stressed.