The highly successful growth investor Peter Lynch once advised investors to “buy what you know.” Another way to interpret this is to buy what you understand.
Lynch isn’t the only successful investor that has recommend the principle of sticking to companies you understand.
Warren Buffett, Charlie Munger, Seth Klarman and Mohnish Pabrai have all stated that this one of the essential principles in the world of finance.
Warren Buffett calls his sphere of understanding his circle of competence. He will only consider a company for investment if it falls within this circle. If it falls outside the circle, and he doesn’t understand the business, Buffett won’t invest.
Investing in something you don’t understand is probably one of the biggest mistakes an investor can make. It’s a quick way to lose money.
If you don’t understand how a company makes money, you cannot accurately project its future earnings potential. That means it’s challenging to place a value on the business and assess what might happen to the enterprise if something goes wrong. This is not investing. Buying a stock without a proper understanding of the underlying business is speculating.
There’s one question investors can ask themselves to establish whether or not they understand an enterprise, and that is: “Do I understand how the company makes money?”
Mohnish Pabrai Harvard Q&A
This might seem like a simple way to approach a complex problem, but there’s a good reason why it makes sense. The longer you look at an investment opportunity, the more likely that it is you will convince yourself it’s worth buying.
Mohnish Pabrai spoke about this at the beginning of April. As part of a Q&A Session with Francis Chou at Harvard, he discussed, among other things, why it is so essential to invest inside your circle of competence.
He gave the following example:
“I like to understand how a business makes money…I’ll give you an example of Amazon. One of the things that I’ve never understood about Amazon — I think it’s a phenomenal business — I know for a fact with all the gazillion things I order from Amazon that they lose money on shipping. There’s no way they can ship me all the stuff I’m buying for $100 a year or whatever they’re charging right now. So when I look at Amazon’s retail operations in my head, I cannot figure out how it makes money. I can understand that when they have the marketplace, third-party sellers, and they provide all the services…I can understand that part, but when Amazon is selling stuff themselves they have the warehouses they’re bringing stuff to the warehouses they’re shipping it to me in two days…I send a FedEx package from Irvine to San Francisco, and it’s $25 to $30….I’m not in any way of implying there are any issues with Amazon’s financials or anything like that but what I am saying is I don’t understand it I don’t need to go there I don’t need to understand it.”
In some respects, this is a bad example because it is affected by survivorship bias. Amazon is one of the best-performing companies and stocks of the past few decades, and it looks as if Pabrai made a huge mistake by passing up on the opportunity to buy.
But Amazon is just one example. There are hundreds or possibly thousands of cases of complex businesses that failed.
Over the past few decades, less than 5% of stocks have produced more than 90% of the market’s return. Many more companies have yielded a negative return a positive one. Therefore, your chances of owning a loser are much higher than picking a winner.
Dodging the losers is the hard part. The best way to do so is to avoid companies you don’t understand.
Having a blanket ban is the only way to make sure you avoid these disasters. Of course, some companies will slip through the gaps. That’s always going to happen all, and it is impossible to avoid.
But avoiding significant losses is much more critical for investment success over the long-term.