Invest in what you understand

By DAVID MOON, Moon Capital Management, LLC
May 8, 2011

On this day in 1886 at Jacob's Pharmacy in Atlanta, Dr. John Pemberton sold his first serving of caramel-colored sugar water. Over the next 100 years, Coca-Cola became the most popular and biggest-selling soft drink in history, as well as the best known product in the world.

Warren Buffett started buying shares of Coca-Cola stock 102 years after that modest beginning. Within a few months, Berkshire Hathaway owned seven percent of the company – more than a billion dollars’ worth. Pundits argued that the purchase of such a large, well-known business could offer little in the area of outsized returns.

Three years later, Buffett's Coca-Cola position was worth more than the entire value of Berkshire Hathaway at the time of Buffett's initial investment. Ten years later his $1.3 billion investment was worth $13.4 billion.

Last weekend, approximately 40,000 people gathered in Omaha to attend Berkshire Hathaway’s annual meeting. For five hours, Buffett answered questions about the economy, stock market and the company's succession plan in the unlikely event Buffett dies.

Each year someone asks about an investment that has outperformed stocks. The question this year was about silver. In the past twelve months, the price of silver has more than doubled. Berkshire owns no silver and the questioner wanted to know why the great investment guru hadn't bought some – either a year ago or now.

Buffett explained the relationship between the price of any investment and its earnings power. Silver has no earnings power. He also discussed the notion of an investor's "circle of competence." A circle of competence can be defined both in terms of the understandability and the predictability of a business or sector to the investor. This area of expertise is specific to each individual. One investor may lack skill or understanding in an area where another is an expert.

If a potential investment does not fall within Buffett's competency circle, he simply passes. As he was recently quoted, “when we look at a business and see lots of change coming, nine times out of ten, we're going to pass. When we see something that is very likely to look the same 10-20 years from now, we feel much more confident about predicting it.”

One of the reasons Buffett invests in companies like Coca-Cola is because he understands the businesses well enough to make a reasonable estimate of the company’s future prospects and its future earning power.

While sticking with what you understand is an easy concept, it is often erratically applied in the investment world. Famed investor Peter Lynch once advised to invest in what you know. Using that advice, if you eat Big Macs, you would buy stock in McDonalds. If you own an iPad, buy stock in Apple.

Lynch's advice is a bit simplistic, however. You might enjoy a company’s products, but have no understanding of the fundamental factors that drive the company’s business or what the economic landscape of its industry will look like in ten years.

Perhaps what Lynch meant was invest in what you understand. It certainly was Buffett's message last weekend.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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