FOOL ON THE HILL
An Investment Opinion
Home Field Advantage Bill Mann (TMF Otter)
November 12, 1999
OK, it's time for the three of you out there who still like me to finally have to turn on me. (And no, you don't count, Mom, you are required to like me. Even when you don't.)
I believe that 80% of the people who own Cisco Systems (Nasdaq: CSCO) should not.
Surely I don't mean you. Well, if you don't own Cisco, I certainly don't mean you. Otherwise, unless you are a person who actively understands the technology of routers and how the Internet works, why yes, I more than likely mean you.
I also include myself in this group of people who own Cisco, but probably should not.
I'd like to take you back to high school football, just to lay out the basis for this thesis.
Two teams are playing. They are evenly matched, with one having a star-studded offense and the other with a defense that has not yielded a touchdown all season. They have both won every game they have played.
Which team has the advantage? Well, common sense tells us that, all else being equal, the team playing at home does.
This is not to say that the home team will win, but they do have an intangible but quantifiable benefit from playing in a friendly environment, before their own crowd. It is as psychological as it is real. And it makes sense, doesn't it? The players are just that much more comfortable by virtue of the familiarity of their surroundings.
This translates to most aspects of life, not just sports. Machiavellian business executives speak about the psychological advantage of conducting negotiations on home turf. Restaurants breed customer loyalty through familiarity. Children grow uneasy when their parents leave them at home with a baby-sitter. We all remember the chaos that reigned when we had substitute teachers in school. Was it because they were "bad" teachers? Nope, it was because their presence broke the familiar pattern to which we were accustomed.
Human beings almost always operate better when they are dealing with a "known quantity." Why would investing work differently?
Why, in investing, do we insist upon handing over the one major advantage we have? Why do the boo-bears decry the greatest investor of our generation, Warren Buffett, as "old-fashioned" or "behind-the-times" because he resists investing in high technology because he does not understand the financial model?
Warren Buffett and Peter Lynch have always espoused, especially for individual investors, that we buy what we know. The rules under which Lynch had to operate when he managed the Fidelity Magellan Fund made this simple rule not practical for the amount of funds he had under management. But in the case of Buffett, a look at the companies held by Berkshire Hathaway (NYSE: BRK.A) gives us a perfect view into his circle of competency. Restaurants. Sundries. Candy. Super-catastrophe re-insurers.
The last item, in particular, speaks volumes about a complicated business where Buffett feels he holds a distinct advantage of direct, intimate knowledge. His basis for investing does not rest upon the notion that "reinsurance is a growth industry, so companies in the industry are bound to go up." No sir -- he understands float, capital costs, risk assessments, and all of the other ways in which the individual insurance companies differentiate their performance.
Do you "know" routers? How will you be able to see in advance that Cisco is becoming the next Wang or Digital or Hayes Corporation (Nasdaq: HAYZQ)? For those of you for whom Hayes does not ring a bell, five years ago it was so dominant in its industry that modems from other companies were at a disadvantage if they were not labeled as "Hayes Compatible." This former standard bearer is now bankrupt, having frittered away its dominance in a tremendous growth market.
What is it that you know? Cosmetics? Are Estee Lauder (NYSE: EL) products superior to those of Revlon (NYSE: REV)? The last time you were at the department store, was one booth active and the other deserted? This is direct information that you have that the Wall Street analysts may lack. Why aren't you basing your investment on your direct knowledge?
What about consumer electronics? You hear that Hitachi's (NYSE: HIT) next generation DVD player is far superior to Sony's (NYSE: SNE)? Did you know early on that DIVX, sponsored by Circuit City (NYSE: CC), was doomed to be a bust? In retrospect, this company would have been a great short during the DIVX debacle, as it shed nearly half its value during the latter course of 1998.
If either of these things are your bag, this is your home field! Got a bunch of kids who go through Band-Aids (Johnson & Johnson) and Neosporin (Warner-Lambert) like it's going out of style? Well, then that's an industry you know about.
But how on earth will you know that a competitor has introduced a superior technology to Cisco's? When the stock tanks? The reason I'm pounding this issue is that it has happened to other industry darlings before, and Cisco's celebrated status and high-flying stock in no way make it immune. How do those who do not understand the underlying economics know when to get off the bus? Trust other people? Guess? Tirelessly study the industry?
Unfortunately, in the long run, the last answer is the only one giving the individual investor any kind of sustainable advantage. If you buy what you know, you have the luxury of not having to trust anyone else's instincts.
Corporate finance does not run by a different set of natural laws. Cisco, for example, is not a company that has a stock that is destined to go up just because it has a history of doing so. No company is immune to the laws of the marketplace. If your products don't sell, you don't make money. You don't make money, you die. Simple.
But who among us has ever seen a Cisco router? Do you, Cisco investor, know specifically what a router does, how it works, where it sits on a data network, or even what it looks like? Of course, there are millions of people worldwide who know and understand this technology, and if you are one, I am not talking to you. You likely know the reasons that Cisco products have come to dominate the router industry, as well as the flaws its products have. In this realm, you hold the advantage. Over analysts, over me, over everybody else. You KNOW Cisco.
I am thinking about this in part because of the announcement yesterday by Nortel Networks (NYSE: NT) that it has an agreement with Intel (Nasdaq: INTC) to include its new open Internet components to Intel's Web offering and will offer its routing products at 50% below the prices of Cisco's.
Now, I'm sure that many Cisco (and Nortel and Intel) investors have read the press releases on Nortel's new assault on the router king. I could likely produce several articles worth of deeply technical analysis on how this is a threat to Cisco, how it is not, and how Cisco's position as a closed-source dominant player on the Internet give it a natural incumbency.
The unfortunate reality is, the vast majority of investors in Cisco might as well be reading Chinese as technical descriptions of chipsets, network bottlenecks, and the benefits of open/closed source. The remainder of the readers would quickly expose me as the technical poseur I am, since, when it comes down to it, I cannot possibly understand the full technical or financial implications of what may happen by Nortel making its routers open-source.
My point (and I do have one), is that we place ourselves at a disadvantage by investing in companies that we do not deeply understand. Will it turn out OK? There are millions of Cisco investors with billions of dollars of stock who could attest that, in this case, so far it has. But we as Foolish investors would be wise to remember that the marketplace can turn on a dime, and if we don't see the bend in the road coming, we will be hard-pressed to react to it before a potential crash.
Fool on and prosper.
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