Peter Lynch called it the "amateur's edge," the ability of nonprofessional investors to outperform Wall Street professionals because (1) they invested in what they knew; and (2) they weren't blinded by Wall Street conventions. This is how Lynch and John Rothchild begin the chapter in the classic
on how to find a 10-bagger, a stock that will go up 10 times while you own it: "The best place to begin looking for the 10-bagger is close to home -- if not in the back yard, then down at the shopping mall, and especially wherever you happen to work." I think that's still great advice for the individual investor. But I think it needs a bit of a tweak to fit current conditions. Lynch was writing in the midst of a fast-growth economy that produced a massive explosion in creativity in the consumer sector of the economy. Companies like Wal-Mart Stores ( WMT) and Dell ( DELL) were inventing new ways of doing business. Start-ups like Starbucks ( SBUX) and Whole Foods Market ( WFMI) created new market niches, then took them into the consumer mainstream. The amateur investor with an ear to the ground could identify these new businesses early enough to get in at the first stages of opportunity. One Up On Wall Street
A Different WorldThings are quite different now. Growth is tepid at 1.6% in the first quarter and at a projected 2.5% or less for the entire year. The creativity that characterized the earlier period has given way to consolidation and extension, as the Dells and Starbucks and the like build on their earlier momentum. That doesn't mean the current consumer sector isn't going through big changes now -- and won't go through even bigger changes in the years ahead. But if the current period of below-average growth turns out to be an extended one -- and I think there's a good chance it will -- the consumer sector won't be characterized by companies exploiting new demand, but rather by companies trying to take advantage of what I call substitution.
Substitution in the current economy takes place whenever any consumer decides to buy one product in place of another because:
- He wants to save money. He wants to maintain as much of the psychological pleasure of buying the higher-priced product as possible.
The Substitution SolutionSubstitution can take place at any price point. At the upper end, a wine lover decides not to spend an extra $20 or $30 on a bottle of red wine with a rave rating from one of the wine magazines because an $18 no-name red is just as satisfying. That's substitution. Further down the price scale, deciding to buy a new pair of earrings to freshen up a familiar outfit rather than buying an entirely new ensemble is substitution. Substitution doesn't mean denial. Far from it. After all, the consumer is still buying something. But the change in what's being bought is enough to throw a consumer sector into turmoil. When consumers substitute one product for another (store-brand crackers for, say, Wheat Thins), new winners emerge, and some companies inevitably lose. Remember that substitution is close to a zero-sum game. Companies positioned by luck or skill to catch the direction of a substitution can ride the trend a long way -- sometimes all the way to permanent gains in market share. Companies with competitive advantages such as flexible pricing, lean inventories and just-in-time marketing gain an even bigger edge during a substitution economy.
The Amateur's EdgeGoing back to Peter Lynch's original point, amateur investors do have an edge in separating the substitution winners from the losers. Your own reaction to the complexities of psychological value in this economy may well be the best place to start looking for attractive stocks. And that's a significant edge as investors try to figure out where the current economy and stock market might be headed. (I concede it's dangerous to generalize from your own individual behavior to that of consumers as a whole.)
Here are my own four very personal substitution stocks. Use them to jump-start your own thinking about how substitution is changing the consumer sector -- and the lineup of winners and losers.
Claire's StoresThe largest retailer of teen-oriented fashion accessories in the world (items are typically priced at $2 to $20), Claire's Stores ( CLE) is a classic substitution play. When the economy gets tight and consumers look to pull in a little, previous economic slowdowns tell us that they're likely to substitute small, feel-good buys for more expensive, big-ticket purchases. Wall Street projects that Claire's earnings per share will climb 17% in the fiscal year that ends in January 2004 and 12% in fiscal 2005. If history follows form, the substitution effect should give those projections plenty of protection, even if the economy continues on its current slow-growth path. The stock now trades at just 14 times projected fiscal 2004 earnings and at just 1.2 times trailing 12-month sales, a 10% discount to the price-to-sales ratio for the S&P 500 as a whole.
Ritchie Brothers AuctioneersOne strength of the idea of substitution is that it takes account of our desire to shop. In the early 21st century, shopping is one of the major leisure time activities of the average U.S. consumer. But consumers aren't the only ones looking for value in this economy and willing to go outside traditional purchasing channels to do so. Ritchie Brothers Auctioneers ( RBA), based in Richmond, British Columbia, hits that same value sweet spot -- but for the corporate purchaser of agricultural, construction, forestry, mining and transportation equipment. Wall Street projects the company's earnings per share will climb 20% this year and 9% in 2004. That latter number is likely to be low if the economy continues to grow slowly. In that environment, corporate buyers will look for ways to find equipment at a discount and a slow-growth economy will give Ritchie Brothers Auctioneers lots to sell. The stock trades at 19 times projected 2003 earnings per share.
GameStopGameStop ( GME) is the new brand name for a computer and video-game retailer that combines the former Babbage's, FuncoLand and Software Etc. chains. What makes GameStop an interesting substitution play for me is its rank as the No. 1 seller of used games. Of the company's 1,200-plus stores, the 45% in malls focus on impulse buyers looking for new games. The other 55%, located in strip shopping centers and other locations, target value-buyers and hardcore gamers looking for new game titles at value prices. And that often means used.
Before you turn up your nose at the idea of buying a retailer of used games, consider this: Used games sell for a higher profit margin than new games. That has helped GameStop increase operating profit by 2.4 percentage points in the fiscal year that ended in January 2003. Thanks to its 1996 bankruptcy reorganization, the company carries almost no debt and showed $3 a share in cash at the end of 2002. Cash flow is positive, and the company is buying back shares. In the conference call after its May 21 earnings report, the company projected earnings per share of $1.03 to $1.06 for the fiscal year that ends in January 2004.