Peter Lynch advised investors to buy companies where they know and like the products. I disagree. This is too simplistic and dangerous.
This article isn't at all an attack on Peter Lynch, he was a great investor and I admire him greatly. However I do doubt strongly the idea to "buy companies you know". Investing is more complicated than that.
I believe the financial strength of a company is first and foremost. This is because as an investor you want to avoid blowups in your portfolio. You also want to receive cash flows for a long period of time and not see the company fail in the near term.
A great tool to use is the Altman Z-score which is a formula for predicting bankruptcy. I won't go into the details here, but the Wikipedia page has everything you need to know about the technical details.
I ran a screen of S&P 500 stocks using Altman Z score from the last full year of financial statements.
A score below 1.8 indicates financial stress and growing risk of bankruptcy.
Out of 505 stocks in the S&P 500 currently, I could calculate an Altman Z score on 393 of them. Many of the weakest companies were commodity companies which have been stressed by low commodity prices. So I will ignore those for now, as the bull market in commodities would have materially picked up the financial strength of those companies.
In the top ten and bottom ten companies I found two interesting pair trade candidates.
From Internet Software & Services sector: Sell VeriSign, Inc. (NASDAQ:VRSN) and buy Facebook (NASDAQ:FB). VeriSign has the worst Z-score from the 393 companies at a massive negative 8.0. Facebook meanwhile has the best Z-score of with a massive 36.7. This means VeriSign is highly risky and Facebook is the company with a "fortress balance sheet".
Another interesting pair trade, this time in Consumer Discretionary. Buy Michael Kors (NYSE:KORS) and sell Time Warner Inc (NYSE:TWX). While the spread of Altman Z score is less: 16.1 for Michael Kors vs. a lowly 0.4 for Time Warner, Michael Kors has still blown past the 2.99 "safe zone" level for financial risk and Time Warner has a long way to climb to get out of the "Distress Zone".
Ironically, I don't use Facebook myself. I don't recall having ever bought anything from Michael Kors. Meanwhile I'm a big fan of Time Warner's HBO and I've always liked Warner Bros! But my belief in financial strength has to over ride Mr. Lynch's advice to buy / avoid stocks based on your personal consumer preferences. If a company is weak financially, as an equity holder you have very little power. Remember bond holders and other creditors have first claim on assets in the event of a bankruptcy.
I happen to like Facebook as a company though. Talking to people who follow the sector more closely than I do suggest that Facebook has a good ability to drive more value per advertiser and a focus on making their adds more targeted and effective which will continue to help the company grow revenues though increased capture of ad spend. For many people, Facebook is an integral part of their life. A risk of course is user fatigue or privacy missteps but the company seems to be largely on top of that.
Clearly, Michael Kors is a luxury product that has no doubt benefited from Quantitative Easing and the wealth effect of a bull market in assets. But with such a high Z-score, the company is so financially sound and therefore it must also have been managed very well. Also it's worth pointing out the company is expanding in the Emerging Markets, such as China, Brazil and Russia, countries with growing middle classes and a rising appetite for western luxury products.
I am not predicting bankruptcy for VeriSign or Time Warner, but they have much higher probabilities of financial distress than the vast majority of S&P 500 firms. To own these two stocks requires a strong belief in a credible turnaround story, something that is not easy. Otherwise, it's gambling.
Disclosure: I am/we are long FB.
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.