Peter Lynch might be an investing god, but like with all religions there is great misinterpretation of what he meant by what he said, and the common understandings are often plain wrong. We want to explore probably the greatest of these (Buy What You Know). Yet first a caveat: our team at GeoInvesting loves Peter Lynch, but we have a problem with his statement that you should avoid smaller companies until they are profitable (Rule 12 from Beat the Street: With small companies, you’re better off to wait until they turn a profit before you invest) as it is hypocritical of Lynch to make that statement while his spectacular returns included smaller companies in the portfolio that can experience volatile earnings that dip negative at times.
Peter Lynch Math
Let’s look at Lynch’s math to drive that point home further. As he points out, if you have five stocks and all but one is going to go to zero value, but the remaining is a Ten Bagger (10x return of initial investment), your small portfolio’s return is over 60%. How many large companies go to zero? A handful a year. Smaller companies like the ones we follow (and those that Lynch used to build Magellan) have a higher probability of modeling this decline than an organization with billions in annual revenue does. On the flip side of the argument, a Fortune 1000 company probably won’t have a very high and sustainable growth rate and positive revenue surprises like their tiny cousins can, which is part of the archetype for the Ten Bagger. Lynch saying, “avoid small companies” and then discussing the way they can behave as the model to embrace can be somewhat misleading to the non-sophisticated investor. But again, one must dig to find the truth in what is often mis-quoted.
Microcaps are actually ideal for the smaller newer investor because of the upside opportunity, and the fact that small dollars can be diversified across many investments easily. You can’t readily buy a handful of blue chip stocks with $1,000 without having decent acquisition costs eating into your returns, but with microcaps you can be buying ten or a hundred-fold the number of shares for the same dollar allocation to build a broader portfolio. And with over half of the publicly traded stocks being microcaps, a month later when you are ready to invest another small chunk there will be an opportunity among the 10,000+ microcaps available. And the next month, and the next, and…
Buy What You Know?
So now that we have put the “Avoid Small Companies” myth to bed, let’s turn our attention to Buy What You Know and delve deeper than the average reader of Lynch generally does. The average reader unfortunately looks at the product more than the process producing it. This is a major error, a surface focus instead of the deep dive that Lynch (and GeoInvesting) would endorse. An example is the Green Bay Packers, the only NFL Club that is publicly owned. Americans know and love football, Green Bay is one of the premier franchises (as even a Vikings or Bears fan has to grudgingly acknowledge), and yet the organization is well managed. Are you going to buy their stock? Only a CheeseHead would.
As Lynch discussed in this Wall Street Journal article a few years ago, he didn’t mean just because you love coffee and can tell the difference between Arabica and Robusta, or scalding the milk for a perfect cappuccino does not mean you should go and buy all the coffee stocks out there. However, if you know the entire supply chain from bean to cup, have familiarity with weather patterns in the growing regions, and research the economics of the industry, you are posed to be able to make a much better call than the average caffeine junky because of your knowledge of the space. Someone that works as a turbine engineer is better able to assess the way GE’s acquisition of Alstom will negatively affect them, especially if you also happen to understand the labor rules in the European Union and why profits will drop like a rock. Building from this knowledge you can then sift through the microcap universe to find organizations that could take advantage of the situation, whether by grabbing market share (easy to grab around the edges from a behemoth) or as an acquisition target to try and patch the holes like LM Wind Power Canada, Inc. (acquired by GE earlier this year).
Use Your Knowledge As The Starting Point
Use your knowledge as the starting point. If you have been in a field for a dozen years, you have built up a knowledge bank of little insights that an investor from another field will lack and be unable to replicate. Understanding the current tech, trends, competitive landscape are all critical to success as an investor, and it is this advantage that Lynch is referring to.
Here we should insert the adage of Woodrow Wilson: I not only use all the brains that I have, but all I can borrow. Having access to great minds with experience in a wide swath of fields is valuable.
But finding good potential companies to invest in is only the triage of ideas as Lynch and GeoInvesting agree. Then comes the additional work once a company passes the initial test. The delving into the financials, and footnotes, and the other details. This is where you can see if the company is growing rapidly enough to justify the PE ratio, or if there is a lawsuit that appears to be resolving to remove risk. The initial idea of “this could be a good company” is only the first step, and the reason Lynch says you need to turn over many rocks to find the treasures.
As Information Arbitrage specialists, we have a team doing research on dozens of interesting companies at any time and tracking scores more. If you don’t have the inclination or the time to read 10-K’s and interview management teams, GeoInvesting could be your brains that you borrow. So, the next time you see a teenager playing Pokémon Go while drinking a Starbucks Corporation (NMS:SBUX) latte, don’t rush out and buy those coffee stocks just because you seem to see them everywhere. Build on what you know, work on developing deeper knowledge, and be ready to take committed actions when the numbers do add up. That’s how Peter Lynch built his legacy, and what we do every day now at GeoInvesting.
Article by Maj Soueidan, GEO Investing