It's a Saturday night and you're out to dinner at a new local gourmet burger restaurant that just opened in the neighborhood.
The place is packed. You have to wait a half an hour in line to order at the counter.
It's all natural burgers and fries with craft beers and shakes for the kids. The price tag isn't too horrible.
As more people pile into the line behind you, until it snakes out the door, you think: "This place must be making money hand over fist. I should invest in this."
And that's how the "buy what you know" strategy is born.
You love it; everyone else must too.
Why not cash in?
The Birth of "Buy What You Know"
Buying the stocks of companies that you know became an actual investing strategy in the 1980s.
It was popularized by Fidelity mutual fund manager Peter Lynch, who created a strong record of beating the market by investing in consumer names at the beginning of their growth cycles. He states in his book, One up on Wall Street, that he had the most success buying stocks in places where he simply ate and shopped. He understood the business because he was trying out the product.
Lynch has told stories of buying shares of The Limited because his wife came home with bags full of clothes after shopping there. He bought shares of a hair cutting chain after getting his hair cut there and loving the results.
He made it sound so easy.
But it's not.
More . . .
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The Problem With "Buy What You Know"
Eating at one burger restaurant, in one location, really doesn't tell you much about how a company is actually performing as a business. While there may be lines at the one you ate at, other locations may be empty on the weekends.
The "buy what you know" strategy CAN work, but it is just a starting point. Even Lynch himself said you can't rely solely on it. To be successful at buy what you know, you have to drill down into the fundamentals of a company.
But how do you do that?
It's not too hard if you take it step-by-step.
Deploy these steps to get the most out of the "buy what you know" strategy.
3 Steps Every Investor Must Do to Succeed With the "Buy What You Know" Strategy
Step 1: Google It
Every company has a story. The restaurant or the store you were in isn't the only one that exists. It's a chain.
Use Google to find out the scoop.
Yes, this first step seems really easy.
Look for details like how long the company has been in business and what are its best-known products.
Even if you've never worn a pair of yoga pants before in your life, you probably know that lululemon makes one of the most coveted pairs of them in the business. But did you know it's a Canadian company? What other countries does it sell in?
Basic information about the company, such as where it is headquartered, is often found on its corporate website. Check it out.
You may also run across recent press releases announcing new products or store locations. This is also a great way to gather information on the company's "story."
Step 2: What Do the Analysts Say?
Once you have the basic background on a company, then you might want to turn to what the professionals are saying.
Research analysts at firms like Goldman Sachs and Oppenheimer "cover" many of the well-known companies. They provide in-depth research into the company's prospects and often give their own outlook. These are the people who give the "buy" and "sell" ratings.
The problem is that most investors don't have easy, or cheap, access to this information. The reports are often expensive or only available to big time money managers.
But you can still get an idea of where the analysts stand on a company without actually reading their in-depth reports.
Their quarterly and yearly earnings estimates are often available on financial sites like Zacks.com.
What should you look for in the analyst estimates?
You might want to know if that new burger chain is even profitable. You can check out this year's earnings estimate to see if it's making money.
Another key signal to look for is if the earnings estimates are rising. If they are, that's usually a bullish sign as that means the analysts see good things going forward.
You can actually use the Zacks Rank to do the work of looking at the analyst estimates for you, as the Zacks #1 Rank (Strong Buys) picks only the strongest of the analyst estimates, which will be rising.
If the earnings estimates are actually falling, then it is time to continue on with more research to see if this is a company worth investing in. What is causing earnings to decline?
Step 3: Listen to the Quarterly Conference Calls
To drill down even further into a company's fundamentals, I recommend listening to a company's quarterly earnings conference call.
This is where you get the heart of what is going on at a company. If there are ANY problems, they are usually uncovered in the analyst questions.
The conference calls are open to everyone to listen in on. If you can't listen "live" you can listen to the recording afterwards. Most companies keep them on their website, under the Investor Relations tab, for days afterward.
But don't just read the transcripts of the calls. Listen to one. You'd be surprised how much you can learn about a company listening to management's tone of voice.
Now You Are Ready
Once you've done your research, now you are ready to determine if the company is really one you want to invest in. Don't skip the steps.
Does it have outstanding fundamentals and good management? Then it could be time to pull the trigger.
"Buy what you know" is a great strategy. Great growth companies can be uncovered by using it. And as an added bonus, you will actually be a big fan of the company and its products.
But invest smart.
You probably enjoy products and services from more companies than you can count. Doing research on all of them would be unreasonable. How do you know which are the best stocks to own?
If you're looking for advice in that area, I highly recommend Zacks Confidential. This exclusive service features the experience, resources and extensive research from our team of experts. It also shares 2 or 3 trades each week that are worthy of your immediate attention.
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Tracey Ryniec is the Editor in charge of our Value Investor and Insider Trader. You will also find her contributions, as well as those of 9 other Zacks investment experts, in Zacks Confidential.