Peter Lynch, the gentleman that achieved 29% annual returns while running Fidelity’s Magellan Fund from 1977 through 1990, is famous for saying that you should never invest in any idea that you can’t illustrate with a crayon. A variation of this advice is that you should never own a business where it takes more than a few sentences to explain how the company turns a profit.
The highest-quality businesses can usually be explained quite simply.
Coca-Cola makes its profits by making syrup concentrates that allow them to make about $0.30 or so on every dollar once it is said and done.
Hershey sells chocolate in varying serving sizes in such a way that the company can achieve 16% total returns on assets.
Philip Morris International manufactures cigarettes for pennies per pack, and sells them for $5-$10 per pack.
Procter & Gamble sells household products like Tide Laundry Detergent, Gillette razors, and Duracell batteries. It has so many products that 398 out of every 400 American homes contain a product somewhere that is manufactured by P&G.
Pepsi sells soft drinks, snacks, and breakfast foods, leveraging a diversified stream of profits from soda, Quaker Oats, and Frito-Lay to create lasting profits even in the worst of recessions.
Colgate-Palmolive sells toothpaste and dish soap in a way that allows it to achieve 30% or so returns on equity, which explains why the company has been making dividend payments every year dating back to 1895.
Wal-Mart sells hundreds of billions of dollars of merchandise each year while collecting about 3% or so in net profit on each item after it is all said and done, and the high volume churn explains why the company is able to make such substantial profits for its shareholder owners.
McDonalds well franchise its hamburger joint out to individual managers, who have to pay substantial rent and a percentage of costs to the parent company. This allows the company to profit immensely from every fast food operation while limiting the downside associated with restaurants that do not perform well.
Now explain to me exactly how Citigroup and Linn Energy generate each dollar of profit. See what I mean?
Peter Lynch’s crayon test is a variation of Warren Buffett’s advice to know your circle of competence when it comes to investing, and always stay within that circle. Peter Lynch’s crayon test is a nice metaphor that allows you to refocus on owning companies that generate profits you can easily understand.
If you scroll through your current stock holdings, could you easily explain why you own each one of them?
I’m probably the dumbest investor out there. There are only one hundred or so companies out of 15,000+ whose profits I easily understand, and feel I can reasonably predict going forward. But sticking with the Johnson & Johnson’s and Nestle’s of the world is no confinement. They compound wealth just fine. Having a narrow circle of competence is no problem when you’re building. It’s the ability to honestly acknowledge what you do understand and do not understand that makes all the difference.
After all, if you do not understand how Gilead Sciences makes its profits, do you really think you’d be able to hold on if the stock fell 50?
On the other hand, Coca-Cola could fall to $20 per share, and I’d be able to walk through Wal-Mart and see the Coca-Cola flying off the shelves. I’d see the Coca-Cola trucks on the highway. I’d be able to read the financial reports about how the company has 500+ beverage brands making over $10 billion in annual profits in just about every country in the world. When you understand a company on that level, it is much easier to not only withstand substantial stock price declines, but treat them as the opportunities that they are to buy more.