As investors, we believe it is possible to estimate a range of intrinsic value for a company based upon its financial statements and filings. This cannot be done, however, if you do not understand how a company makes money. If, for example, you know nothing about drug manufacturing, you shouldn't invest in Merck. Why? Unless you understand the company's products, market, competitive strengths, and weaknesses, you won't be able to project the future cash flows.
Warren Buffett's Circle of Competence
In his lectures and writings, famed investor Warren Buffett often discusses the concept of a "circle of competence." This circle of competence consists of all the businesses with which the investor is familiar and thoroughly understands. An investor that has spent the last 10 years as a checker at a supermarket would have an advantage when analyzing the financial statements of a grocery store chain; they would be able to pinpoint the strengths and weaknesses of the business, evaluate the competitive climate of the industry, and compare the performance of a prospective investment against those of an excellent grocer.
The size of an investor's circle of competence isn't as important as clearly defining the borders. If you are unfamiliar with the insurance industry, don't even attempt to evaluate the performance of a property and casualty company. Likewise, if you don't understand the Internet, don't bother ordering the annual report of an Internet stock. Straying from the circle of competence leads a would-be-investor into the land of speculation.
Discovering Stock Investment Ideas
How do you find companies you can understand? Take a trip to your local mall and scout out the stores to see what is popular. Pay attention to where your kids want you to take them back to school shopping. Peter Lynch, one of the most successful money managers in history, got some of his best investing ideas from listening to his wife and kids after they came back from running errands. In fact, Lynch bought stock in Hanes after his wife brought home the newly-introduced L'eggs she discovered while in the checkout line at the grocery store; the investment made millions.
Another way to get investment ideas is to go through your pantry, cupboards, laundry room, and garage to find products you use regularly. Most labels contain information on the product's manufacturer. You may be surprised at what you find.
What do Tide, Pampers, Always maxi pads, Pantene Pro V, Charmin Toilet Paper, Bounty Paper Towels, Crest Toothpaste, Downy fabric softener, Oil of Olay, Bounce, Cascade, Fixodent, Mr. Clean, Pepto Bismol, Old Spice, Febreze, Head and Shoulders, Herbal Essences, Gain, Ivory, Luvs, Joy, Scope, and Tampax have in common? They are all made by Proctor and Gamble (PG).
Price Still Matters
Finding companies that are easy to understand is only the beginning. The circle of competence test should merely be a starting point to generate a list of investment possibilities based on an investor's strengths and insights. A company must still display excellent economics, an attractive price, and shareholder-friendly management. When discovered, these holy-grail investments are sure to produce stellar returns for the investor's pocketbook.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.