Sometimes simple is best – especially in investing.
When you buy stock in a company, you’re buying shares – or, literally, a portion of the company. You’re a partner in the company. Would you become a partner in a business that you didn’t understand?
What’s simple for one person might be complicated for someone else. Medical doctors might find pharmaceutical companies straightforward, but be puzzled by banks. Financial analysts might have the opposite perspective. People who invest in a company without understanding its underlying business open themselves up to a whole new type of risk. They’re not even able to understand how to tell whether or not the company is doing well.
Some businesses are too complicated for anyone to understand. The business model of energy services and trading company Enron – one of the largest companies in the U.S. just months before it went bust in 2001 – was complicated enough to impress millions of investors. But Enron wound up being an enormous fraud. Investors who asked themselves if they understood Enron’s operations would have stayed away from the stock.
“Never invest in any idea you can’t illustrate with a crayon,” legendary investor Peter Lynch said.
Unfortunately, the finance industry – including brokers, analysts and bankers –have a vested interest in selling you shares of companies you may not understand. Sounding smart is how they help justify fat fees and commissions. They also count on the customer not feeling comfortable with saying, “I don’t understand.”
One way to tell if you’re in over your head is to see if you can explain the business of a company using a few crayons and a piece of paper. Most things worth understanding can be explained using the tools of the trade of a five year-old.
Or, can you summarize a company’s business on an index card? If so, it passes the KISS test: Keep It Simple, Stupid.
For example, conglomerates are the opposite of KISS. Philippine company GT Capital has banking, property development, power generation, car, import, wholesaling, financing, and insurance businesses. Each one of these is complicated. Put together, they’re almost impossible to get a handle on.
Selling food. Getting metal out of the ground. Taking people from one place to another. These are businesses that a child could understand – and explain.
A business that’s simple to explain isn’t necessarily simple to operate. Grocery chains sell food – but sourcing, transporting, storing and selling food isn’t easy. Mining is straightforward, but lots of companies lose money doing it. Airlines are notoriously difficult to manage, even if the basic objective of the business is simple.
As an investor, you’re always a prisoner of what’s called “execution risk”. Are the managers of the company you own performing? Can they make the business grow? There are plenty of “simple” businesses that go bust… and complicated businesses that deliver strong returns to investors.
But investing in something you understand means that at least you have an idea of what the business is… and what success looks like. That’s why your portfolio should pass the crayon test.