“Never invest in any idea you can’t illustrate with a crayon.” — Peter Lynch, Beating the Street

If you want to outperform 99% of all mutual fund managers, you need to start thinking like a seventh-grader. That is the message Peter Lynch conveys in the first chapter of his bestselling book, Beating the Street.

In 1991, the long time Magellan Fund manager received a package in the mail from Joan Morrissey’s seventh grade social studies class at St. Agnes School in Arlington, Mass. It was a scrapbook filled with a model portfolio the kids put together as part of a class assignment on investing. And it was complete with company descriptions, pictures of the products and reasons to own each stock.

A student of the market herself, Ms. Morrissey wanted to prove to Lynch and the world that you do not need an Ivy-League education and a fat money clip to beat the market every year. So she taught her 12- and 13-year-old kids how to invest for themselves.

She had the students read Investor’s Business Daily every day to identify companies with solid earnings, relative strength and healthy dividends. That was their crash course in equities analysis. From there, Morrissey divided her class into teams of four and gave them a “pot” of $250,000 to invest with.

The energetic teacher urged her students to use the play money to buy at least 10 stocks — to spread out the risk. And she made only one hard-and-fast rule…

Before they could add any stock to their portfolio, they had to be able to explain exactly what the company did and understand the service or product the company provided. If they couldn’t do that, they couldn’t invest in the company.

With that guideline in place, Morrissey’s students got to work. They did their own due diligence and made their selections. Some of the more popular companies the kids chose were: Disney, Nike, L.A. Gear, The Gap, PepsiCo., Topps, Wal-Mart, Food Lion and Pentech Int.

The kids knew all of these companies well. And they could easily explain what their products were.

Pentech made colored pens and markers with highlighters on the other side. And nearly everyone in Ms. Morrissey’s class used Pentech markers. So it was a natural addition to the portfolio.

Topps made baseball cards. And back in 1990, trading baseball cards was as popular as reality video games are today.

Food Lion was a grocery store the kids knew about. After doing a little bit of homework, they discovered it was a well-run business with a high return on equity. Plus, they saw a video on the company and learned that a $1,000 investment in Food Lion in 1957 was worth $14 million in 1990!

Here is a look at the sample portfolio Ms. Morrissey’s class put together:

These stocks — chosen completely by 12 and 13-year-olds — rose 70% in 1990. Their portfolio outperformed 99% of all stock mutual funds run by Harvard grads with fancy cars, real time quotes and traders on the floors of the major exchanges. And it absolutely annihilated the S&P 500 — beating it by more than two-fold.

Ms. Morrissey and her students proved what they set out to prove: You really don’t need an IQ of 200, an MBA or fancy real time software to do well on Wall Street. All it takes is a combination of research and simple common sense. And if you are willing to put in the time to invest in individual companies that you can actually understand, you have a pretty good chance of beating the Street.

Unfortunately, most people aren’t as smart as Ms. Morrissey’s seventh graders.

Instead of doing their own research, amateur investors listen to hot stock tips from their Uncle Harry. Or they read about an up-and-coming company in a trade magazine and go all in. Inevitably, what happens? They lose out.

According to Lynch, amateurs can’t accept losing positions. “It’s human nature to keep doing something as long as it’s pleasurable and you can succeed at it, which is why the world population continues to increase at a rapid rate.” So to make sure they don’t lose, people simply fork over their money to the mutual fund managers. After all, they are smart.

The problem with that strategy is 75% of all mutual funds fail to perform as well as the stock market averages. Why?

Fund managers are just as scared as you. In order to avoid looking stupid, most money managers do not invest in small-cap companies like we feature in Penny Stock Fortunes — the kinds of companies that can outperform the market but are also far more volatile than Microsoft or GE.

So essentially, they limit themselves to investing in a group of large-cap stocks that simply mirrors the S&P 500, the Nasdaq or the Dow Jones. And after they take their fees, you are left with a portfolio that lags the overall market.

Doesn’t seem fair.

You work hard every day, save your money, give it to a Harvard-educated MBA and at the end of the year, you are beaten by an index — and a group of seventh graders!

Come on, Sleuthers. You are smarter than the average amateur investor. You don’t need some seven-figure fund manager to tell you how to invest. Right? So prove it.

I’m issuing a challenge.

You have $250,000 of play money to invest in between 10-15 stocks of your choosing. The only rules are you must be able to explain each business in one clear sentence. And you must understand exactly what the product or service is. If you can’t do those two things, you can’t include the stock in your portfolio.

After you have made your selections, put together a list of your favorite stocks. Tell me how many shares of each you recommend buying — and at what price. E-mail me your entries by May 31. And the person with the best portfolio after three, six and 12 months will each win a free membership to my new Small-Cap Insider.

What do you think? Can you beat the market? Or better yet, can you beat Ms. Morrissey’s seventh grade class?

E-mail your model portfolio to thesleuth@agorafinancial.com. I will publish the best portfolios in upcoming Sleuth alerts. So don’t be surprised if you see your name mentioned.

Good luck,

James
April 27, 2006

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