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Peter Lynch is mistaken, so have a Krispy Kreme

Flipping through Peter Lynch's Beating the Street the other day, I came across this chestnut - Lynch calls it "Peter's Principle 14" - that made me shake my head:

"If you like the store, chances are you'll love the stock."

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I love the do-it-yourself ethos of the former Fidelity Magellan manager's books. They serve to say, "Yes, you too can be a stock-picker!" But this particular adage I'd sooner call "Peter's Mistake 14." The last thing you want to do is buy a stock just because you like the store.

Confusing a company with a stock is a common mistake. After all, Lynch's assertion makes some sense on paper. Store X is crowded and doing well; ergo, Store X must be a good investment.

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We beat up on Krispy Kreme Doughnut a lot, but I can't help doing so again now. It's a classic Lynchian company, with lines out the doors of most of its shops and hype surrounding every new opening. How could you go wrong here?

Peter's Principle 14 ignores a couple of extremely important things. The first is valuation. Chances are, if you like the store and bought the stock, lots of other folks have been thinking along the same lines - and bidding up the shares.

For Krispy Kreme, even if we assume a fairly rosy 25 percent annual revenue growth rate for the next five years and an increase in margins, we can't see the stock worth more than $28 based on the discounted value of its future cash flows. That's about 43 percent below where it's trading now. (Plus, the thought of paying 55 times forward earnings for a doughnut maker gives me a stomach ache.)

The second thing is the economic moat, or rather, lack of it. Most retailers simply don't have one. The only way a retailer can have a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'. It can do this by offering unique products or low prices.

The former method, which is Krispy Kreme's, is tough to do on a large scale because unique products don't remain unique forever. How long before somebody - Dunkin' Donuts? Starbucks - puts out an imitation of Krispy Kreme's doughnuts? It's rare to find a retailer that has any kind of economic moat for more than a few years.

There's a good reason that you don't see Warren Buffett buying too many retailing operations. (Ice-cream chain Dairy Queen and a few furniture and jewelry stores are notable exceptions.) In short, retailing stinks. When it comes to investing, be sure to look beyond where you shop. (With all due respect to Mr. Lynch.)


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