The Peter Lynch methodology? Not so fast . . .

I had a lot of fun chatting up the WSJ’s Erin Schulte on why so many people misunderstand the investing philosophy of Peter Lynch. The former Magellan fund manager used to exhort investors to take advantage of whatever their expertise was — buy what you know — in order to find outperforming stocks.

Erin looked at the E-Tailers in particular, and asks the question: “Are their Stocks Worth It?” Lots of people misunderstand Lynch’s concept, and can get themselves into investing trouble. But “walking into a store and liking the layout or customer service” should not be an excuse to buy the stock — 10,000 people per day walk into that store; What’s your edge? What Lynch referred to was a “special, legal informational advantage.” What is the stock picking advantage in being one of 10 million daily Wal-Mart customers? Nothing. But if you work for one their largest wholesalers, ahhh, that’s something else entirely.

Here are a few of my favorite examples of what Lynch did — and didn’t — mean when it came to “buying what you know.”

Scenario 1:
You buy a new gadget. This device is lauded as the future of technology, and yet, you are extremely disappointed. The interface is awful, the techology is actually line command code driven. Its slow, klunky and crashes frequently. You call customer service for help, and they are terrible; The hardware manufacturer blames the software company, who of course return blame to the hardware company. When you finally get someone on the phone who can help you, they insist on charging you for the privilege of making their poorly designed product work!

You tell their customer service rep “To hell with you — I’m returning this hunk-o-junk tomorrow.” The experience sours you on the product the company and the stock. You sell your holdings the next day, for a tidy little profit.

Oh, and one little thing: The year is 1988, the product is a PC, and the company is Microsoft (MSFT). Nice going, bub, you just left a few million dollars on the table.

The secret to investing in Microsoft was never their products or user experience; A good rule of thumb was to never buy anything Microsoft below 2.0 — unless you want to be an unpaid beta tester or product debugger.

No, Microsoft’s special sauce was their restrictive covenants with all the PC manufacturers. If they wanted MS-DOS, they had to agree to pay Microsoft a fee on every single computer they ever sold — even if it didn’t have a Microsoft OS in it. That lock-in — subsequently stricken down in the DoJ Anti-Trust case — was the real secret to their success. How can competitors possibly compete when Mister Softee gets paid anyway? Hmmm, anti-competitive monopoly profits . . .

But if you relied on what you knew — your end user experience — you were toast!

Scenario 2:
You are a car salesman, and business sucks. The dealership you work for sells a marquee (name brand) with terrible products. The auto maker has bad management, and their balance sheet is a disaster. The products have been dull, but reliable. You keep reading in the business press that the company is either going to be sold and torn apart, or heading for bankruptcy. The stock has plummeted over the past 5 years, and is now at multi-decade lows.

You get sent to the regional HQ for sales training for the new products — and you are blown away. Every product you see is a category killer — good looking, reasonably priced, powerful, sexy. A new sports car is totally kick ass, and priced $10,000 cheaper — and with more horsepower to boot! — than its closest competitor. You see the new mid-sized 4 door sedan; its not only innovative and striking looking, but extremely reasonably priced. So much so that you wonder why people would pay up for the full sized more expensive sedan.

The SUVs are wicked cool — a high end one looks like nothing else out there; The entry one is a college kids dream; The mid level is unique looking and priced right. Also on the drawing boards: A monster SUV to compete with the most profitable Fords, GMs, and Jeeps there are.

You leave excited. You just know if you had these vehicles in your dealership, you would sell a ton of them — in fact, they will sell themselves.

You get back home. Its the spring of 2000. You scrape together some cash, and buy as much stock of the car company your dealership sells — Nissan (NSANY) — as you can.

Congrats! The 350ZX comes out to terrific reviews, and the sister car, the G35 coupe, is also a winner. The mid-sized Altima is an absolute smash hit. The unique looking Murano SUV, as well as the powerful and beastly FX45 are both smashing success. Sales are up 30% Quarter over Quarter. And the stock triples.

THAT’s buying what you know, applying an expertise, finding a legal edge to use. That’s what Peter Lynch meant.

Obligatory excerpt:

Peter Lynch advised to invest in what you know. But that doesn’t mean someone happy about their winning bid on an old Transformers lunchbox should necessarily dive into eBay stock. His advice about knowledge went far beyond walking into a store and liking the layout or customer service: knowledge in that case referred to a special, legal informational advantage. A customer of Wal-Mart is one thing, its largest wholesaler is another.

“If you order a book from Amazon, or buy some tchotchke from eBay, you don’t know either of those companies,” cautions Barry Ritholtz, chief investment strategist for Maxim Group in New York. “You’re a minor customer. You have no special insight . . .”

“Amazon and eBay have become household names. They are very well-known, well-followed entities that the smartest minds have looked at and tried to assess their value,” says Mr. Ritholtz. “They have tremendous franchises — the question is, how much upside is left in each of the stocks?”

That’s a bit more self referential than I like, but it really gives the flavor of the article. Worth the weekend read . . .

E-Tailers’ Activity Soars, But Are the Stocks Worth It?
Taking Stock, WSJ, December 6, 2003 11:55 a.m. EST
By Erin Schulte
http://online.wsj.com/article/0,,SB107048290213320200,00.html