Peter Lynch and The Power of Common Knowledge

When it comes to picking retail stocks, customer satisfaction is key.

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Investing great Peter Lynch. James Schnepf/Hulton Archive/Getty Images

It's easy to fall prey to information overload when it comes to investing. We digest financial results, pundit opinions, and analyst reports on a second to second basis. While financial metrics play an important role in stock selection, when it comes to retail stocks, your greatest source of information may be yourself. 

Behold: the power of common knowledge
Great brands, delighted customers, and wonderful customer service, are the trademarks of great retailers.

 Finding stocks that have those advantages early can be your most useful edge.  Peter Lynch, the legendary manager of Fidelity's Magellan fund, believed that ordinary investors could do this better than Wall Street money managers 

Before you dismiss this idea, keep in mind that Lynch was no scrub. His remarkable performance, achieving a 29.2% annual return over a 13 year period, is among the best of all-time. He believed that ordinary people had an edge, because they had a front row seat to emerging businesses before they hit Wall Street's radar. In other words, as a consumer, you'll likely experience a great product or chain before the stock is bid up enough to register with institutional investors. Lynch called this edge the "power of common knowledge." If you are aware enough to use your "common knowledge" for investment leads, it can help you find budding stocks.

In his book One up on Wall Street, Lynch explained how  he found one of his best investments, Hanes, thanks to his wife's excitement over its new L'eggs pantyhose product.

Obviously his wife's interest in Hanes was just the first step of his process, it led him to the stock. Upon doing some research, Lynch realized Hanes was poised to pick up market share. Stocks like Wal-Mart and Chipotle are recent examples of Lynch's "edge," for many investors. Both spent years trading at relatively low prices before they took off, despite reporting solid results early on.

While seeing a line out the door at your neighborhood Chipotle (in 2006) was not reason enough to buy the stock, it was a good sign that the stock was worth researching.

Buying what you know: more than small-cap success
Individual investors who commit to "buying what they know" will see their biggest returns on small-cap stock investments. Simply put, you will likely identify great products, or stores of small companies, before they are large enough to interest many institutional investors. However, the "buy what you know" strategy can work for large-cap stocks too.

  • Buying what you know, also means buying what you understand. As I recently wrote, studies show individual investors lose to the market by a wide margin because they buy and sell at the worst possible times. Many investors buy stocks of companies they don't understand, trade them frequently, and become market victims. By simply buying stocks in businesses you understand and researching the underlying fundamentals, you can avoid selling into panic. 
  • If customers are wild for a product, there is no ceiling. Popular retailers have pricing power, and can raise prices to grow revenue after they're "discovered" and during periods of high inflation. Consumer facing stocks with strong brands often exploit new markets, create new products, and grow from large-caps to mega-caps. Some recent examples are Nike, Starbucks, and Amazon.com, all of which experienced tremendous growth as large-caps. 

Putting it all in perspective
Following Peter Lynch's "buy what you know" strategy doesn't meant you should buy stock in your favorite retailer, just because you like shopping at their store. You should never buy any stock without doing homework on the underlying businesses fundamentals. For retailers this means analyzing statistics like same-store sales, inventory levels, and sales per square foot, to name a few. Yet, buying what you know is an important first step to focusing on customers and treating stocks like businesses (not ticker symbols). For retail stocks, finding a stock that customers can't get enough of is half the battle. That alone, makes Peter Lynch's mantra beneficial to all retail stock investors. 

Disclosure: I do not own any of the stocks mentioned in this article and I do not intend to buy shares in the next 72 hours. Never buy or sell a stock based solely on what you read here (or anywhere else) and always do your own research before investing. 

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