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Investing: Buy What You Know

April 09, 2007 | About:
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Eric Schleien

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With almost ten thousand publicly traded companies in the United States, investors have an overwhelming and daunting task of cherry picking the best investments. While a person can use online screeners to find investment ideas, chances are the average investor will be more than overwhelmed with the amount of companies he or she comes up with. A better idea would be to sit down and write a list of sectors and industries you understand. It is unwise and purely speculative to invest in something you don't understand. Ask any investment guru like Warren Buffett, Monish Pabrai, or Seth Klarman and they will tell you the same thing; if you don't understand a company’s operations it is not even worth your time. This is what Warren Buffett calls the “circle of competence”.

In Seth Klarman's book Margin of Safety, he preaches to readers about taking as little as risk as possible. While you may be right 90% of the time, the 10% you are wrong can destroy an investment track record. Klarman shows that being up ten years straight with a portfolio yielding 16% a year is better than a portfolio yielding 19% a year for nine years and being down 20% the tenth year. By making sure you are right almost every time will allow you to achieve better investment results.

A perfect example is the sub prime mortgage business which now seems to be in freefall. At one time this business was highly regarded by analysts and investment banks. If the average investor had listened to the analysts speaking highly of the sector, one may be very tempted to buy shares of a sub prime mortgage lender. Chances are, most investors don’t know how a complicated industry such as the sub prime mortgage industry works. While people were buying what they thought were great businesses a few years ago now have lost much of their investment.

A coin collector I was talking to recently told me he was buying shares of gold companies in 1999 when everyone was saying how gold as well as every other commodity was a bad investment. This coin collector told me that he understood the business as he sold gold coins for a living. He was able to observe that the price to get gold out of the ground was more expensive than the actual gold itself. By understanding the gold sector he was able to get in early on the commodity bull market because he could foresee a commodity shortage causing a large supply and demand imbalance in the years ahead.

There are many companies that may appear cheap by current financial metrics such as price to earnings and price to sales. These financial ratios can only go so far. If you don't understand why a companies Return on Equity decreased or increased or why profit margins are so low, then it is not worth investing in that industry.

Wal-Mart is a perfect example of a great company in Warren Buffett's portfolio. Wal-Mart currently has very low profit margins and they will never get any higher. But low profit margins at Wal-Mart surely don’t mean Wal-Mart is a bad business. In fact, it is quite a wonderful business. If one understood Wal-Mart's business model they would realize that because Wal-Mart is a low cost producer of goods, they can afford to sell everything cheaper than every other business out there. That is their economic moat as Buffett likes to call it. They have a business model that can't be touched. Low profit margins are a way of generating boat loads of revenue year after year.

This idea of understanding a business can be applied to Coca-Cola (KO). If one understood the business nature of Coca-Cola, one would be able to know that every year more and more people drink Coca-Cola. As the population grows exponentially, Coca-Cola's net income will follow. The logic behind this is that if every person drinks x amount of Coca-Cola a year, then the more people alive, the more Coca-Cola drinkers there are.

Let's say company XYZ Inc. is making vaccines for Cancer. To understand this business, one has to know the regulatory environment, understand the laws of healthcare, understand the medical industry, and probably have to be a doctor to have some judgment of whether this company would succeed. While company XYZ Inc. may make you a fortune, it could also do the opposite and put you in the poor house. That is why so many great guru investors stress that you buy what you know.

It is foolish in my opinion to buy a company's stock just because your favorite investor bought that stock. Monish Pabrai currently owns shares of Pinnacle Airlines (PNCL). There are many factors in understanding the airline industry. That's not saying it is impossible, certainly Monish Pabrai does but there is a chance that you reading this article may not. If you didn't understand Pinnacle's business my advice, and I rarely give financial advice, would be to stay away from the business no matter how good of an opportunity it appeared to be.

"Stay within your circle of competence." Much of Mr. Buffett's success has stemmed from his disciplined focus on investing in businesses that he understands and avoiding those that he doesn't. This is the first thing we need to learn from him.

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About the author:

Eric Schleien
GuruFocus - Stock Picks and Market Insight of Gurus

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