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Summary Peter Lynch is the father of the very popular “invest in what you know” strategy that was very lucrative for him and has always enjoyed mass appeal. Today many names that are popular selections according to this strategy make terrible investments due to extremely overpriced stocks. Most people are not implementing the “invest in what you know” strategies the way Lynch intended. These days it may be more suitable to “invest in what you know” based on a personal edge gained from professional expertise. Peter Lynch is considered one of the greatest investors of all time because he managed the Fidelity Investments’ Magellan Fund in the 1980s, which was the best performing Mutual Fund in the world during that time. With average annual gains of over 29% it regularly more than doubled the yearly gains of the S&P 500. “Invest in what you know” is one of Lynch’s investment strategies that was not only very successful, but was easy to understand for the masses. He outlined his strategy in two highly popular and widely read books, One Up on Wall Street and Beating the Street , and many investors since have adopted the strategy. I also find this strategy very appealing simply for the fact that I can use the products and services that I already consume on a regular basis, but get the added satisfaction of contributing to the success of a company I partly own. However, today I find that Lynch’s philosophy is difficult, if not impossible, for many to profit from due to growth chasers and other investors who believe so strongly in a company that they are willing to pay any price for its stock. Buying a company simply because you like it is enticing and easy, but can lead to sideways performance, high volatility, or huge losses and as I will discuss in this article, is not the only way to “invest in what you know”. How Not to Invest In What You Know Many naive investors don’t know any better and will blindly make purchases of stock at insane multiples of potential future earnings simply because it is a company that they like. What’s worse is these purchases are made at times when reasonable growth is either already priced in or the company has reached its potential and future growth is limited. Three recent examples include: Amazon.com (NASDAQ: AMZN ) which has fallen 24% from a 52-week high of $408.06 to its current share price of $308.52. The stock still sports a very high stock price given the valuation of $145.85B, and the company is not profitable, with a loss of -0.47 per share in the last 12 months due to major expenses on infrastructure, customer subscription acquisition, and low margin contracts designed to gain market share. Netflix (NASDAQ: NFLX ) which has fallen 28% from a 52-week high of $489.29 to its current share price of $348.94. With a very lofty P/E multiple of 92.6, any potential future growth the company can receive is already priced into this stock, and then some. Tesla Motors (NASDAQ: TSLA ) which has fallen 24% from a 52-week high of 291.42 to its current share price of $219.31 These companies all have changed how industry operates and are forcing others to follow its lead by capturing the hearts, minds, and wallets of the public. I would jump at the chance to own NFLX or AMZN at a reasonable price because I love the services they provide and believe they have forced other companies to adopt a more consumer friendly business model to remain competitive. TSLA makes the only luxury electric car that is attractive and it has made huge strides in battery power storage, which makes it highly appealing to investors and consumers (I must confess I personally would not purchase stock in any company that relies on sales of vehicles over $70,000, a price I find ridiculous for any vehicle). The problem with investing in stocks like AMZN, NFLX, and TSLA is two-fold: Despite these companies being positioned for future growth and huge earnings, an investor’s risk of losing capital remains very high. Lofty investor expectations are priced into the current stock price and the risk of a huge drop in a short amount of time is dramatically increased if the company fails to meet the unrealistic expectations. Valuations continue to remain extremely lofty following the fall in share price that results from the company failing to meet unreasonable growth expectations. Even after the fall in stock price, there is no room for the investor to make money, and the investment becomes a speculation that the company will either beat lofty expectations repeatedly or you purchase based on technical analysis and the belief that other people (suckers) will be willing to pay a higher price in the future. I personally prefer to purchase stocks of good companies I believe will provide me a low risk of loss in the future due to a stock price below intrinsic value, and I don’t purchase stocks based on my belief that others will soon find it more desirable than it currently is. AMZN, NFLX, and TSLA are not the only examples of excellent companies with either a dominating market position, huge growth potential, or both, and sporting an extremely overvalued and unattractive stock price. Here are a variety of my favorite companies with overvalued stocks: Chipotle Mexican Grill (NYSE: CMG ) with a P/E of 52.9 The Habit Restaurants (NASDAQ: HABT ) with a P/E of 45.2 Starbucks (NASDAQ: SBUX ) with a P/E of 30.1 Visa (NYSE: V ) with a P/E of 30.8 Google (NASDAQ: GOOGL )(NASDAQ: GOOG ) with a P/E of 27.5 Don’t get me wrong, many investors have amassed huge returns from stocks in the above-mentioned companies and many will see huge returns in the future. However, I am trying to remain a disciplined investor, and the extreme valuations are more speculative to me considering the downside risk despite my natural attraction to stocks of companies I really like and I believe have excellent management and future growth potential. I was highly anticipating the recent IPO of HABT prior to its market debut on November 20th, because I love to eat at its restaurants, its casual dining atmosphere is appealing to customers, and management’s goal of growing from 99 to 2000 total restaurants. the growth potential is amazing, but I can only wait for the price to fall dramatically before I can even consider an investment. How did Peter Lynch do it? How to Properly Invest In What You Know First off, I don’t believe that Lynch’s investing advice is for “suckers” as my title suggests; in fact Lynch was living proof that when the strategy was used properly it was incredibly successful. It was so successful that he coined the term “ten bagger” to refer to investments that achieved a price 10-times greater than his purchase price. I doubt that Lynch would purchase the stocks discussed above at the current price, none of which have ten bagger potential at current prices. Lynch would purchase a stock when the company was small and had huge potential for growth before others in the investing community noticed. Getting in before others is really the key to making huge profits. As we have noticed recently with HBT and the amazing success of CMGs fast casual business model, most companies are good at touting future potential and attracting investors. This leaves little selection for value investors seeking to “invest in what we know” at a discount. Average holding time for one a Lynch investment was 6-7 years, which is how long it typically took for a company to reach its full growth potential, attract the full attention of the investing community, and reach overpriced status. Holding a stock for a long time is a place of common ground for value investors and growth investors, but takes extreme patience. Most investors have a difficult time holding losing stocks, and the volatility that can lead to boom and bust moments for high growth stocks can easily lead to huge losses for investors prone to emotional stock buying and selling, and let’s face facts, that is most of us. Buying companies whose products and services you like is not the only way to “invest in what you know”. Investing in companies or industries where you are a profession expert or you have indirect professional knowledge of can give you an edge. For example, I am a wildlife biologist and environmental impact analyst, and I consult for government agencies and large utilities and infrastructure developers regarding environmental impact avoidance and compliance with environmental laws. My understanding of environmental regulation gives me an edge regarding investments in industries such as solar energy, where solar panel developers may post huge profits in 2015 after prices fell considerably in recent months. The end of tax incentives for solar panel makers in 2016 will lead to increased profit in 2015 because many developers will rush to finish large project ahead of the deadline. My knowledge of environmental regulation and incentives I received from my job gives me an edge in this instance. Anyone can apply this same principle to their own profession and find many great companies that have excellent growth potential and attractive valuations. Closing Remarks I have great admiration for Peter Lynch as an investor, and I believe his philosophy has mass appeal, because it makes investing more personal and can be very lucrative if done well. However, many investors let emotions or naivety get the best of them and invest in what they know with purchases of stocks at the peak of popularity or at excessive earnings multiples and then hastily sell after the stock price drops when the company fails to meet unrealistic earnings goals. Successful purchases of stocks of companies that you like is done when the company is small and growth is ahead of the company, but most importantly before the masses are convinced that the company is the next CMG. Another way to “invest in what you know” is to invest in companies in industries you work in professionally. Knowledge of regulation, new product, successful internal business practices, and other hard to research information impacting companies’ future outlook can give you have an advantage over others. Don’t just look for the easy names of the new hot restaurant or the already established industry leader that commands a rich valuation, and be creative to find names that other investors may overlook or where you may have expert knowledge and information before it is widely known. Scalper1 News
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