A Solid Investment Strategy: Buy What You Know . . . Right?

Ok, the short of it here is that investors, particularly new investors, should be careful when applying the folksy bit of stock picking wisdom that you should "buy what you know."

The appealing aspect of this simple phrase is the fact that it's just that, so simple. Any investor who's ever heard of Peter Lynch likely knows the famous Lynchian lore about how he bought Hanes (before it left the public markets and re-entered as Hanesbrands (HBI)) after his wife told him about great L'eggs were. He did great on that investment, and a legend was born.

The misnomer goes like this: Johnny Everyman (or maybe Joe Average?) gets a new car and it has Sirius Satellite Radio (SIRI) built in. Johnny listens to his new satellite radio every day on his way to work and loves it. One day it clicks and he says, "Sirius is great! I should buy the stock." And buy he does.

Right on?

Well, maybe.

As I've talked about before, there can be a big difference between a company and its stock. Likewise, there can be a pretty big difference between a product and its company. Believe it or not, not every company that produces a killer product has clean, honest, efficient business operations to back it up.

Here are a couple of examples of the "buy what you know" principal.

Do you like your sleek Walkman-of-the-modern-age, the iPod? Well, that dandy little product has been powering Apple (AAPL) over the past few years and the stock is up over 1,000% over the past five years. Score one for "buy what you know."

If you are not a woman yourself, go grab the nearest woman and ask her what she thinks about Coach (COH) bags. See that smile? That reaction has helped the stock rocket over 600% since 2002.

If you've ever gotten lost in an area you're not familiar with, you know why Garmin's (GRMN) products are so popular. Well, so is the stock. It gained nearly 500% since 2002. That's three quick ones for "buy what you know."

How many of us have come home from a long day at the office and sunk into a La-Z-Boy (LZB) chair and had the feeling that life would be A-OK? Well, not those who had La-Z-Boy in their stock portfolios -- it's down 56% in the past five years.

Who can turn down a fresh, fluffy, delicious, freshly baked doughnut? How about one of those Krispy Kreme (KKD) doughnuts? It's pretty darn hard. Hopefully you held off on the stock, it's lost 77% of its value since 2002.

If I could count the number of times that Blockbuster (BBI) has been there for me on a lonely Friday night I'd be . . . well, I'd probably realize how pathetic I am. But I also might consider buying the stock if I were a simple "buy what you know" kind of guy. But if I had done that five years ago I'd be pathetic and a good deal poorer -- the stock is down 83%. Ouch, ouch, OUCH!

The bottom line is that "buy what you know" isn't right and it isn't wrong. Focusing on companies and stocks that you are familiar with through their products is a great jumping off point, but that's about all it is.

Had you dug into Blockbuster's story and industry, you may have realized the potential threat that the low-cost Netflix (NFLX) could be to Blockbuster's business. On the flip side, some more research into Coach would have turned up that the company is exceedingly well managed, produces really impressive returns on equity, and has customers that are absolutely wedded to the brand.

Investing is not an overly complicated field -- I'd say it's pretty simple, but not easy. If you're willing to put in the time and effort, I believe that many people can produce pretty good returns. The trick is not falling into the trap of taking a very simplistic investing catch phrase at face value and not doing the necessary leg work. If all you have time for when it comes to investing is saying "Oh, Google (GOOG)? I like that search engine, I'll buy it," then maybe it's time you started looking into some low-cost index funds.

And how about our friend Johnny Everyman? Well, it really depends on his timing, but if he picked up those shares of Sirius pretty much any time during 2005, then he's now found himself down a swift 50% or more.

Comments

[Tom B]

Buy what you know-- after contemplating the balance sheet and competitors!