When you find a product or service you like, love or know a lot about, should you consider investing in the company that makes the product? The short answer is that it could be a good starting point. After all, we are consumers, and many companies sell consumer products that we know and like. But, we should not buy stocks just because we like the products. There is much more to the story.
The idea of buying what you know was popularized by Peter Lynch, who achieved incomparable investment success running the Fidelity Magellan Fund (Magellan) from May 1977 to May 1990. When Mr. Lynch assumed control of Magellan in May 1977, the fund’s assets were only $18 million. During his tenure, the mutual fund became the world’s largest. His performance was likely well beyond what any of his investors could have ever imagined, as he generated annualized returns of 29.2% during his 13-year span as Magellan’s manager – he outperformed the market by 13.4% per year on an annualized basis.
Because of his stellar track record, Lynch wrote several books describing his investment philosophy. While one can obtain much more detail by reading his books, Lynch’s philosophy can be summed up by three main tenets:
1. Only buy what you understand
2. Always do your homework
3. Invest for the long term
The first element of Lynch’s approach comes into play when we look back to the question we asked above. Lynch believed that our eyes, ears and common sense are integral elements of the stock research process. In his books, Lynch talks with pride when discussing how many of his great ideas were found while walking through the grocery store or talking informally with friends and family. In fact, one of his favorite stock picking techniques was to take his wife and kids shopping at a large shopping center, which would allow him to see for himself which chains were doing well, before they reported earnings.
To do this type of research he would give his daughters some pocket money and watch where they spent it, which usually led him to a clothing store like the Gap, which was always packed with kids making big purchases. This approach was aimed at helping him to identify extremely profitable stores before they expanded nationwide. His kids also helped him by telling him what drinks were popular, which often led him to some small operation making a niche range of products that later achieved great gains.
Of course, the type of scuttlebutt research Lynch did back then would have to be done differently today, as more and more shoppers are searching for their wares online rather than in the local shopping mall.
However, while you may find a product you like or enjoy, there is more to the investing process than just buying companies that make goods we like. We have to be able to look past our individual tastes and preferences in order to have an understanding of what the returns might be. For Lynch, this meant going back to the office and performing investment due diligence, focusing on the company’s valuation and financial strength. In short, you have to evaluate the business like you are going to be an owner. This last element ties into the idea of investing for the long term. Holding shares in a company does not just refer to owning pieces of paper (stock certificates); you own a portion of a business. Turning your shares over quickly is not the best approach.
Using our personal experiences to identify potential investment opportunities is an example of qualitative analysis (examination of non-measurable data such as a firm’s reputation, a brand’s image, or a customer’s feelings about a product). Quantitative analysis (focuses on numbers that can be found in a company’s financial statements and the related footnotes) helps take the emotion out of the process.
At BWFA, we use a combination of qualitative and quantitative analysis to help us identify attractively valued companies that we believe are well-managed and have the potential to deliver long-term gains to client portfolios.