Does Buy What You Know Actually Work?

There are many different methods to determine how you should invest your money. One that was made famous by Peter Lynch is to buy what you know. Buying what you know has created a lot of informed investors, but it has done little to expand the universe of possibilities when picking a stock. Institutions, hedge funds, and a plethora of do-it-yourself investors have built a financial nest around a basket of very common household names -- but is that a prudent move?

I would argue that buying what you know is simply too shallow to base an investment on. You might feel that you have a good understanding of a company, but likely the purchase is influenced more by your "liking the brand" than by an actual understanding of the company's financials. This isn't to say that you shouldn't understand what you're investing in, but you need to dig further than just a brand name before you put your hard-earned money to work.

Think I might be wrong? Take a look at the five-year performance of some of these portfolio stalwarts.

Company

5-Year Total Return

Annualized Return

Microsoft (Nasdaq: MSFT  ) 15.4% 2.9%
General Electric (NYSE: GE  ) (34.7%) (8.2%)
Citigroup (NYSE: C  ) (87.8%) (34.3%)
Cisco Systems 13.2% 2.5%
Johnson & Johnson (NYSE: JNJ  ) 16.2% 3.1%

Source: Yahoo! Finance. Adjusted for dividends.

These are some of the most popular names on Motley Fool CAPS and regularly top the NYSE and Nasdaq most-active list, but they haven't done much for you. Dividends have been a saving grace for Johnson & Johnson, but have these companies honestly had any real momentum behind them in that time period, or are they just tying up your money? It could be time to wipe off the cobwebs and trade out these portfolio dinosaurs for companies with greater long-term growth potential.

Old Softy
Microsoft might be referred to as "Old Softy," but the only thing soft lately has been its returns. Microsoft has struggled to innovate its product line, produced numerous duds, and failed to excite customers with its products in general. Its stock price has been range-bound for the better part of a decade, and with a dividend yield of only 2.2%, I think you can do better.

What could you replace Microsoft with? One possibility is Intuit (Nasdaq: INTU  ) , the leading provider of financial accounting software. Its QuickBooks and TurboTax products have an absolute stranglehold on market share in the sector. TurboTax, which has more than 20 million users, has both brand recognition and a clear-cut pricing advantage over competitors H&R Block and Jackson Hewitt. Intuit doesn't have Microsoft's level of cash on hand, but its cash flow growth has been impressive and may be strong enough to support a dividend in the future.

Battleship sunk
General Electric's slogan used to read, "We bring good things to life." But apparently its stock price is not one of those things. Despite being spread over a wide range of industries, GE still succumbed to the market meltdown, with its financial arm, GE Capital, taking the brunt of the hit. Its quarterly dividend now sits more than 50% off its highs and GE is still suffering through contracting margins and falling revenues. This doesn't sound like a recipe for long-term success.

Although no single company can replace GE's diversification, one that does match it in value and dividend growth is ConocoPhillips (NYSE: COP  ) . ConocoPhillips has not reduced its quarterly dividend payment since 1989 and currently yields 3.2%, which is marginally higher than GE. The compelling idea here in my view is that energy demand worldwide is only going to increase, so it makes sense to have a company involved in energy creation in your portfolio. Perhaps even more important, energy demand should remain strong even in market downturns, so ConocoPhillips may provide downside protection to your portfolio.

Citi never sleeps
Few large-cap stocks have seen more of a cataclysmic downturn in the past five years than Citigroup. In short order, Citigroup's loan portfolio turned sour as the mortgage crisis escalated and the quality of its loans declined. Without U.S. government assistance, it likely would have filed for bankruptcy protection. Meanwhile, shareholders have been left high and dry as Citigroup issued billions of shares to pay off its TARP loans. No longer paying a dividend, is there any reason to still own Citigroup?

One possible replacement is Visa (NYSE: V  ) , which offers a strong brand name but more importantly, solid long-term growth potential. Visa has produced huge amounts of free cash flow over the past 12 months, which easily allows it to pay out a dividend and keep cash in reserve. Its strong cash flow can be attributed to consumers' willingness to keep using their credit cards; if history is any indication of future success, consumer credit use should continue to rise, which should charge up Visa's profits.

Final thoughts
Buying what you know is good, but understanding what you own and why it makes for a good investment is really what matters. Investing is all about doing your homework and trying to become as informed an investor as possible. Tonight, take a long look at your portfolio and make sure you understand why you invested in what you own, because it just might make you a more successful investor.

Do you have a company that you feel excited to own, or do you disagree with what I've said? Let's hear about it in the comments box below!

Related Foolishness:

Fool contributor Sean Williams does not own shares in any companies mentioned in this article. He freely admits to using corny slogans to get across his point. You can follow him on CAPS under the screen name TMFUltraLong. Motley Fool Options has recommended diagonal call positions on Johnson & Johnson and Microsoft. Johnson & Johnson is a Motley Fool Income Investor selection. Microsoft is a Motley Fool Inside Value pick. Motley Fool Alpha owns shares of Johnson & Johnson. The Fool owns shares of Microsoft and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 22, 2011, at 11:44 AM, midnightmoney wrote:

    Dear Sean,

    I'm wondering whether your logic might be applied to the fool's old swan, berkshire hathaway. I own some and am entirely unconvinced that it's going to outperform, especially given Mr B's coming retirement. How would you feel about selling half to pick up afsi, a potential growth stock in the same industry. Further, I'm curious whether you would add berkshire to the list of underperformers in the table you've provided above. Aside from the bump it got from joining the s&p, it really hasn't done much (since April it has done exactly nothing, in fact). Can we anticipate shrinking margins and a slow fall from grace there as well, or am I just being impatient?

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