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Tickers in this Article: KKD, TASR, KO, WMT, HPQ, T, SBUX, DELL, AAPL,
One of Peter Lynch's principles is that you should "never invest in any idea you cannot illustrate with a crayon." Mr. Lynch famously articulated this principle after he noticed a portfolio created by an actual classroom of seventh graders-and illustrated with crayons (of course it included toy makers and Coca-Cola)-outperformed the S&P 500 in the early 1990s. If the idea is that you should only invest in companies that you understand, it is both appealing and wrong for us today. I think the "crayon principle" might just push you right off a cliff, at least for the foreseeable future.

First, the "crayon principle" will often point you to over-exposed, consumer-oriented names. A good formula for losing money is to buy a faddish company that is splashing all over the headlines. Investors inevitably rush into these stocks and create bloated valuations. A bloated valuation requires aggressive future growth to justify its bloat (i.e., it "discounts" aggressive growth expectation into the stock).

Such stocks are precariously perched, waiting for a tiny bit of bad news to send them tumbling. You know the stories – Krispy Kreme (KKD), Taser (TASR), Boston Market, etc. All too often, a healthy desire to understand the company leads you to a retailer-naturally, if we do our shopping there, we think we "understand" the company-but in retail, the losers outnumber the winners. Here is a fine first principle of investing: try not to put yourself in jeopardy.

Second, the crayon principle points you toward large-capitalization, growth-oriented stocks with names like Wal-Mart (WMT), Hewlett-Packard (HPQ), AT&T (T), Starbucks (SBUX), Dell (DELL), and Apple (AAPL).

And these are great companies, don't get us wrong! But all too often, the real money was made by investors who purchased the companies years ago, before the companies become famous. Let's try and think like the early birds.

An eye-popping little study was just released by Robert Arnott, who is Editor of the Financial Analysts Journal and wields a unique ability to create relevant, legible academic studies (I know, "legible academic" is an oxymoron). He compared the historical returns of the largest stocks to the average stock (both in terms of market capitalization) in the S&P 500. He illustrates that buying the largest names was an almost certain formula for relative underperformance. What was the difference between the largest stock and the average stock? The compounded 10-year shortfall was 26%. Yikes. Apparently, we are still learning lessons from the twenty-year raging bull that ended in 2001.

The raging bull was a "happy mask" that concealed a lot of ugly, relative underperformance. In the 80s and 90s, you were "better off lucky than smart," because the average was up and, as they say, the rising tide lifted all boats. In this decade, lucky won't be so easy to find. The key point of his study is that market capitalization-weighted indexes or mutual funds that hug cap-weighted indexes like the S&P 500 (hmmm, let's see, that would be most of them!) can be worse than a simple basket where you purchase an equal amount of each stock. Because you won't be dragged down by the largest names. But he also says two other interesting things: "In this world, value beats growth, on average, over time....[and]...In this world, small beats large, on average, over time." (source: What Cost "Noise", 2005 March/April issue of Financial Analysts Journal).

Finally, the idea that you can fully "understand" a company stock was always and everywhere false. The worst thing, in my opinion, about the crayon principle is that is lulls you into a false sense of security – e.g., we buy our coffee at Starbucks, so we convince ourselves that we know the company. Buying the product is a good first step – but too many investors, and far too many newsletters, stop at this step.

This is the problem with "story stocks." Stories are easy to spin. But you cannot afford to stop at the story. Take Starbucks, you like the story, that just means you are ready to do some homework: who are the institutional owners and what kind of investors are they (e.g., if they flee, the stock will surely drop)? Is there a massive overhang potential dilution awaiting your future? How does revenue break-down, by product, by store, by region, by average purchase? What are the new products? Where is international growth coming from, and what are the prospects? Are there off-balance sheet financing vehicles we should know about? Etc, Etc. These are just a few questions, not including the valuation questions (is it fairly valued?)-among dozens if not hundreds-that need to be asked.

Why do we need to ask these questions?

The first reason is that we prefer not to place ourselves in unnecessary jeopardy. We want to identify as many red flags as possible, in order to reduce the risk (a risk we can never truly eliminate) that we are about to wade into a field of land mines. For example, at Advisor, we insist on being able to understand the balance sheet. Don't get us wrong, we aren't afraid of debt. (In fact, some companies are under-leveraged because debt is cheaper than equity, to a point).


But if we need a PHD in financial engineering to understand the debt structure, history proves that we are increasing our odds of wading into a bad scenario. Do not take unnecessary risk-that is, risk you don't get paid for. After these questions have been answered, the sobering reality is: we still will not really understand our company. A company is like an onion, with layers and layers and hidden truths. The crayon principle teaches you to be complacent ("I buy their coffee, ergo I know the company"). But if you recognize the company is an onion, you will never regret asking more questions. And waking up to this reality will help you avoid the charlatans who hold recommendations merely because they have a story to tell.

Now is a good time to replace the crayon with a magnifying glass.


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