A crucial part of Warren Buffett (Trades, Portfolio)'s investment strategy is his requirement to understand a business. To put it another way, he will only buy a stock if he can see how the company makes money and understand how the enterprise will grow and develop for the next five, 10 or 20 years.
Of course, no investor, even the Oracle of Omaha, can tell the future, so how does Buffett narrow down his opportunity set, decide if he understands a business and figure out what boxes he needs to tick to feel comfortable?
How to understand a business
One shareholder asked Buffett if he could say why he didn't understand or want to invest in the technology sector at the time. Buffett started his reply by saying, "We understand the product. We understand what it does for people." However, what the investor could not work out was the "economics of it 10 years from now."
He went on to explain that most people could understand all sorts of businesses, like homebuilding and steel, but the hard part was trying to "think where it's going to be in five or 10 years."
Buffett added that it is not really about understanding the product but the "predictability of the economics of the situation 10 years out." He said that is why he didn't want to deploy too much capital into the tech sector at the time.
Understanding the economics of any business is vital for investors. If one does not understand the company's economics and its sector, how can one be comfortable owning the stock? Buying something you do not understand is an easy way to lose money.
Buffett stated in 2001 that with "every business I look at, I think about its economics. It's built into me." He went on to add that he knew the co-founder of Intel (INTC, Financial), Bob Noyce, in the late 1960s, and when Noyce talked to him about the business, he thought about its economics. Buffett didn't invest in Intel when it was starting out because he couldn't figure out where the business would be in 10 or 20 years. But he went on to caution that he does not just "shut off the valve" when he's looking at these firms he does not understand.
"It's just that we don't get anyplace. We don't know what it'll look like," he went on to explain. "You know, there are a lot of things in life that, they're just beyond comprehension for many of us," the Oracle concluded.
An insight into the process
While these comments are over two decades old, they do give us some insight into Buffett's way of thinking. When the Oracle is looking for companies he understands, he is looking for businesses where he understands the economics well enough to predict cash flows out for the next decade or so. That is why he tends to stay away from cyclical companies and focuses on firms that have durable competitive advantages.
There are some companies and sectors with inferior economics. The steel industry is a good example. It's easy to understand how a steel producer makes money, but it is harder to understand the factors that will allow it to keep making money in all environments. The same can be said for the shipping sector and many companies in the technology sector.
For example, it is easy to understand how cloud computing companies make money, but in this commoditized industry, is it possible to say with certainty that a company will still be making the same level of profit 10 years out? That is the difference between understanding a business and understanding an investment opportunity.