The legendary Peter Lynch made famous the "buy what you know" investing philosophy. His purchases of companies such as Fannie Mae and Chrysler were catalysts for some of the tremendous gains that made his Fidelity Magellan (FUND: FMAGX ) fund so well-known. However, Lynch also had another genius quirk: He loved obscure, boring companies.
Here's why grasping this concept can be extremely profitable.
Under the radar
Investing in obscure stocks may seem counterintuitive at first, but that's entirely understandable. After all, it's obvious the real money is being made in big names such as Wal-Mart (NYSE: WMT ) and Citigroup (NYSE: C ) , right? The problem is that big money has been made in these stocks. Who knows what will happen from this point forward? Each of these stocks had a great run, sure. But consider the fact that the big boys have already bought into each of these stories heavily: 40% of Wal-Mart's outstanding shares are owned by institutions. That's $79 billion worth. For Citigroup, the figures are 68% and $173 billion.
Wouldn't it be better to find the companies whose great runs are still to come?
That's where the obscure and boring part comes in. We're much more likely to unearth a future Lynch 10-bagger among the names that are not yet household, but will be in a few years. It's not a bad thing if your friends remark, "You bought what?" when hearing of your latest investment.
Lynch, for example, raised a few eyebrows with his purchase of Pep Boys. Many had never heard of the auto-parts store and found the name rather silly. That was fine by Lynch, because it allowed him to get into the stock at bargain prices. Wal-Mart is another example of a company that was all but ignored in its early days. Yet a $5,000 investment in 1980 would have turned into nearly $2 million today.
More examples can be found in some of Tom Gardner's Motley Fool Stock Advisor recommendations. Have you ever heard of Healthways (Nasdaq: HWAY ) ? How about Paccar (Nasdaq: PCAR ) ? Don't worry, most people haven't. The former provides health-care services, and the latter designs and manufactures trucks.
Boring. Obscure. But Tom recommended them to members in 2005, and they've easily topped the market since.
You can see how unknown companies are more likely to carry bargain price tags than their headline-grabbing brethren. Because fewer people have heard of them, there's less demand for their stocks. Lower demand, lower prices.
But the best part is that as long as a company executes well and continues to rake in the cash, it will attract greater notice. It can't be helped. More investors begin to buy in, driving up demand right along with the stock price. Two examples, Akamai Technologies (Nasdaq: AKAM ) and MEMC Electronic Materials (NYSE: WFR ) , have both had tremendous five-year runs (but are now more than 80% owned by institutions).
Tom and his brother David have employed several Peter Lynch principles on their way to outstanding performance in Stock Advisor -- 67% total average returns versus 28% for equal amounts invested in the S&P 500. You can get a look at their two new picks, plus all their past recommendations, free of charge with a 30-day trial. There's no obligation to subscribe.
This article was originally published Feb. 17, 2006. It has been updated.
Rex Moore thinks it's high time for a Green Acres reunion show. He owns shares of Paccar, but of no other companies mentioned in this article. Fannie Mae and Wal-Mart are Inside Value recommendations. Akamai is a Rule Breakers pick. The Motley Fool has a disclosure policy on that Internet thingie.