"Buy what you know" -- it's one of the terms you'll often hear
associated with the investment strategy of the great Peter Lynch.
The former Fidelity manager, who posted a remarkable 29.2% average
annual return during his 13-year tenure at the Magellan fund,
believed one way to find good investment ideas is to focus on
companies you deal with personally -- and like.
"I talk to hundreds of companies a year and spend hour after hour
in heady powwows with CEOs, financial analysts, and my colleagues
in the mutual-fund business, but I stumble onto the big winners in
extracurricular situations, the same way you could," Lynch wrote in
One Up On Wall Street. "Taco Bell, I was impressed with the burrito
on a trip to California. ... Apple Computer, my kids had one at
home and then the systems manager bought several for the office.
... Dunkin' Donuts, I loved the coffee."
There's logic to Lynch's "focus-on-what-you-know" advice. He
realized that when new products or companies hit the market, you as
a consumer may well be able to get a read on their quality before
Wall Street analysts and big institutions, which have a big impact
on stock prices, get around to assessing them.
But investors often overlook a couple key points when considering
Lynch's buy-what-you know mantra. First, Lynch warns that focusing
on what you know is a good starting point when examining a company,
but far from a be-all and end-all. "Never invest in any company
before you've done the homework on the company's earnings
prospects, financial condition, competitive position, plans for
expansion, and so forth," he warns.
Second, while it was the most publicized, "focus-on-what-you-know"
was just one of many jumping-off points Lynch used when looking for
stock ideas. He cited in his book a number of qualities a firm
could have that would also pique his interest, and I've listed
several of them below. Remember, as with "buy-what-you-know", these
qualities only serve as jumping off points for further research.
That's why along with each I've included an example of a stock that
currently possesses that particular quality, and has the
fundamentals and financials to pass my Lynch-inspired Guru Strategy
(which is based on the quantitative stock-picking criteria he laid
out in One Up On Wall Street).
A DULL BUSINESS
Forget high-flying tech stocks -- Lynch found that if a company
with terrific earnings and a strong balance sheet also does dull
things, it can fly under the radar of most investors. And that
gives you a lot of time to purchase the stock at a discount before
others catch on.
The Pick: Packaging Corporation of America (
While this Illinois-based firm ($2.4 billion market cap) offers
some innovative consulting and design services, it is at its core a
box-making company -- something unlikely to get investors too hot
and bothered. It's producing some pretty hot growth numbers,
however, upping earnings per share at a 37.7% pace over the long
term. (I use an average of the three-, four-, and five-year EPS
growth rates to determine a long-term rate.) That makes it a
"fast-grower", according to my Lynch-based model -- Lynch's
favorite type of investment.
Lynch famously used the P/E/Growth ratio to find undervalued growth
stocks. This approach likes P/E/Gs below 1.0, and really likes
those below 0.5. Despite its strong growth, Packaging Corp. is
selling for just 12.8 times trailing 12-month earnings (perhaps
because of its boring business). When we divide that by its growth
rate, we get a P/E/G of just 0.34, which passes my Lynch model's
test with flying colors.
A DISAGREEABLE PRODUCT LINE
If a firm does something that makes you a bit queasy or uneasy,
that's another sign it might get passed over by Wall Street,
allowing you to get it on the cheap.
The Pick: DENTSPLY International Inc. (
Few things can make grown men and women squirm the way thoughts of
going to the dentist can. And this 111-year-old Pennsylvania-based
firm makes a variety of products -- bonding adhesive, bone grafting
material, crown and bridge cement, to name a few -- that would make
But while its product line may make you uncomfortable, its
fundamentals are a different story. The $4.6-billion-market-cap
firm has been growing EPS at a 25.4% pace over the long haul, and
it sells for a reasonable 17.4 times trailing 12-month earnings.
That makes for a solid 0.68 P/E/G, a sign this fast-grower is
selling on the cheap. In addition, Lynch liked conservatively
financed companies, and DENTSPLY's debt/equity ratio is a about 28%
-- well below this model's 80% threshold.
A NICHE BUSINESS
Lynch found that if a company focused on a particular niche, it
often had little competition.
The Pick: MWI Veterinary Supply, Inc. (
This Idaho-based medical equipment small-cap ($720 million) keys on
a very specialized group of end-users: animals. It sells its
products, which include pharmaceuticals, vaccines, parasiticides,
diagnostics, capital equipment, and pet food and nutritional
products, to veterinarians in the U.S. and U.K. In the past year,
it has taken in more than $1.1 billion in sales.
MWI has been growing EPS at a strong 28.2% clip over the long haul,
which my Lynch-based model likes. That justifies its 23.1 P/E, as
the two figures make for a solid 0.82 P/E/G. MWI also has a
debt/equity ratio of less than 9%, and its inventory/sales ratio of
12.3% is down from the previous year's 14.2%, a good sign. (Lynch
saw it as a red flag when inventory was increasing faster than
sales were -- unwanted inventory piling up isn't a good sign.)
A BORING NAME
Much like companies with boring businesses, companies with boring
names can also fly under the radar, Lynch found.
The Pick: Smith & Nephew PLC (
"Smith & Nephew" sounds like it should be the name of your
local plumber or hardware store -- hardly the sort of name that
will catch most investors' eyes. In reality, this London-based firm
is no Mom & Pop business -- it has almost 10,000 full-time
employees, and it's involved in some high-tech pursuits. It makes a
variety of medical devices, such as joint reconstruction implants,
high-definition digital cameras that allow doctors to see inside
joints, and radiofrequency wands used in repairing damaged tissue.
And it does what it does well. Smith & Nephew has been growing
EPS at a moderate 15.9% pace over the long term, which, combined
with its multi-billion-dollar ($3.9 billion) annual sales, makes it
a steady, reliable "stalwart" according to my Lynch method. For
stalwarts, Lynch adjusted the "G" portion of the P/E/G to include
dividend yield. Smith & Nephew has a 0.86 yield-adjusted P/E/G,
which comes in under the model's 1.0 upper limit. The firm also
appears to have manageable debt, with a debt/equity ratio of about
COMPANY IS BUYING BACK SHARES
If a company is buying back its own shares, that's decreasing the
total number of shares outstanding. That can make earnings per
share "magically" increase, Lynch found. Since earnings are a key
driver of stock price, that can give these firms' shares a nice
The Pick: Hewlett-Packard Company (
The California-based computer giant ($92 billion market cap) has
decreased its number of shares outstanding from 2.84 billion to
2.38 billion in the past five years, and in August it announced
plans to repurchase an additional $10 billion worth of shares, at
least $3 billion of which is to be bought in the fourth quarter.
HP also has the fundamentals my Lynch model likes -- its 25%
long-term EPS growth rate and 11.4 P/E make for a 0.46 P/E/G,
indicating the stock is a bargain. And it has a reasonable
debt/equity ratio of about 47%.
Disclosure: I'm long MWIV.