Peter Lynch's 'Buy What You Know' Is Just The First Step

Includes: BUD, HSY, KO, LUV, PEP, WMT
by: Tim McAleenan Jr.

In Bill Gross' most recent "Investment Outlook" commentary, he begins by musing aloud whether Peter Lynch (and other legendary investors of the latter half of the 20th century) merely benefited from being in the "right epoch" to invest because of a general trend in credit expansion, stating:

In questioning initially whether I am a great investor, I open the door to question whether other similarly esteemed public icons like Bill Miller are as well. It seems, perhaps, that the longer and longer you keep at it in this business the more and more time you have to expose your Achilles heel-wherever and whatever that might be. Ex-Fidelity mutual fund manager Peter Lynch was certainly brilliant in one respect: he knew to get out when the gettin' was good. How his "buy what you know best" philosophy would have survived the dot-coms or the Lehman/subprime bust is another question.

When Peter Lynch talked about buying what you know, it was only supposed to be the first step in a general screening process. It was not an end game. When Lynch ran the Magellan Fund from 1977 to 1990, he achieved annual compounded returns of over 29%. Every $1,000 invested into the Magellan Fund at the start of Peter Lynch's management rein would have turned into over $28,000. Give the guy some benefit of the doubt.

The context behind Lynch's "buy what you know" quote was this: he invited a seventh grade class over for a pizza lunch at his Fidelity executive suite and he gave the kids the option either to explain how a company made money in a few short sentences or to draw their business model with some crayons provided. The purpose for Lynch was to make investing seem much less esoteric than it really has to be.

When a kid draws a picture of soft drinks manufactured by Coca-Cola (NYSE:KO), Lynch was quick to explain that for every share you buy, you would receive $1.12 in annual dividends while the company earned $1.97 in total per share. Lynch pointed out that telling others about your investment in boring consumer staples like Coca-Cola and Pepsi (NYSE:PEP) is not going to dazzle anyone with your brilliance, but it will make you reliable money, provided you do not overpay (both Coca-Cola and Pepsi have grown earnings by over 10% annually during the past twelve years).

The take-home point, though, is this. Lynch was illustrating basic financial concepts to children when he discussed the "buy what you know" approach to investing, and this is only the first step of screening a proper due diligence process. You still have to look at how management allocates capital. You still have to study balance sheets, competitive positions, and valuations. Hershey's (NYSE:HSY) valuation is approaching 30x earnings. A chocolate bar is about as "buy what you know" as you can get. The company is trading at its richest valuation in the last fifteen years, and is growing at about 8% or so. Do you really think Lynch would put this stock into the Magellan Fund at this time? Of course not.

Anheuser Busch (NYSE:BUD) is another company that would fall into the "buy what you know" category. It doesn't take a genius to appreciate the cash cow nature of brands like Budweiser, Bud Light, Beck's Stella Artois, Rolling Rock, Busch, Michelob, and Natural Light. The company is a money-spitting machine, and is exactly the kind of business that Lynch would put in his familiarity category. But, the company also trades at over 20x earnings and is carrying a $40 billion debt load that will put a long-term drag on current and future profits. At the current time, "buy what you know" wouldn't be enough to justify a purchase of Anheuser-Busch because that is only one part of the story.

Furthermore, this was only one component of Lynch's strategy. He was a sucker for low-cost operators in a given industry. To my knowledge, Southwest Airlines (NYSE:LUV) is the only airline stock Peter Lynch ever owned because it was leveraging its low cost structure to lower prices and steal airline customers from the competition. A similar story plays out with Wal-Mart (NYSE:WMT). The retail giant is exactly the kind of company Lynch would like because it is an easy-to-understand business that also happens to be the low cost producer in the industry. At the right price, I'd imagine that Lynch would be a net buyer of the Bentonville company's shares.

I do find it funny that Gross questioned whether Lynch's strategy would be durable enough to withstand the dotcom bust. Lynch's portfolio was notoriously unglamorous and generally devoid of companies that were highly subject to technology. Lynch's observation about "buying what you know" is relevant because the kind of products that you encounter regularly year in and year out are the kinds of companies that sell dependable products that can profit in all business environments. But we should also resist the urge to over-simplify Lynch's wisdom. "Buy what you know" can be destructive advice if not followed by balance sheet examination and analysis of proper valuation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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