Invest In What You Understand

There are tons of companies out there. Some of them sell candy, while others sell the most advanced technological devices ever constructed by humankind. Other ones sell complex services with a hard-to-grasp and possibly uncharted business model. In order to be successful investors, we must acknowledge that there are some types of companies that we understand, and some that we do not, and then we must only invest in what we understand. Investing in dividend stocks we don’t really grasp is speculation.

Warren Buffett is a prime example of this. The man made his fortune investing in things like banks, oil, food, car insurance, soda, and razors. You don’t have to predict the next multi-billion-dollar tech ascension to perform well with your investments. Instead, you just have to identify well-run, growing companies with reasonable valuations that you understand. You need to understand the business model and the various risks and opportunities that the company has, as well as the financial side of their business. If you can do that, you can make educated predictions derived from quantitative facts and qualitative opinions about the company.

So sometimes I’m curious why I see people that don’t know much about a given industry investing in that industry. I’m not saying we all have to be gurus of a variety of industries, but we do need to understand the businesses at least. Few people understand how Intel makes what they make. Few people can predict in exactly what form cloud computing is going to take off, and who is going to prosper from it the most. Few people grasp new and risky medical companies or high-flying tech upstarts. Before investing in these companies, make sure you really “get” them and be honest with yourself.

Sure, there are some blue-chip companies that have some complex products. They’re also diverse and mature, though. They have a steadier place in the economy and offer a variety of products and services of various levels of complexity, and often wield huge patent shields. But many other companies don’t have those luxuries, and to invest in companies that you don’t have an understanding of boosts your risks.

I’ll use myself as an example, so take a look at my portfolio. You’ll find companies that make cooking appliances, blue-chip dividend-paying healthcare companies, infrastructure companies, food companies, insurance companies, consumer products companies, and one mature technical conglomerate. My primary profession is that of an engineer, and yet you don’t see a collection of fancy tech companies. Why? Because I find it difficult to gauge the viability of a tech company 5 years down the line, which is my minimum investing horizon. Sure, I have a fair technical understanding, but that doesn’t mean I can accurately predict which technology is going to catch on, what clutch patents are currently held, and how industry trends will favor one tech upstart over another. Technology moves at a rapid rate, and companies can become threatened or obsolete very quickly. On the other hand, things like peanut butter and jelly, gas pipelines, shaving cream, property insurance, and baby powder aren’t going anywhere anytime soon.

This is more relevant now than ever. I don’t know about you, but I’m becoming increasingly interested in the low valuations of some tech companies like Intel, Microsoft, and Texas Instruments, which I’ve been following for quite a while. If investors decide to invest in tech, make sure you really do your homework, and for the most part try to spread out your risk and focus on shareholder-friendly, value-priced, mature businesses.

Banks are another example. The fact that so many bank investors had their dividends cut and fortunes lost is a testament to how little most people truly know. Many economists and professional portfolio managers totally missed the signs of a collapse. The trillions of dollars of derivatives on huge bank balance sheets hidden behind obscure accounting standards were just too much for most people to grasp. Conservative banks make more reasonable investments than others, but make sure you do your homework.

If you’re an expert in a given industry, then leverage that to your advantage. If not, stick to what you know and what is straightforward. Constantly expand your knowledge, but be realistic with your investment choices by identifying what you do and do not know. Investing is never easy, and every company has complex elements to it, but it helps to at least stack the deck in your favor by focusing on companies that you feel you can realistically grasp.

McDonald’s (MCD) Stock
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Comments

  1. Excellent point and excellent post!

    Thats why I like investing in the bigger dividend paying blue chip companies now because you know more about the industry than just the stock ticker!

  2. This is very true, if you put your money in something you don’t understand then you are just asking to lose. However, when you say “if you’re an expert in a given industry then leverage that to your advantage” I think we should be careful to realize that even if you are an expert in oil and gas, you can’t own only oil and gas. Keeping your stock positions diversified is one of the most important aspects of investing. If you don’t understand something then we as investors need to take the time to learn.

  3. Young and thrifty,

    Thanks for the comment- there are certainly some excellent blue chip dividend investments out there. Some of them are even selling for pretty low valuations at the moment.

    Money Man,

    I agree that diversification is important. Even people with a focus towards a specific sector should have holdings in other sectors.

  4. Great post!

    One of my rules of investing is, don’t invest in anything you couldn’t explain to a 10-year old. I too, try to keep within my circle of competence.

    Cheers!

  5. That’s a useful rule. For the most part it’s a great piece of advice. Some of the best investments over the last several decades have been exceedingly simple companies.

  6. Hey guys- I’m going to play the devil’s advocate on this one. First off I think it’s possible to feel strongly that an area is going to take off and yet not understand a whole lot about it-example: biotech. The way to play it is to buy a fund of companies and that way you’re not picking a specific company. I would say the same with respect to technology.
    I know this isn’t Buffett’s way Buffett is special.
    Secondly, for any company there can be things going on that the investor doesn’t know about. Banking is a prime example. Banks were doing great a few years ago, at least on the surface. And they seemed to be pretty easy to understand. What wasn’t seen was what was going on off balance sheet with all the CDOs etc. Thus, many looked at banking and felt they understood it and got clobbered!
    As always, the key is to buy at reasonable valuations and diversify. At least that’s my take.

  7. Hi DIY Investor,

    Thanks for the comment; it’s good to have discussion on this sort of thing.

    I agree that spreading risk among multiple companies is a respectable strategy if someone is bullish on a given sector. For example, the healthcare sector has fairly low valuations at the moment (some due to patent cliffs and some due to economic/regulatory uncertainty and a host of other reasons), so I’ve been buying up several healthcare companies. Each of them carries a lot of complexity, but as a whole, I like the sector and I like their financial situation and products of each of the companies I’ve invested in and plan to invest in.

    And I agree that even a seemingly straightforward company can carry unseen risk. There are plenty of simple businesses that can carry risk simply due to the risk that what it appears to be is not what it really is, so now matter how well one thinks they understand a business, they can always be mistaken.

    I do feel that investors should be able to thoroughly describe the reasons they’ve chosen to invest in a given area. If it’s a given company, they should have a solid grasp of the financial situation of that company and an idea for where that company is going. If it’s a fund of companies, I urge investors to know several of the names and current valuations of companies in that fund to ensure that they are buying a collection of reasonable investments.

  8. I agree that understanding what you invest in is important. And I admire Buffett. My reading of him has gotten me to pay a lot of attention to the business going on around me and he is right – there are a lot of really great, straightforward businesses right under our noses.
    In fact, I’m trying to find out who makes soft drink dispensing machines. In the U.S. most fast food places hand you a soft drink cup and you go over and get your own drink. The machine that dispenses the drink is the same in most of the places. It’s got to bring in a lot of revenue. I just wonder about the economics (are they leased, bought outright?) of it. Couldn’t find anything on line all though I haven’t tried very hard…Anyways…just a long winded example of an opportunity that may be right under our noses.

  9. That’s an interesting opportunity. Simple, predictable, cash-flow generating, “boring” opportunities tend to be very lucrative.

    Thanks for the comment contribution, and I hope to see more from time to time.

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