A successful investment decision blends an appropriate amount of subjective opinion with a strong dose of objective analysis. Of the two, objective analysis is easier to define. Objective analysis should include an understanding of an industry's fundamentals and the competitive landscape, and it should include a strong familiarity with a company's financial statements, operating basics, and goals. The other criterion, subjective opinion, is more difficult to define.
The most common subjective mode of investing is credited to Peter Lynch. He's typically seen as the person who first said "buy what you know." Buy what you know implies that you'll understand what you're buying, and if this is the case, you're less likely to get burned. This argument has merit, even though it is greatly simplified thinking. "Buy what you know" is dumbed down into a catchy advertising phrase, one that is short enough to work in any medium. It is most often read to mean buy the brands that you know, buy the companies that make products that you like, and buy the company names that you always hear in daily life.
When large-cap stocks are soaring, this strategy, simple as it is, appears brilliant. "If I just buy Coca-Cola, GE, and Hershey, I could double my money every three years!" Of course, when large caps go into long periods of rest or retraction, the strategy requires patience and offers less than blistering returns, especially if you "bought what you knew" as it was hitting a seven-year peak.
Buy what you know is one-dimensional advice for three reasons. First, what you know may not be worth investing in. Second, the practice of buying what you know is rarely interpreted to mean buy the business model, the cash flow statement, and the balance sheet that you know backwards and forwards. It too often is seen as "buy your favorite brand." Period. If you happen to know and love Kmart, but you didn't learn about its financials, you're in a sorry situation because you were an uninformed investor. Third, I've never heard the term "buy what you know" coupled with anything regarding valuation. It seems to be "buy what you know at any price."
In The Motley Fool's personal finance book for beginners, You Have More Than You Think, Tom and David Gardner updated Lynch's popular phrase to "buy what everyone knows." This covers the first vulnerability behind the popular advice. Instead of buying just what you know (which could be something as obscure and hopeless as a local $5 million penny stock), you buy what everyone knows. The book gives examples of Coca-Cola, Campbell Soup, Microsoft, PepsiCo, and others. There is scarcely a soul in the world who hasn't heard of at least one of these companies. We can assume that everyone knows these companies for a reason, meaning that the companies typically have market dominance and staying power.
This catchphrase still leaves a few bases uncovered. First, the phrase does not consider valuation, and although if you're investing for 10 years or longer the valuation is less important (and it is, at some times, the least important concern), it is still meaningful. The prices at which you begin to invest will, of course, determine your total return. Valuation is difficult, though, so should we just ignore it and let fate sort it out? Well, sometimes, yes. Especially with young Rule Breaker companies. Why try to value something now, when that something is small and poised for explosive growth for 10 years?
Another weakness in trying to determine valuation levels is that you only have the past as guidance, and it is often difficult to fathom possible futures. When Microsoft was a $100 billion stock, the price was enough to turn many valuation-concerned investors elsewhere. Most people wouldn't have dreamed that Microsoft would become a $500 billion business.
When valuing a company, you need to be able to account for a much better than "normal" future valuation, and for a much worse one, too, because both can happen. You must weigh the possibilities, pro and con, and reach a risk-reward scenario that is either attractive or not.
Second, "buy what everyone knows" almost makes knowing the balance sheet, cash flow statement, business model, and competitive landscape inside and out even less of a priority than "buy what you know." How? Because it implies that you can rely on what everyone else knows to help you decide what to buy. "Everyone knows Coca-Cola. I should buy it."
Although the Rule Maker investment approach, which was developed after the "buy what everyone knows" phrase, teaches you to adamantly follow a company's balance sheet, people who invest according to "buy what you know" principles too often invest on that simplified phrase alone, meaning they don't worry about business fundamentals or financials. Plus, when buying what everyone knows, you may, if you're not careful, miss what everyone else is missing: a new emerging competitor, a change in an industry, and so forth.
Finally, "buy what everyone knows" and its predecessor phrase don't fully take into account the notion that you should be comfortable in what you're buying on a personal level that goes well beyond mere "recognition." If you're comfortable and proud to buy a company for the right reasons, you're more likely to hold on, and on, and reap full benefit. Everyone knows Philip Morris, but would you be comfortable owning it? Everyone knows Coca-Cola, but do you enjoy drinking it enough to own it yourself? As subjective as "buy what you know" is, it isn't as flexible at second glance.
Like many other investors, I invest by finding the balance mentioned at the beginning of this column. Subjective opinion is coupled with objective analysis to find companies that I believe in both personally and fundamentally. The phrases that I would coin, if I had to, would be "buy what you know to be a quality business" and "buy what you are comfortable buying." I would have a difficult time marketing these long phrases. They're not as snappy as "buy what you know," and they're not nearly as simple. Buying what you know to be a quality business actually implies work. Rather than just looking in your pantry to decide where to invest your dollars, you need to look into the boiler rooms of several companies, see what makes them tick, and how hot they're running.
The second part of the equation, buy what you're comfortable buying, rounds out the investing process by covering two important criteria. First, it implies that you're comfortable enough with the stock's valuation. Again, this can be arrived at only with some work. Second, this phrase implies that you want to own the stock in the first place. It implies that you'll be proud to own the business. This, yet again, implies work on your part. You'll need to dig into all of a company's operations and learn the company's mission, any past digressions, and so forth. You may love Mitsubishi cars, but did you know that the company is one of the worst offenders in the world's fight to save the rain forests? This company continually destroys rain forests while stomping over protesters, legislation that is in process, and anything else that gets in its way. I would never buy their cars, let alone support the stock.
Investing smartly is not simple. It can only be seen as simple if you choose to ignore many key underpinnings to smart investing (such as cash flow analysis). This is your choice to make. Sometimes, I admit, simple is much better, especially if you don't believe money is "a god" worthy of hours of your time every week. If you're investing for only 10 years, however, valuation should take on far greater importance in your investment process. And if you're investing for five years or less, you're taking large risks whatever you do. Don't let the past five years lull you into thinking that investing is this: "Put money in the market and make money within weeks." Sometimes it goes like this: "Put money in the market and have less money several years later." A knowledge of valuation principles helps an investor avoid this and maximize returns. (Consider Pfizer vs. Johnson & Johnson since November 1997 for a short-term example: J&J is up 82%, Pfizer 54%.)
Objective analysis should be combined with subjective opinion to find our investments. This means that personal preferences will certainly come into play in our decisions. Both aspects are important. Combined, they make a great investing team. Buy what you know to be a quality business, and buy what you're comfortable buying.
Jeff Fischer, TMF Jeff on the message board
