Buy What You Understand

I think the best advice I can give anyone about stocks is “buy what you understand.”

This mnemonic is easily confused with its deceptive cousin “Buy what you know.”  People–and I used to be one of them–are fond of buying stocks of companies that they “know,” usually from using the company’s products but sometimes from something as fleeting as seeing the company’s ads on T.V.  This is perilous.  As everyday consumers, the only thing we really know about the company is whether its products work, whether you like it and how popular it is.  You may also have come across its customer service line and, on rare occasions, got a glimpse of the corporate culture.  But there’s much more to a successful, vibrant and growing business than a popular product or good customer service.  After all, regardless of how happy the customers are, if the company is spending $10 to sell a product for $5, the company is a terrible investment.

Of course, knowing the company’s end-product is an important first step to “buy what you understand.”  For all the hype around Enron in the 90s, very few people understood what exactly the company did.  Was it a trading company, akin to a securities trading company like Goldman, Sachs & Co., or was it a trading platform company, like eBay?  Investors are supposed to be able to easily access this information because all publicly traded companies are required to file an annual report with the Securities and Exchange Commission called the Form 10-K (for domestic companies) or Form 20-F (for foreign companies) that explains its business in an easy-to-understand fashion.  The truth is, though, some companies’ annual reports are cryptic.  I had heard Enron’s was.  And I know from personal experience that the steel companies’ are.  You read them in plain English and you simply don’t understand the business model.

It’s important to know beyond what the company does because you want to understand the risks.   A couple years ago I decided to invest in water.  It was one of those only seemingly brilliant ideas that I came up with  in college when a professor insightfully said, “Water is the next oil.”  I immediately thought I need a water stock.  A five-minute internet search will show that there are  two basic end products that relate to water:   water provider or water infrastructure builder.   These businesses are fairly self-explanatory, or so I thought.  I decided to invest in the former and ended up buying stock in a company called SJW Corp.* (standing for “San Jose Water”).  It wouldn’t have taken much reading into their 10-K to realize, though, that their business is rife with problems.  It’s in a highly regulated utility that’s at the mercy of mother nature: if there’s a drought and the company is unable to provide water by natural means, it can’t just cut off supply–it has to go out into the market and buy water, an expensive proposition.  Had I fully understood these risks, in all likelihood, I would have invested in water infrastructure company.

The “buy what you understand” also has a common sense element, something important in not getting caught up in the euphoria.  I have two examples of this.

In the first, I again come back to Enron.  The few Enron skeptics who bothered to look beyond the hype thought it peculiar that the company that consistently reported  growing earnings somehow reported  negative cash flow.  Cash and earnings are not necessarily correlated, but it doesn’t take a C.P.A. to figure out that the two can’t be going in diverging directions for too long without their being something wrong.  It simply doesn’t make sense–and hence, you can’t understand–why a company can have blockbuster earnings growth while bleeding cash.  And all it took to recognize something was amiss was to glance at the company’s financial statements.

My second example is oil prices.  I don’t have the best track record for anticipating the heights and depth of economic trends, but there is one thing that I did nail:  the peak in oil prices.  For this, I can point to a specific day when, during the midst of sky rocketing oil prices that seemingly couldn’t go down, an analyst on TV was articulating a new economic model to explain the trend.  His theory was that oil prices were now operating under a supply-capacity model, i.e. how much oil was available in relation to how much oil can be produced.  As capacity goes down, prices go up; as supply goes up, prices come down.  The demand was out of the picture.   Abandoning the supply-demand curve, the most basic of economic theory, sounded awfully like the “irrational exuberance” that exemplified the tech bubble.  I knew then that the oil gig was up.  Within a month oil prices came crashing down.  Fast.  And what triggered it?  The collapse in demand.

Warren Buffet once said that investors should spend three times as much time reading as they do trading.  It’s wise advice from the Oracle of Omaha.  If you’re thinking of investing, pull out the company’s annual report and read it.  If you understand the company’s business, its business model and risks and if all makes sense, then take a look at popular methods of evaluating stocks like ratios, charts and peer comparisons.  After all, you’re investing in a company, not a PE ratio.

*  Full disclosure:  I continues to hold long positions on SJW.