Buy What You Know - But Do Your Homework, Too

by: John P. Reese


Mutual fund legend Peter Lynch said individual investors can "buy what they know" to get a leg up on professional investors.

But Lynch also warned that you shouldn't buy stock in a firm just because you like its products; you also have to do thorough fundamental and financial analysis.

Here are five stocks with popular products or services you probably know, and which also have strong fundamentals.

Can you use your own shopping experiences to find winning stocks?

Yes -- but be careful.

In his classic book One Up on Wall Street, Peter Lynch -- perhaps the greatest mutual fund manager of all-time -- offered a tip that he said could give individual investors an advantage over the big guys: Invest in what you know.

Lynch thought that if you knew something positive about a stock -- you buy the company's products, like its marketing, work in its industry -- you could find strong stocks before professionals caught on to them. In his book, he somewhat famously said that one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes (NYSE:HBI) -- was his wife's affinity for the company's new pantyhose.

But while focusing on "what you know" can be a helpful starting point, it's far from the be-all and end-all of investing. In fact, in the revised version of One Up on Wall Street, Lynch said many had misinterpreted his advice.

"Peter Lynch doesn't advise you to buy stock in your favorite store just because you like shopping in the store," he wrote, "nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food." These are merely good starting points, he said.

His bottom line: "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."

I couldn't agree more. With that in mind, I thought it would be interesting to highlight some firms with popular products or services that are also fundamentally and financially sound. Each of these gets approval from one of my Guru Strategies -- investment models based on the approaches of history's best investors (including Lynch).

The Gap Inc. (NYSE:GPS): The clothing retailer isn't the hot stock it once was, but its apparel remains quite popular. Gap has grown earnings at a 14.5% clip over the long term (I use an average of the three-, four-, and five-year growth rates to determine a long-term rate), part of why my Lynch-based model is high on the $18-billion-market-cap retailer. Its moderate growth rate and high ($16 billion) annual sales make it a steady "stalwart" according to the Lynch approach. To find stocks selling on the cheap, Lynch famously used the P/E-to-Growth ratio, adjusting the "growth" portion of the equation to include yield for stalwarts, since they often pay solid dividends; yield-adjusted P/E/Gs below 1.0 are signs of value. When we divide Gap's 16 P/E by the sum of its growth rate and yield (2.1%), we get a yield-adjusted P/E/G of 0.96 -- a good sign.

Apple, Inc. (NASDAQ:AAPL): While its shares are no longer skyrocketing as they were a few years back, the popularity of iPads, iPhones, and all sorts of Mac computers is undeniable. And while growth has slowed (how could it not), my Lynch-inspired model thinks the stock is still a buy. It likes Apple's 15.6 price/earnings ratio and 42% long-term growth rate , which make for a 0.38 P/E/G ratio. (Growth could be significantly slower going forward and it would be a good buy at this price.) Another reason the model likes Apple: the company's very reasonable 14% debt/equity ratio.

Monster Beverage Corporation (NASDAQ:MNST): This California-based firm makes energy drinks and alternative beverages under such names as Monster Energy, Java Monster, X-Presso Monster, M-3, Worx Energy and Hansen's natural sodas and juices. It gets a 100% score from my Warren Buffett-based model, thanks in part to its having upped EPS in all but one year of the past decade. The model also likes that it's averaged a 34% return on equity over the past decade, and has no long-term debt.

Signet Jewelers (NYSE:SIG): Ads from this Bermuda-based parent of the Kay and Jared jewelry chains seem to be everywhere these days as the firm continues to post strong growth. With a long-term growth rate of 25.3% and a 23.8 P/E, Signet has a 0.94 PEG ratio, a big reason why the Lynch approach likes it. In addition, Signet has a debt/equity ratio under 1%, showing the kind of conservative financing this model likes to see.

Buffalo Wild Wings (BWLD): Founded in 1982, this Minnesota-based restaurant/bar chain seems to be surging in popularity. It has over 1,000 locations across all 50 states in the United States, as well as in Canada and Mexico. It's been expanding rapidly and has plans for even more growth.

The stock gets strong interest from my Martin Zweig-based strategy, thanks in part to its strong, accelerating growth. EPS grew 71% last quarter, up from an average of 41% in the previous three quarters, which was up from 22% long term. The Zweig model also likes that sales growth -- not one-time factors -- has driven earnings growth over the long term (25% long term sales growth rate, using an average of the 3-, 4- and 5-year sales growth rates). And it likes that the firm's debt/equity ratio of just 7% is far below the restaurant industry average of 158%.

Disclosure: The author is long BWLD, SIG, MNST. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.