Buy Only What You Really Know

In his books and speeches, legendary former Fidelity mutual fund manager Peter Lynch advises investors to "buy what you know" by looking for investment ideas during daily life--among the malls, restaurants, and other businesses you frequent, for example. After all, the logic goes, if you appreciate a service or visit a store that always seems crowded, there's a good chance others will too, and your observation could uncover an investment opportunity.

Unfortunately, in their zeal to uncover new ideas, many investors apparently didn't heed the latter parts of Lynch's message when he discusses the need to consider not just sales and growth, but also a company's business model and its overall financial performance (growth, profits, cash flows, debt levels, etc.) before investing. History has proven that for some prudent investors, "buying what they knew" could have uncovered blockbusters such as  Home Depot (HD) or  Starbucks (SBUX), while other less-discriminating stock-pickers might have just as easily ended up with one-time wonders like  Krispy Kreme  or Boston Chicken, whose stock soared 400% from its IPO before collapsing into bankruptcy five years later, where it was acquired by  McDonald's (MCD) at a fraction of its former price.

At Morningstar, we believe observing the world you inhabit is a great starting point for uncovering smart investments. Warren Buffett has described this as investing in your "circle of competence." Once you've uncovered a potential idea--a growing retail chain or an always-busy restaurant--it's time to look into the details and start asking questions. For example: Do booming sales translate into growing operating profits and cash flows? What kind of profit margins does the company generate? Is the company increasing same-store sales or is all the growth coming from new store openings or acquisitions? How much debt does the company carry? Will it need additional financing to expand? What's management's background? Does the company have an economic moat? What is the basis for the company's moat? Using questions like these as a starting point, you'll begin to understand whether your idea will turn out to be a long-term winner like Starbucks or a fallen angel such as the now-defunct KB Toys. Morningstar retail analyst Anthony Chukumba took a deeper look at many of these questions in a June 2005 article, which you can read by clicking here.

In this edition of Stock Strategist, we decided to screen for some high-quality companies that you might know. We began by looking within the consumer goods and services sector of our coverage universe, which includes retailers, restaurants, and a wide range of other consumer-oriented companies. Next, we looked for companies that have grown revenues and operating income over the past few years. Then we added criteria for financial health, since excessive debt used to fuel expansion has led to the demise of many promising retailers over the years. Finally, since competition for consumer dollars is tough, we looked for companies with economic moats that provide a competitive advantage.

Not all of the stocks that pass the screen are cheap enough to be compelling right now, like fast-growing  Whole Foods . It meets all of our criteria, but currently trades near our estimate of its fair value, so it's worth keeping an eye on this list. Many of these stocks can experience wide price swings in response to short-term sales and earnings data. Since the fundamental investment thesis often remains unchanged despite the short-term bumps, the volatility can provide a buying opportunity for long-term investors.

As a caveat, most of these companies rely on consumer spending for growth. Any economic event that hurts consumers, whether it's slow job growth, high-gas prices, or the collapse of housing values, could hurt these stocks. Nonetheless, our screen is designed to find high-quality companies with the long-term potential to weather the economy's ups and downs. Here are a few of the highlights:

Blue Nile 
Morningstar Rating: 4 Stars
Economic Moat: Narrow
Blue Nile has emerged from the Internet-mania's rubble to become a force in online jewelry retailing. From the  Analyst Report: "This purveyor of gems, known for its customized engagement rings, is shaking up the diamond industry with its exclusive agreements to sell select diamond manufacturers' stones online. While the online diamond jewelry market is nascent, we think Blue Nile has developed an extremely solid position and will continue to expand its share."

CarMax (KMX)
Morningstar Rating: 5 Stars
Economic Moat: Narrow
From the  Analyst Report: "Although demand for used cars is considered mature, CarMax is expanding geographically and gaining market share. We like the company's long-term growth prospects. Since its formation in 1993 as a unit of Circuit City Stores, CarMax has been replacing the high-pressure sales tactics, backroom deals, and other questionable business practices common to the used-car industry with bright showrooms, a professional staff, and straightforward "no-haggle" pricing. Car buyers seem to love the concept, and CarMax has become North America's largest used-car retailer with sales and profits growing about 20% annually over the past five years."

Petsmart  
Morningstar Rating: 5 Stars
Economic Moat: Narrow
Petsmart's second-quarter financial results disappointed Wall Street, but we think the company has excellent long-term potential. From the  Analyst Report: "Petsmart has excellent prospects, supported by very favorable long-term demographics, including increased pet ownership among empty nesters and young professionals, who are delaying starting families. The company's superstores continue to be the most productive in the industry and its fast-growing pet services differentiate it from much of its competition."

Tempur-Pedic International (TPX)
Morningstar Rating: 5 Stars
Economic Moat: Narrow
From the  Analyst Report: "Tempur-Pedic has built a narrow economic moat through its proprietary products, brand recognition, and established relationships with mattress and bedding retailers, as evidenced by its industry-leading profit margins and returns on invested capital well in excess of its cost of capital. Tempur-Pedic has several additional avenues available for future growth, including introducing new products and gaining more floor space in stores its items are already in, increasing sales to health-care providers (where its products have been shown to prevent and treat bedsores) and further expanding its international sales."

Wal-Mart (WMT)
Morningstar Rating: 5 Stars
Economic Moat: Wide
High energy prices and disruptions from Hurricane Katrina could hurt Wal-Mart in the short run, but the long-term prospects for the world's largest retailer remain attractive. From the  Analyst Report: "Many retailers have managed to maintain or expand their niches in the retail world in the face of Wal-Mart's expansion, but Wal-Mart remains the dominant force in U.S. retailing, and it's growing more formidable by the year. The company continues to steamroll department stores, smaller discount chains, specialty retailers, and, most recently, grocers. Wal-Mart's scale provides massive amounts of operating leverage, and its enormous share of the U.S. retail market gives the company unprecedented leverage over its suppliers. These are the sources of the firm's wide economic moat."

To run this screen and see all the stocks that pass, click  here. Note: The stocks mentioned above passed our screen as of Sept. 9, 2005. The results may change due to daily price fluctuations or other factors. After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (You will need to be logged in as a Premium Member to view and save the complete screen.)