In early 2008, I convinced my wife -- with much arm twisting involved -- to set up a portfolio in The Motley Fool CAPS community. She's not into investing at all, so after making her initial seven picks, she put it completely out of her mind. And though I checked on the portfolio occasionally for a while, I lost track of it as well. Until yesterday.
Roughly three and a half years later, five of her original seven picks are beating the market by an average of more than 52 percentage points per pick. Three of those seven picks have been serious home runs, each beating the S&P 500 by 50 points or more. Specifically, she's ridden Nordstrom
What's her secret?
Fans of Peter Lynch won't be too surprised to hear me say that "she buys what she knows." In other words, her stock picks -- with the notable (underperforming) exception of Cisco
Nordstrom may be a pricey destination next to Macy's or Kohl's
Why this works ... and why it doesn't
I recently wrote an article focusing on competitive advantage and, specifically, on companies that seem to have a really strong grasp on exactly what makes them better than their competitors. While it's important for a company to understand what gives them an edge, it's also important for investors to understand the same if they're going to become shareholders.
Buying stocks of companies you frequently patronize provides you an advantage because your understanding of the company's products or services gives you first-hand knowledge of exactly what makes that company better than its competitors. And if you ask Warren Buffett -- a guy that knows a thing or two about good investments -- it's hard to overemphasize the importance of competitive advantage.
That said, as I pointed out earlier this year, the "buy what you know" advice could also get you in big trouble. You may be a customer of a company and know its products well, but it's also possible that you're a fan of a fad, the company has great products but terrible management, or the company's stock is wildly overvalued. Any of these could turn a seemingly good investment idea into a gaping hole in your portfolio.
Buy what you know and is a good buy
My wife's CAPS portfolio has done quite well on nothing more than the straight-up, no-chaser, "buy what you know" strategy. However, for Foolish investors putting real money into the mix, I think "buy what you know" can be a great starting point but can be nicely augmented by these three additional steps:
Is it really better? "Buy what you know" works best when you're buying a company because its products or services are a must-have for you rather than just another purchase. For my wife, MAC makeup isn't a makeup choice; it's the makeup choice. On the other hand, we currently have Aquafresh toothpaste (a GlaxoSmithKline product) in the bathroom, but I couldn't really care less about which toothpaste I'm using -- I could just as easily buy Colgate-Palmolive's
Tom's of Maine or Procter & Gamble's (NYSE: CL) Crest. (NYSE: PG)
- Is it well-managed? Who exactly runs the company? Have they had past success? Do they have an applicable background for the industry? Are they paid like a trusted steward or a greedy mercenary? You can make a lot of headway on these questions with a few Internet searches and a good read of the company's proxy statement. If you want to cheat to get a quick view on this, check out a company's return on capital -- well-managed companies are typically earning attractive returns on the capital they've deployed.
- Is the stock fairly priced? The subject of determining whether a stock is fairly priced is a whole article (or book) of its own. In short, though, the best companies are generally hard to find at steep discounts, but they can still be bad investments if you drastically overpay, so pay attention to the valuation.
Don't get me wrong, there are great investments to be dug up in dusty corners of the market where most investors simply aren't looking. But as my wife reminded us with her CAPS portfolio, some of the best investments out there may be right under your nose.
In the special report "13 High-Yielding Stocks to Buy Today," my fellow Fools kick off with "one dividend stock for the rest of your life." That stock is a company that we all know very, very well, but is it a good investment? Download a free copy of the report and find out.
The Motley Fool owns shares of Cisco Systems. Motley Fool newsletter services have recommended buying shares of Amazon.com, GlaxoSmithKline, Cisco Systems, and Procter & Gamble. 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.
Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.