Warren Buffett (Trades, Portfolio) frequently says that he will not invest in a company that he does not understand. This is a relatively easy comment to understand on the face of it, but there's much more behind this statement than it initially gets across.
As is the case with many of the Oracle of Omaha's comments, we should not take this in isolation. Not understanding a business and not wanting to invest in a business are two very different things. I understand many businesses but don't want to invest in them for different reasons, whether it be too much debt or a mistrust of management. It's possible to understand how a business operates but not understand its risks.
Not understanding how a company makes money is another way to not understand a business. One can understand how a company makes money and still not entirely understand how the business operates.
Understanding a company's outlook
At the 2000 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual shareholder meeting, Buffett explained what he meant when he said he did not understand a business and why he avoids some companies and not others in the same sector.
Buffett explained to the audience that he would often look at a company and understand the product, but he would find it difficult to understand where the business will be in a decade.
This is the overriding challenge investors have to overcome. Understanding how a company will grow and develop over the next five or 10 years is incredibly challenging. When looking at many businesses, it is just too difficult.
"You can understand all kinds [for businesses] you can understand steel. You can understand home building. But if you look at a home builder and try and think where it's going to be in five or 10 years, the economics of it, that's another question. I mean, it's not a question of understanding the product they turn out or the means they use to distribute it, all of those sort of things. It's the predictability of the economics of the situation 10 years out. And that's our problem."
At the time, Buffett was responding to an audience member who was asking the Oracle for his views on technology stocks and why he hadn't made any investments in the sector.
We can look back now with the benefit of hindsight. In 2000, it looked as if the internet would revolutionize the world, and companies all over the place were springing up to take advantage of this. Although the market is more developed, investors face a similar situation today.
Some of these companies that were making headlines in 2000 did go on to change the world, but the odds were stacked against investors. Picking Google (GOOG) and Amazon (AMZN) out of the thousands of different businesses that popped up not only required a considerable amount of conviction, but luck as well.
In 2000, Buffett accentuated his point by stating that he had had conversations with his close friend Bill Gates (Trades, Portfolio), and then CEO of Intel (INTC), and they "would not want to put down on paper their predictions about where 10 companies you would choose in the tech field would be in 10 years."
I think this is an important point. It is easy to look back with hindsight and say which companies changed the world, but it's far harder to find these enterprises before they change the world. If Gates could not pick out which companies would succeed in 2000, the average investor stood no chance.
Investors face precisely the same change today, whether it be technology stocks or steel stocks. If one does not know the company and market, one may find it very hard to predict future growth over the next decade.
Even if one does understand the company and market, one may still find it difficult to predict future growth. In this situation, there is no shame in avoiding the company. No one ever got rich buying something they didn't understand, unless it was by sheer dumb luck.
