I have a confession to make: I am a stalker. Yep, there you have it. I stalk people, in particular investing gurus. Well, to be fair, I don't stalk the gurus in person. I just follow their investing closely, very closely. One of my favorite is investing legend, Peter Lynch.

Peter Lynch ran the Magellan mutual fund at Fidelity between 1978 to 1990. Under his management, the fund grew an average of 29% a year. Interestingly, he managed to do this investing in what some would consider high risk stocks. These seemingly high risk stocks once traded at prices so low investors would avoid them at all costs. However, these are what turned out to be Peter Lynch's multi-baggers.

Peter Likes Pennies
So how do I stalk Peter Lynch? Through the friendly EDGAR of course. A quick search in EDGAR reveals some very interesting investing strategies Peter is using. Scanning his most recent holdings, I found that Peter (Like how I'm already on a first name basis with him?) favors penny stocks. Penny stocks are stocks that trade under $5 a share.

Some of Peter's recent penny stock acquisitions include Abraxas Petroleum (AMEX: ABP) at $4.55/share, Segmentz (AMEX: SZI) at $0.56/share, World Quest Networks (NasdaqNM: WQNI) at $1.34/share and Hartville Group (OTC BB: HTVL.OB) at $0.40/share.

Why Penny Stocks?
Like most stalkers, I only watch from a distance. Obviously, I have never spoken to the man himself. So what I'm about to say is pure speculation.

I think Peter loves penny stocks because he's poor and can't afford anything more penny stocks are usually volatile. High volatility could mean high risk or high reward. Before you stone me to death for saying that, let me clarify.

True, risk is determined by a multitude of factors. To name a couple:

How much you know
The more you know the smaller the risk.

How big is your margin of safety
The bigger your margin for error the smaller the risk.

Reward, most of the time, runs hand-in-hand with risk. The higher the risk the higher the reward. Think bonds versus stocks. So how does high volatility translate to high risk and thus high reward? First, let's define volatility. The FASB defines volatility as follows:

A measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Volatility also may be defined as a probability-weighted measure of the dispersion of returns about the mean. The volatility of a share price is the standard deviation of the continuously compounded rates of return on the share over a specified period. That is the same as the standard deviation of the differences in the natural logarithms of the stock prices plus dividends, if any, over the period. The higher the volatility, the more the returns on the shares can be expected to vary - up or down. Volatility is typically expressed in annualized terms. [Statement 123R Glossary]

As you can see from the second last sentence, the higher the volatility the greater the return up or down. Why are penny stocks volatile? Simple. Let's examine one of Peter's buys, Segmentz (AMEX: SZI). Segmentz last traded at $0.56/share. A one penny drop in the price results in a 1.75% drop! Compare that to say Berkshire Hathaway (NYSE: BRKa) where a $100/share drop results in a meager 0.12% fall. Clearly, penny stocks are not for the faint-hearted.

Of course, the opposite is true about penny stocks as well: a small increase in the price results in a huge increase in the return. So if you purchased $10,000 worth of stock at $0.50/share and the share rose $0.10/share, you'd be making a 20% return ($2,000). And the beauty of penny stocks is this could easily happen in a day.

So Why Not Invest Like Peter Lynch?
You must think I'm crazy to advise people not to invest like Peter Lynch. I'm young and can probably survive penny stocks volatility. When I examine the stocks that Peter bought, I could not, for the life of me, understand why he bought the stocks in the first place.

Take Rainmaker Systems (NasdaqSC: RMKR) as an example. The stock was trading at $0.65/share. Yesterday's after-hour trading kicked the stock up almost 12%.

A closer look at Rainmaker did not give me any indication that the company is even worth buying. Rainmaker provides sales and marketing programs for service contracts. They have been losing more and more money every quarter since March 2004. Their balance sheet is deteriorating like nobody's business. Sales dropped almost 40% in the most recent quarter.

There are only two good things I observed about Rainmaker:

1) The stock price is down almost 44% for the last 52 weeks. This could mean it's a could buy opportunity. But who knows if it's going to plummet further into the abyss and never return.

2) Insiders have been on a buying spree in June 2005. When you see insiders buying like crazy, you know they know something that you don't know. They expect the price to shoot up soon if not later. Perhaps this is the only thing that Peter Lynch is relying upon.

Not My Cup of Tea
Whatever Peter based his judgement on, I just can't put my finger on it. Making a 20% return in a day is very tempting. But I'm not so sure about losing 100% of my investments just because I tried to invest like Peter Lynch. I'll leave the magic tricks up to the master while I stick with my simple, slow and hopefully steady growth stocks.

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