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The Deeper Side of ‘Investing in What You Know’

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The Deeper Side of 'Investing in What You Know'

There’s Validity in Peter Lynch’s ‘Investing in What You Know,’ But Understand it on a Deeper Level

Peter Lynch, formerly the famed manager of the behemoth Fidelity Magellan Fund, once extolled the virtues of investing in what you know. That statement appears simple enough on the surface, but Lynch himself admits it requires a deeper level of understanding.

One of the misunderstood elements of “investing in what you know” is something akin to a frequency appearance bias.

“I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock,’” said Lynch in an interview with MarketWatch.

Maybe not the best example simply because shares of Starbucks, the world’s largest coffeehouse operator, recently hit all-time highs, but the statement is valid nonetheless. Consider another real life example from the restaurant industry. Imagine if Subway was a public company. There are lots of Subway restaurants around the world, more than 42,000 in fact, but a lot of locations doesn’t mean a company’s stock is good.

Chances are if Subway was a public company, its shares would be sagging amid increased competition offering more appealing food and a spate increasingly hostile complaints from franchisees.

In other words, simply because we are consumers of a particular company’s goods or services, that doesn’t mean we should be investors in that enterprise as well. As Lynch himself notes, affinity for a company’s products is not a replacement for proper due diligence and research.

“Research is a part of an investor’s due diligence,” according to the Securities and Exchange Commission. “Whether you work with investment professionals or on your own, it’s wise to do your homework.”

Digging Deeper On What You Know

Sticking with the restaurant theme, Lynch said in the MarketWatch interview that someone who had worked in that business for a long period of time probably would have amassed the knowledge and skills to have, at least somewhat, forecast the stunning success of companies like Chipotle and Panera.

The Chipotle/Panera example doesn’t necessarily mean investors should only allocate to the fields they work in. No advisor worth his or her salt would tell their physician clients to be 100 percent allocated to the healthcare sector.

Looked at another way, investing in what you think you know can be limiting and carries risks. Taking the what you know concept a step further, investing in what we understand is a potentially rewarding strategy. Arguably, this what Warren Buffett, long an advocate of investing in what you know, is saying.

Remember doing the go-go days of the 1990s tech boom, Buffett famously said he was not interested in technology and internet stocks because he didn’t understand the business models. It was 2011 before Buffett got around to buying shares of IBM and 2016 before he embraced Apple.

Of course, it takes time, in some cases months or years, for advisors and investors to fully comprehend some companies. When considering buying a stock, even when highly familiar with the company’s products and services, fundamental research is a must

“Fundamental analysis is the process of evaluating a company’s business performance and competitive positioning—such as revenues, expenses, earnings, and cash flow,” according to Fidelity.

As an advisor, chances are you’ve had a client or two that have brought up individual stocks to you because those companies make a product or provide a service the clients’ kids use. This may appear to be example of buying what one knows or understands, but the strategy is risky. Twenty-years ago, a client may have mentioned her child’s affinity for the iPod and, obviously, Apple would have been a winning investment.

More recently, another client may have noted his teenagers’ love of Snapchat, but that stock struggled immediately after its initial public offering (IPO), though it has recovered this year.

Bottom Line: Avoiding Complexity

Investing in what we know isn’t always about buying shares of a company that makes a product we buy frequently or investing in firms that produce tangible goods we can put our hands on. Much of the thesis is rooted in understanding how companies build and acquire market share, how they invest capital and, most importantly, how they generate profits.

And for advisors and investors that do want to apply invest in what you know maxim, those opportunities will always be available, we just have to be selective about putting them into practice.

“For example, Lynch said that after his wife raved over the fact that Hanes Co. conveniently sold its L’eggs pantyhose in grocery stores, he figured the company was on to something good,” according to Morningstar. “His hunch was right. Hanes’ stock rose sixfold while Magellan held it. Lynch’s main point here is to look around you, because that’s where you are most likely to find your winners.”

Related: Why Your Clients Get Investment Advice From Odd Sources

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