About a dozen years ago, some friends took me to a little bar in Charlottesville, Va., for a typical night of highbrow literary critique and perhaps some pinochle -- OK, the plan was to down way too many beers and attempt to flirt with cute University of Virginia women.
The bar was charging admission that night because a band was going on stage around 10 p.m. Cover charge: either $3 or a canned good item. Having left my cling peaches in light syrup at home, I paid the cash.
That night, I heard some really good music. More than 10 years and 10 albums later, that bar musician is at least a B-list star, his eponymous group finishing 2000 as the top-grossing touring band in the United States, with legions of loyal fans who enthusiastically sing along off-key to his dozens of hits.
This is why it makes sense to devote part of your portfolio to small, relatively unknown consumer-facing stocks. You don't follow?
Buy what you know
Made famous by master investor Peter Lynch, "buy what you know" is perhaps the second-most famous adage in investing (next to "buy low, sell high," of course). Now imagine if Dave Matthews (Ticker: DMB) was a stock. I knew he was good. I saw that everyone else in the room knew he was good. This guy had a future. And if I had plunked down a small investment in him back in 1992 -- after his IPO (he started playing gigs a year or two before I saw him) but before Wall Street analysts started paying attention to him (the critical and popular acclaim that accompanied the release of his second album and major-label debut, Under the Table and Dreaming) -- I'd be looking at a solid 40-bagger.
This is precisely the train of thought that led the Motley Fool Rule Breakers team to recommend The Knot (NASDAQ:KNOT) in February 2006. Just two years after turning a profit, The Knot's triple-digit trailing price-to-earnings ratio (P/E) looked expensive. But its place in the Internet of the future seemed assured. Analyst Rick Munarriz saw a website that was the best in its niche, with 2.1 million unique visitors per month -- mostly young couples looking for ways to spend money on their big day. That's an online marketer's dream. All that ad revenue meant expanding margins and bigger profits.
The stock is up more than 40% for Rule Breakers subscribers in less than a year.
Be a smart consumer
The world is full of great stock ideas, and you can rest assured that the next AOL and Dell are out there. But it's up to you to find it.
Consider that one of Peter Lynch's greatest finds was Hanes, before it was absorbed by Sara Lee (NYSE:SLE). And how did he find it? Not through any extensive research or technical screen, but because his wife Carolyn told him that the company's new L'eggs stockings were simply the best on the market. A six-bagger later and Fidelity was quite happy that Peter Lynch was married.
Consumer stocks are one of the only areas where individual investors have a leg up on the Wall Street pros. Did you notice an increasing number of charges on the family credit card statement from a store called Chico's (NYSE:CHS) back in 1999? A talk with your wife could have netted you close to a 20-bagger -- more than covering the cost of those clothes. What about all those people on the subway who were furiously thumbing away on their BlackBerrys near the end of 2003? An investment in Research In Motion (NASDAQ:RIMM) would have tripled your money by now, even if you were that late to the party (and 2003 was late).
This is the kind of early-adopter research that the Rule Breakers team does to help subscribers get a leg up on the market. In his past few columns for the newsletter, Rick has covered EVDO cards from Verizon (NYSE:VZ) and Sprint Nextel (NYSE:S); previewed the Slingbox, a device from private Sling Media that allows you to watch what's on your TV at home from anywhere in the world; and detailed what the Sony (NYSE:SNE) PlayStation 3 means for gamers, game makers, and investors.
Foolish final thoughts
Consumer stocks can make for big returns. If you know a good idea when you see it, don't be afraid to put some money behind the stock. After all, the world is full of billions who spend just like you.
The idea behind Rule Breakers is that these are growing businesses that will be top-tier companies at some point in the future. The team's recommendations are beating the market by nearly 10 percentage points since inception, with three picks having already doubled. To see what they've uncovered, click here to take a 30-day free trial. There is no obligation to subscribe.
But maybe you don't need the team. With some sharp consumer eyes, you could very well be the first to uncover the next global phenomenon -- the next Dave Matthews Band.
This article was originally published on Dec. 1, 2005. It has been updated.
Roger Friedman is the managing editor of newsletters and the author of Nipple Confusion, Uncoordinated Pooping and Spittle: The Life of a Newborn's Father . He does not own shares of any company mentioned in this article. Dell is an Inside Value and Stock Advisor recommendation. Sara Lee is an Income Investor recommendation. AOL parent company Time Warner is a Stock Advisor recommendation. The Motley Fool isinvestors writing for investors.
