"Real knowledge is to know the extent of one's ignorance."
Two thousand five hundred years later, Confucius' words could not be more apt for investors. We all have our areas of expertise: Mine might include retailers and railroads, while yours may be homebuilders and health-care concerns. What's imperative, though, is knowing what isn't your area of expertise. As Berkshire Hathaway (NYSE: BRK.A ) Chairman Warren Buffett wrote:
The most important thing in terms of your circle of competence is not how large the area of it is, but how well you've defined the perimeter. If you know where the edges are, you're way better off than somebody that's got one that's five times as large but they get very fuzzy about the edges.
When assessing a company, you should always be asking yourself, "What don't I know?" Do I really understand how the business makes its money? Am I aware of how the company intends to grow? Do I know how the managers view the company's money -- as the shareholders' or their own? Is it clear how future free cash flows will be used? Will they be used for repurchases? Capital expenditures? Acquisitions? Do I clearly understand the financial statements of the company? And the footnotes? Do I know what the industry will look like in five years? Ten years? How about in 15 years?
Those aren't the only questions you should ask yourself -- not even close. But after asking and answering all of your questions, if your number of "don't knows" outweighs the "knows," move on... as tempting as it might be to do otherwise.
Stacking the odds
It's not that you need to know exactly what will happen. But you do need to know the range of outcomes and probabilities associated with them. For instance, I don't need to be able to predict the outcome of a coin toss to know that 3-2 odds on heads are compelling. But had I not known the number of possible outcomes (two) and the probabilities of each (50%), I'd have no idea whether 3-2 odds was a good deal or a sucker's bet.
Too often people "invest" in companies that are no doubt exciting, but whose future economics are almost impossible to realistically assess. I know, for instance, that no matter how much I study and how much I wish to, I will never, ever know enough to find the cure for cancer. And for that reason, I don't understand biotechs. Not ImClone (Nasdaq: IMCL ) , Genentech (NYSE: DNA ) , Amgen (Nasdaq: AMGN ) , or any of the others. I can't even understand ImClone's description of its bet-the-house prospective cancer drug, Erbitux (yes, the same one that got ol' Martha in trouble), let alone its entire business. This is from the company's 10-K:
ERBITUX is an investigational IgG1 chimerized (part human, part mouse) monoclonal antibody that selectively binds to the EGF receptor and thereby inhibits growth of tumors dependent upon activation of the EGF receptor for cell division and survival. The activation of the EGF receptor is believed to play a critical role in the growth and survival of certain types of tumor cells and select normal cells.
And on it goes. The only thing that registered with me was the part about ImClone's key product being "part human, part mouse." I'm afraid everything else is beyond me. Without understanding its products, it's not realistic for me to expect to forecast sales and earnings ranges with even the slightest degree of accuracy.
Unfortunately, it's not just high-growth companies that have me scratching my head. Citigroup (NYSE: C ) is another company where my "don't knows" outweigh my "knows." Although I know that it is incredibly well managed and has a great track record, I'd have to exclude it. Why? Citigroup has $12.7 trillion -- that's right, 12 zeros -- in derivatives, sitting on and off its balance sheet (to be clear, that is the notional, or face, value of them).
Citigroup is by no means alone in carrying massive derivatives contracts. J.P. Morgan Chase (NYSE: JPM ) has nearly three times as many, with a $34.7 trillion notional value. Following it is Bank of America (NYSE: BAC ) with slightly over $14.1 trillion. The problem here is I don't know what happens to these derivatives under various doomsday scenarios. Who does know? The answer, in fact, is probably no one. Not even the managers.
Nor the Oracle himself. In his 2002 Chairman's Letter, Buffett wrote:
Even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie [Munger] and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.
It's no wonder he also wrote, "... Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
When the world's greatest investor says he doesn't understand something, you either need to be wrapping up your doctoral thesis on derivatives (and I'd bet you still won't be able to run the odds), or admit you probably don't understand them as well as you need to. There's nothing wrong with saying you don't know -- as long as you say it.
And that's not to say you can't make money on Citigroup. In fact, it might go on creating shareholder value year after year with no trouble from its derivative book at all. The hitch is, I just simply don't know the likelihood or the magnitude of the potential problem.
Don't play the lottery
Investing in something you don't fully understand is like buying a lottery ticket with an unknown payout scheme. While it may end up being a winning ticket, without knowing the odds of winning and the size of the payout, it should be avoided.
This doesn't mean you should never buy shares in biotechs or derivative-laden financials; it just means given the information that I have, I shouldn't. If you feel comfortable projecting various scenarios and probabilities for these companies, more power to you. But be aware that investing without the adequate information is not investing at all -- it is speculation. When selecting stocks for investment, a simple rule will save you a bundle: If you don't get it, don't get it.
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Matt Logan is a Motley Fool contributor. He owns shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.