Investing in What You Know

Throughout the 13 years he was steering the Magellan Fund, Peter Lynch became known for his philosophy that you should invest in what you know. In his 1993 book, “Beating the Street,” he discussed how he built Magellan from a $200 million fund to a $14 billion fund in a little more than a decade. The philosophy Lynch wanted to drive home to individual investors was that you should buy companies that you are familiar with. In Lynch’s case, he liked the “tasty tacos of Taco Bell,” so he added the then-unknown chain into the portfolio; his wife loved the convenience of L’eggs hosiery, so he bought shares of Hanes.

Buying what you know has long since become a bit of Gospel among a large segment of investors–after all, if it worked for Peter Lynch, it should work for you. It’s not a bad idea–certainly if you feel strongly about a company and have what you think is pretty decent insight into its products and market, then you can do all right. I know a few creative types who did quite well buying Apple Computer stock when it was well under 20 in the late 1990s.

Taking it too Far

But it’s possible to take buying what you know too far. It’s one thing to rely on your gut feeling, but another to let it overwhelm your intellect. Peter Lynch, after all, wasn’t a Forrest Gump-like fund manager, blindly lucking into gold because he liked the taste of nacho cheese. He liked the underlying business of Taco Bell, the balance sheet, the management and the growth plan. It certainly helps that the company had a simple story to tell–it prompted Lynch to take a deeper look at the business structure and the stock valuation.

But a lot of other food chains have had simple stories, even better food, but everything from poor management to a too-high debt burden to unrealistic growth plans did them in.  That’s a lesson Peter Lynch also discusses in his book, but because it isn’t so pithy, it doesn’t get repeated very often. There is a difference between a good company and a good stock. One can be the first, but that doesn’t mean it’s the second.

That brings me to one of the more popular stocks of late, Whole Foods Market (WFMI). The first time I walked into a Whole Foods in the mid-1990s, in Edgewater, N.J., it was clear this was a different, and special, store. Attractively merchandised, filled with photos of local farmers on the walls, and flush with organic products, it was the antidote to the confusing gaggle of products churned out by food conglomerates, each filled with long lists of mysterious ingredients. Sure Whole Foods was pricey, but in the mid-90s, where else were you going to get organic fruit and vegetables, coupled with a really nifty cheese department?

Whole Foods delivered a compelling story to hundreds of thousands of shoppers like me, and its share price certainly benefited. From when I pawed my first pomelo there to the end of 2005, Whole Foods shares grew 1,000%. A lot of the growth stemmed from the belief, cultivated by Whole Foods management, that they were a different kind of store. They weren’t a grocery store–that implies low margins and doesn’t justify the high stock multiple. They were a lifestyle store, filled with people pursuing the “new luxury” or paying up for higher quality everyday items. Great story–and true I’d say–at least for a while.

Stock Slips

Since the start of 2006, Whole Foods stock has been eroding, from a high of 77 to a recent low of 19. When Whole Foods reported its quarterly earnings last week, they were worse than Wall Street had hoped. Net earnings dropped 31%, the company suspended its dividend and its analysts realized the company’s growth, as measured by sales per square foot, might actually be negative for the rest of the year if the low end of company guidance is hit.

It’s obvious what the big problem is–the awful economy. Shoppers have changed their habits and retailers are trying to change with them. Now, when I walk through the door of my local Whole Foods here just outside of Boston, they are pushing “Mid-Summer Madness,” with deals on conventional produce. Last week, The New York Times reported that the Edgewater store is giving tours to help shoppers find bargains and make do with less. The problem is, I don’t need a tour to save money. I can go elsewhere. I’ll get less expensive hormone-free milk from humanely treated cows at Puleo’s, the local dairy. I get my vegetables from a community supported agriculture co-op, which pays local farmers to grow and deliver organic food each season.

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Great Company but not a Great Stock

Whole Foods is still a great company. It treats its employees well, paying them better than competitors and providing superior perks. A lot of research done in recent years shows that better-cared-for employees are much more productive and their companies are much more profitable as a result. The stores still do have a great cheese counter, and organic staples such as eggs and milk are priced better than most other places. Whole Foods can still get me to pay a premium–since it doesn’t carry items with artificial sweeteners, it’s good to know I don’t have to worry about high fructose corn syrup in my bread or how many rats got cancer from that additive I can’t pronounce.

But is it a great stock? No, I don’t think so. The long term chart is decidedly bearish and its price-to-earnings of 16 still looks high if Whole Foods turns out not to be a lifestyle juggernaut but is just another grocery store.

If those were the only issues, I could understand the argument to buy Whole Foods–it has after all done very well until lately, and its sales growth of 22% is still impressive. But, it looks like the issues go deeper. Since 2006, Whole Foods sat on its laurels and let the rest of the market catch up.

Its prices for organic produce may be the best around, as management claims, but the conventional produce that often is the bulk of a location’s offerings is priced well above what people can get elsewhere. And established grocers are boosting their stock of organic foods. Across the street from my local Whole Foods, the old established grocery chain Stop & Shop has a whole section of organic food and its own, pretty good, cheese department. Even Wal-Mart a few miles away sells its own organic grocery products.

Management Versus Media?

And often now, Whole Foods doesn’t seem as wholesome management-wise as they’d like you to believe. A recent NPR segment pointed out that a lot of those local farmer photographs blown up on the walls no longer represent the suppliers for their produce–instead they are trucking in over longer distances from larger suppliers. One farmer, the report noted, still sees his photo on the wall of his local Whole Foods even though the chain dropped him and other locals a couple of years ago.

When the chain stopped selling live lobsters, it couldn’t just admit it was losing money on the critters (it surely was). Instead it moralized about how lobsters aren’t treated humanely. But what about those live lobsters that the Whole Foods locations in Maine still sell and the frozen lobster meat it hawks everywhere else? Oh, well, I guess those lobsters are treated just fine.

Then there is founder, Chairman and CEO John Mackey. As you’ll recall, Mackey is the CEO who spent a considerable amount of effort during eight years touting Whole Foods and bashing competitor Wild Oats on stock chatboards. Not very smart, especially considering it appears many readers knew that he wasn’t just some yahoo on the Internet. It’s even less comforting that he is unrepentant to this day about his “bizarre and ill-advised” behavior, as one former SEC head described it. Even allowing that perhaps his chatboard postings were just a harmless peccadillo, his latest comments on Whole Foods performance gives me pause.

Those who listened to the earnings call last week got insight into what Mackey felt the company was doing wrong. What is that? Nothing. The company isn’t flagging because competitors are catching up with offerings or because it was really stupid to open a single, very expensive store in the United Kingdom or because it has become identified in the minds of consumers as expensive by consistently overpricing conventional produce.

Mackey blames the media. “We think we are misperceived. They invented that term ‘Whole Paycheck’ and they continue to repeat it,” Mackey told analysts. “So we’re endeavoring to educate our customers through our value tours, through our education and signage in the stores, through our merchandising, to make sure that our customers understand the compelling values that Whole Foods already has.”

I’ll still be going to Whole Foods because it’s a store I like that carries what I want, but that doesn’t mean it’s a good investment. Before investing in any of your favorite companies, make sure they don’t just have a good story, check to see that they are sound investments with good management and solid charts.

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Sincerely,

Brendan Coffey
For Cabot Wealth Advisory

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