Whether you attribute the advice to Peter Lynch, Warren Buffett, or any number of other savvy stock-picking role models, "Invest in what you know" is one of the most popular and oft-repeated concepts among individual investors.
It's also among the most misunderstood.
Investing in what you know does not mean saying, "I like KrispyKreme (NYSE:KKD), and, golly-gee, Vern, that new store sure had a lot of customers when it was on the 10 o'clock news, so I'm buying Krispy Kreme." A lot of people thought they understood Krispy Kreme. And TiVo (NASDAQ:TIVO). And Netflix (NASDAQ:NFLX). Here's a little peek at what can happen when you invest in what you think you know.
Knowing when to quit
Obviously, there's a big difference between liking something, or being familiar with something, and being good at something. When I find myself enticed by an unfamiliar investment and I need a reminder of this simple truth, I like to think back to my experience in youth sports.
Growing up in Hockey Central USA (a.k.a. northern Minnesota), I spent hours watching hockey, thinking hockey, and playing the driveway version -- with magazine shin guards and all that. None of this changed the fact that I was terrible at hockey. Where the blades met the ice, I would scrape along, chasing the puck at the speed of blight on creaky, wobbly legs skewed out like the legs of Marlon Brando's dining-room chair. Eventually, I was smart enough to restrict my hockey participation to spectating, along with tossing an occasional octopus onto the blue line.
It turned out that distance running was my game. With a toothpick's physique, I was built for it. And where the other people generally can't take all the pain, panting, and pounding that is the essence of distance running, I really didn't mind so much. I wasn't a great runner by any means, but I was moderately successful -- far better than average. The reasons were simple. I was prepared to do a reasonable amount of work (20 to 40 miles per week), and I was willing to put up with long bouts of discomfort to reach the finish line ahead of the pack.
Investing isn't much different. Everyone's got different strengths and different tolerances for pain. (In my opinion, digesting the Dilbert's-worst-nightmare business jargon in the average annual report or conference call is a lot more painful than a half marathon.) Simply put, to have a better than .500 average in the tournament of investing, you've got to identify your weaknesses, find your strengths, and then work with those. In other words, concentrate on your A-game.
Identifying your A-game
Let's get back to Krispy Kreme. How many people out there bothered to sniff out the trouble at doughnut central? How many could have? The answer is, probably, "not so many." That's because the truth wasn't easy to find. As my Foolish colleague Bill Mann pointed out -- back when it was still very unpopular to do so -- Krispy Kreme's fantastic growth wasn't really being built on sustainable operations, but by interesting financial engineering predicated on selling unprofitable franchises.
Krispy Kreme was a dodged bullet for me. I almost bought that bloated pig. It looked so good. Everyone loved it. It was a new, American icon. Luckily, I avoided it for one simple reason: I didn't understand the business completely. Doughnut franchising schemes were not my A-game.
What is my A-game? Simple math, done over and over and over again. There's a reason I tend to do best with the stocks of small manufacturers and retail businesses. Buy some stuff, sell it (or a product built from it) for another price. If you sell it for more than it costs to make it, good. If you sell it for less than it costs to make it, and keep doing that, bad.
My understanding of and willingness to do third-grade math doesn't give me much of an edge over the Street. However, as a database masochist, I actually enjoy building tables, spreadsheets, and formulas to help me keep track of trends such as cash conversion, inventory turns, free cash flow, and returns on capital. That means I can scan hundreds of these companies every month. Since I have a decent understanding of how these measurements filter down to the bottom line, I have a reasonable record of finding winners by spotting improving trends that most others have ignored or underestimated.
Other components of my personal A-game that give me an added advantage are that I'm skeptical and that my skin is fairly thick. By nature, I would rather run against the herd. I don't mind (in fact, I prefer) to buy when everyone else is running for the hills. Yes, that means I'm almost always going to miss out on ever-overpriced, head-nodder bonanzas like Google (NASDAQ:GOOG). But it also means I'm going to steer clear of shrieking groupthink nightmares like TaserInternational (NASDAQ:TASR).
By concentrating on the obvious bits of third-grade math while the Street was full of panicked sellers, I've cleaned up on high-profile bargains like Nokia, Colgate-Palmolive (NYSE:CL), PetroKazakhstan (NYSE:PKZ), and others. (This is, not coincidentally, why I'm part of the extended Inside Value family here at the Fool, where our goal is to take advantage of the market's yellow streak.)
The Foolish bottom line
The first step to investing success is knowing your limitations. The next is identifying your A-game and improving it. If you don't feel like you have an A-game, fear not. It's not too late to get one.
Self-improvement is our core mission here at the Fool. That's why we do more than regurgitate the latest earnings releases and tell you where the market's been. It's why we encourage regular duels between disagreeing Fools. It's why all of our newsletters feature discussion boards designed to help you take your skills up a notch or two or 10. On the boards, you can post questions and even disagreements and Fool staff will get back to you. If you want to get into the game, try a free, no-obligation, 30-day trial to Inside Value -- the Foolish haven for value investors -- by clicking here.
For related Foolishness:
- Stay on the lookout for dirt-cheap dream stocks.
- Want to beat the Street? Do your homework and buy when Wall Street won't.
- Find Lynch's 10-baggers? We think we can do that, too.
Seth Jayson polished his game at the Fool, and his portfolio thanks him. At the time of publication, he had no financial interest in any company mentioned. View his stock holdings and Fool profile here. Fool rules are here.
Krispy Kreme, Netflix, and TiVo are recommendations of Motley Fool Stock Advisor. Taser is a Rule Breakers pick, while Colgate-Palmolive is an Inside Value recommendation.
