So during Thanksgiving dinner last week, my wife's 16-year-old cousin, Sean, came up to me and said, "Benihana." I must have looked at him funny. "The hedge fund manager who lives next door to us -- and drives a Porsche -- told me it was going to be huge. Check it out. Benihana."
The tip intrigued me, so I looked up the company. And at first glance, there are some things to like: growing revenues and profits and more debt than cash. But there's no significant insider ownership, low-ish return on equity, and a worrisome dilution pattern. At any rate, I'd need at least a few more weeks of work (and some help from someone who knows a bit more about the restaurant biz) before I'd even consider Benihana. Because as investors, it's important to know our stocks cold. If we don't, we're liable to make rash decisions. And when it comes to matters of money, rash is almost always bad.
Consider Warren Buffett's 1998 answer to the question of why he wasn't a tech investor: "I don't want to play in a game where the other guy has an advantage. I could spend all of my time thinking about technology for the next year and still not be the 100th, 1,000th, or even the 10,000th smartest guy in the country analyzing those businesses."
Without knowing a business and its operating environment, it's difficult to separate disasters from buying opportunities. And when you do buy, having anything less than full confidence in your buy thesis will cause you to rely on the herd -- Wall Street analysts, friends, bits of Internet information -- for direction. That's no way to profit.
Scary story
Earlier this year, I heard a number of Fools talking about Steiner Leisure (NASDAQ:STNR). The company had return on equity north of 25%, 21% five-year compound annual revenue growth, and $50 million in cash and no debt. Moreover, it was soundly profitable (earning $36 million in 2004 on 10% net margins) and Chairman Clive Warshaw owned a significant number of shares.
These were all green lights for me. The yellow light was that the stock looked expensive. It had enjoyed a steady upward run in 2004 and was trading at a P/E of approximately 26 -- well above its average in 2003 and 2004.
But what stopped me from buying Steiner was that the company sells beauty products and provides spa services on cruise ships. I've never visited a spa. I've never even been on a cruise ship. I didn't know a lick about the business: why folks paid up for seaweed wraps, how this made for a competitive advantage, or whether or not the recent revenue growth was a fad.
I never bought Steiner, and I'm glad I didn't. Even though the stock is up almost 10% since I was looking at it in March, I dropped the stock from my "Stocks I Almost Bought and Track to See if I Made a Good Call" portfolio for a 12% loss when it dipped down to $30 a share after third-quarter earnings. While the report looked OK to me, the market seemed to think otherwise. I figured the market saw something I didn't and got scared.
Scared? That's no way to make money in the market.
The courage of conviction
Compare that to Fool co-founder Tom Gardner's re-recommendation of electronic medical records firm Quality Systems (NASDAQ:QSII) back in the April 2003 issue of Motley Fool Stock Advisor. After laying out the investment thesis in the March issue -- growing market, lots of free cash flow, compelling valuation -- Tom spent the next month watching the company drop to the tune of 12%. And yet he re-recommended it because he was confident in his analysis of the business, financials, management, and marketplace. To date, Quality Systems has been Tom's best performer. His two recommendations are up 660% and 760%, respectively.
Or consider that Tom's brother, David Gardner, earned a double by re-recommending Netflix (NASDAQ:NFLX) after it had been dumped 23% since its original rec. Despite the threat of large competitors such as Wal-Mart and Amazon.com, David was confident in Netflix's visionary management and plan to lower prices and multiply its subscriber base. That confidence in his analysis has paid off very well.
Profit from knowledge
Knowing your investments is no guarantee of market-beating returns, but it at least gets you started on the right foot. So how can you know what you know? Here are two ways to narrow your circle of competence:
- Screen out companies that you would not be interested in following. If ExxonMobil's (NYSE:XOM) nearly 100-page 10-K would bore you to tears, don't buy shares. Although the company boasts a market-beating 16% 20-year compound annual growth rate, the stock tends to fluctuate with the price of oil. But if you were to invest without knowing the company, it would have been difficult for you to earn that same return.
- Screen out businesses you don't understand. I have no idea why Intel's (NASDAQ:INTC) chips are good and/or popular. In fact, another of my wife's cousins (13-year-old Matthew, who is currently building his own computer) told me this weekend that Intel's chips are no good. Is he right? Darned if I know. But I do know that if I owned Intel stock, I'd be in the dark if there were problems.
These two simple screens may eliminate some of the most heavily covered stocks -- think about the 28 analysts covering Applied Materials (NASDAQ:AMAT) or the 20 analysts keeping tabs on the financial black box that is Citigroup (NYSE:C) -- and maybe even cause you to miss out on a big gain or two, but they should also help you find winners in a way that is repeatable. After all, that's what we're all chasing: a way to beat the market for the next 10, 20, or even 30 years.
If you would like a little help getting started, Fool co-founders David and Tom Gardner are offering a free trial to the Motley Fool Stock Advisor newsletter. They make two in-depth stock recommendations every month and help the entire community of subscribers keep track of their selections through regular updates and daily posts on the newsletter's dedicated discussion boards. To date, David and Tom's picks are a very healthy 40 points ahead of the market. Click here to learn more.
Tim Hanson owns shares of none of the companies mentioned in this article. Steiner Leisure is a Motley Fool Rule Breakers recommendation. Amazon.com is a Motley Fool Stock Advisor selection. The Motley Fool has a disclosure policy.
