Peter Lynch is known for beating the market during his stint as manager of Fidelity's Magellan mutual fund in the 1980s. In his popular investing book, One Up on Wall Street, he describes how the individual investor can beat the market with a simple approach.
One of the foundations of that approach is buying what you know and understand. Let's see how that can play out with some real-world examples.
Don't just buy the product; buy the stock
Lynch describes his wife's positive experience buying L'eggs brand hosiery at the supermarket. When the pantyhose first came out, it was a novel concept that brought affordable products to where women were shopping most frequently. That interested him in buying stock in the parent company of L'eggs, Hanesbrands (HBI 0.22%).
There's no magic formula for what makes a stock price go up. But one of the major factors is if a company sells a product that people like. If you have a positive experience with a product or service, you might want to consider whether it's a stock worth buying.
Examples exist all around, from the clothing you wear to the cars you drive to the food you eat. Chances are if you like it, other people do too. And if you're buying more, the company's sales are probably increasing.
This isn't the only factor. But it's a start. Once you've identified a product you love or a restaurant you enjoy, the next step is to dig deeper.
Image source: Getty Images.
Let's say you've tried personal stylist company Stitch Fix (FIX -3.02%) and love the service. That wouldn't be surprising, since it has excellent reviews. If you check out its financial performance, you'll notice that it hasn't been running its business efficiently over the past few years. That may be due to external factors, but sales are declining, and it has reversed from net income to net losses.
You might believe enough in the business, based on your personal experience and review of the financials, to say it's worth the risk because it's just that good, and therefore likely to bounce back. If so, you'll have a real bargain on your hands right now, as the stock is trading at less than 0.3 times trailing-12-month sales. This gives you an edge over Wall Street analysts, who aren't evaluating the company from a personal perspective.
If the financial performance doesn't meet your standards, you can move on to the next stock that does.
Know when the game is over
Another example Lynch gives is The Limited. It was a growing and popular fashion chain in the late 1970s, but few analysts were covering it. As the stock jumped, more began to cover it.
But by the time it reached popular-stock status, the quality had started to deteriorate, and shoppers weren't so enthused. The stock tanked after that. If your eyes are open to what's going on around you, you'll notice when a company looks like it's heading in the wrong direction.
In the original Hanesbrands example, the stock soared for decades after the book was written. But it peaked in 2015, and it has yet to get back to that high.
It's important to periodically assess where a company is holding and see if it's still the long-term star you thought it was when you bought it. If it's not, it might be time to sell.
Focus on the long term
The ideal is to buy stocks that you can hold forever. Every stock has its tough times and challenges, and that doesn't mean it's necessarily time to sell.
A great example of this is Estée Lauder (EL 1.70%). You might love some of its cosmetic brands or products, which include names like MAC, Bobbi Brown, and many more. You might see that this is a solid company with decades of high performance and a well-developed business strategy. Not only that, but you'll also see that it's facing near-term headwinds because of the macroeconomy, and its stock is down 18% this year.
EL Cash and Equivalents (Quarterly) data by YCharts
However, it's well funded, with strong cash generation and profits. Not only that, but as sales and profits are declining, it is increasing liquidity. This is a well-run company with plenty of gas left in the tank, and it's the kind of stock you'll want to hold on to.
But you might already know that if you're still loving your lipstick. Any investor can use this kind of knowledge to create a successful stock portfolio.
