Investing in What You Understand

Sounds simple doesn’t it?  Only put your hard earned money into investments the companies of the products that you use.  If understanding what you are investing in was as simple as knowing that the chocolate the company makes is what everyone likes then it would be easy to invest.  Unfortunately, there usually is more beyond the product and service that the business you would like to invest in does. Many make the mistake of thinking because they use a companies product that they know the business. This type of thinking can be dangerous. There are the elements of how well the business is run, such as how do they employ their excess cash, or what portion of the businesses revenues come from the products that you know, and is their leader good at growing the business and keeping them on track, and is their competition on their heals, or do they have a patent on their product, or would it be erroneously expensive to duplicate their information base, locations, or manufacturing.  A lot of elements play into investing into what you understand. Here are a few of the basics to start with when investigating the company you are interested in.

In my opinion, the most important element is understanding their business product or service and what differentiates them from their competition.  This would be things like knowing they make incredible chocolate, or great coffee, or have systems and information that no one else has, or that their product has a secret formula that can’t ever be reproduced, or they have locations all over the world.  This element is “what they use or sell to surpass their competition.” Understanding exactly how much dominance this element of their business has with consumers is critical. A great example of this is Coca-Cola and their secret formula that can’t be duplicated, and that formula soft drink is enjoyed world wide.  Amazon’s dominance in the digital retail world is another example. It would be extremely expensive to duplicate Amazon’s business. Starbucks multi-location coffee stands would be another example. All of these examples have the commonality of a product that is protected, a service or system that would be incredibly expensive to duplicate, or multiple locations that would be expensive to set up.  There are many ways a business can dominate their industry beyond the examples I’ve provided. When this type of dominance becomes huge and it creates a large moat around the business that competitors can’t touch this is where you want to start your search for investments that you understand. When a business has this type of element it can propel the business through tough economies or not so good internal decisions.  This is important, because the true test of a good idea is durability to withstand all business challenges.

The second element of understanding beyond how a company makes it’s money is how much more money does it make on the product or service, or it’s margins, than it’s competitors (or if it even has any competitors).  Margins reaffirm the businesses products or service dominance. If your product or service is superior or something that no one else has consumers will pay more for it, and the company will be able to increase it pricing when needed.  So if the company you are looking at has margins of forty-five percent on its products and the industry average is fifteen percent this is a solid reaffirmation that what that business is selling has a competitive edge as you suspected.  This competitive edge allows the company to generate higher profits or cash. More cash makes it easier to grow and deal with difficult times.

Management is another element I like to review before jumping in.  I like to ascertain if the management is investor friendly. In other words do they understand that their shareholders are the real owners of the business and do they build the business so it’s end game is providing value to the shareholders over the long term.  I emphasize the long term, because a short term view is not what builds wealth. I start with the annual reports and the quarterly reports and read the business leaders letters to shareholders. Surprisingly these letters provide good insight into the person’s thinking and goals.  Another good option is reading the quarterly reports or listening to the quarterly conference calls. These can give great insight to thinking and they usually have multiple people from the top team on them. If you can get to a shareholder meeting where you can see this person speak its even better, but this isn’t always easy to do since the meeting may be in another state.  Fortunately, today with the internet you can watch or listen to an interview online if you can find one.

If all of these elements above line up for me I then take the next steps of valuing the business and determing if and when would be a good time to invest into it.  I take the view of investing in a business as if I was buying one hundred percent of the business and not just a few shares. If you take this approach your thinking becomes much more intense as to what you are reviewing and if this is right for you.  As an example, if you were to take all of the savings that you had and invested in a franchise sandwhich shop or something to this extent you would spend a lot of time and analysis determing if this is what you want to do with your hard earned cash, since this will be a long term choice that won’t be easy to get out of.  You should treat all of your investments this way whether or not it is one share or the entire business. You’re partnering up with the business for the long term. I like to operate this way because the stock market is so liquid it is easy to forgo the work and just buy because you think, “well, I can always get out,” and this isn’t the right thinking needed to make good investment choices.  At the minimum you should look to hold your choices at least three years with the goal of forever or five years as a minimum. You’re going to make an incorrect choice occassionally, but by taking a longer term perspective on your ownership it’ll help you to not jump in so quickly and spend the time truly understanding what your are investing in.