"Buy what you know" -- Peter Lynch's famous credo -- is a favorite of individual investors, and it's easy to see why. It's a simple strategy to comprehend, and it purports that you don't need a CFA or an advanced degree in economics to pick winning stocks. You may be able to beat the market simply by being a savvy consumer.
Unfortunately, it's also easy to see why most investors don't realize Lynch-like returns when they attempt to buy what they know -- it's only a sound investing strategy if "what you know" includes a solid understanding of a company's earnings prospects, financial condition, and competitive position.Yo Joe!
The real American heroes of G.I. Joe summed it up best with "Knowing is half the battle." Lynch himself backed off his famous claim in the introduction to the millennium reprint edition of One Up on Wall Street:
Peter Lynch doesn't advise you to buy stock in your favorite store just because you like shopping in the store, nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food. Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it in your research list, but it's not enough of a reason to own the stock!
Indeed, familiarity with a company's products is a crucial component of successful stock selection, but it shouldn't be the crux of your investment thesis.
Due diligence? Yawn
Sometimes a popular product is an indicator of a great investment -- look at Apple's iPods and Research In Motion's
Have sales been skyrocketing at your favorite store? Before you click the "buy" button, make sure you can answer the following questions.
1. Can the company protect its profitable product?
Superior growth can't continue indefinitely. Did you notice the increasing number of red Netflix envelopes in your mail carrier's bag? So did archrival Blockbuster
2. Will the increased revenue budge the company's bottom line?
Even if sales growth is soaring, it doesn't necessarily mean the company's earnings will follow suit. Are you aware that Sony loses money on the sale of each PlayStation 3 console in hopes of making it up on software sales? Honda's
3. Is this growth potential already baked into the stock price?
Finally, you must consider whether the share price already includes the market's lofty expectations. Comparing a company's price-to-earnings (P/E) ratio to those of both its chief competitors and the broader market will reveal whether investors have already priced in premium growth prospects. Check analysts' five-year growth forecasts -- do they seem reasonable? If the market already expects a company to deliver incredible earnings, the slightest slip-up can send the share price plummeting.
If you see a product flying off the shelves at your favorite store, spend a few minutes evaluating the potential impact on the company's share price. Will this sales growth persist? Will the product boost earnings? And is the earnings growth already incorporated in the share price? Now you know the right questions to ask -- and knowing is half the battle.
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Rich Greifner's favorite G.I. Joe character was Snake-Eyes, the team's mute martial arts master. Neither Rich nor Snake-Eyes owns shares in any of the companies mentioned in this article. Netflix and Starbucks are Stock Advisor recommendations. Pfizer is an Inside Value pick. The Fool's disclosure policy is trained in hand-to-hand combat.