Knowing a Company
How well you know a company is one of the most influential factors in deciding which stocks to buy. Peter Lynch popularized the strategy of only buying stocks that you know and Buffet has stated many times that he only invests in companies that he understands.
One of the biggest mistakes investors make is overestimating how well they know a company. One reason is that they spend so much of their time concentrating on external information like fundamentals, charts, and news, that they don't even consider how much they understand the information.
Another reason is purely psychological. Investors brainwash themselves into thinking they know a company when there are key questions they aren't able to answer about the company or the industry it operates in. In order to keep yourself from falling into this trap, it helps to codify the process of determining how well you know a company and then have a metric that can measure it. Having a scale like the one below helps to keep yourself honest because buying a stock that you don't know is one of the most common and hard-to-break mistakes investors make.
The "Look Up Myth"
Whenever I explain to a non-investor that I'm not sure about putting on a trade because I don't know the company too well they invariably ask, "Can't you just look that up?" Well you can look up the financials but there is only so much you can know about a company by reading numbers.
Knowing the company, its products, and competition intimately is something that takes a personal interaction with the company over time. This is something to keep in mind when doing a routine screen for cheap stocks. If you come across a stock that looks fantastic on paper but it's a company that you have never heard of before, remember that there is always a risk that there is an aspect to the company that you don't know about.
How to Determine How Well You Know a Company
There are several key questions about different areas that you can ask in order to determine how well you know a company. This list is not meant to be all-inclusive.
- The company - What do they do? What are their main products? What is their place in the industry? What is the cost structure?
- Competitors - Who are the biggest competitors? How good are they? How well do you know them?
- Market characteristics - How big is the market? How fragmented is it? How fast is it growing?
- Industry trends - This is probably the most important thing because it relates to the future. It is also the most difficult thing to know.
Rating Your knowledge
I like to rate companies on a scale of 1 to 4 on how well I know them. I describe each category below and also chose a company as a case study which investors made a mistake with. The examples below are based on the knowledge of the average investor so, obviously, there will be investors who have more knowledge about some of the companies than other investors. Generally speaking, doing some research on a company can move a stock up by one category but it takes a lot of experience with a company to move it up more than one.
4 out of 4
These are companies you know inside-and-out without even having to look up much info. These tend to almost always be either retail companies you have shopped at or companies you have worked for. These are also stocks where you know the competition and the industry very well and can understand the changes going on in the industry. As far as common characteristics, they tend to generally be large-cap stocks and, hence, they also tend to be more likely to pay a dividend.
If you are an investor or trader that has traded for a decent amount of time (3 years or more maybe?) and look at the list of trades you have made over the years there is a good chance that many of your biggest profits came from stocks in this category and that your overall trading in these stocks was more profitable than stocks in other categories.
This is because you are much less likely to make a mistake in your analysis of these companies. And when you buy the stock and it declines, you are better able to make the correct decision of whether to hold onto it or not. These stocks tend to have high information flow (and, therefore, low information risk) so when something goes wrong at the company you will see many links to financial sites talking about the company's issues or see a story in BusinessWeek about the company.
- Case Study #1: McDonald's (NYSE: MCD).
- The Company: They do fast food - burgers and fries. They make almost all their profits from it. They have attempted diversification into the fast-casual market with Chipotle. They have stores in many countries and probably have revenue in the low double-digit billions. They have margins that are higher than industry average. They have a strong brand. They have good management. They have a relatively low growth rate of (probably) 5-7% top-line growth over the next 5 years.
- Competitors: I know them well. The biggest ones are Burger King & Wendy's. Wendy's has executed better than Burger King and is also smaller so it has more potential to grow and take market share. The smaller competitors like White Castle tend to be regional (not national or global) so they tend not to make much of an impact. Indirect competitors are made up of companies with alternative products like pizza.
- Market characteristics: The market is very big. It is global. It is not too fragmented. Although there are many mom-and-pop burger places, McDonalds has still pretty much saturated the market. Food tends to be an area where there will always be a medium amount of fragmentation due to the fact that there are different tastes. This isn't like Staples putting mom-and-pop stationary shops out of business. The industry is very competitive and fairly commoditized with price wars keeping a lid on margins.
- Industry trends: Secular move towards healthy food. Criticism of portion sizes. Brand possibly becoming passé. These are not trends which pose a danger in the near-term because they are big picture issues. They may pose a long-term threat but then management has time to react to them.
- Conclusion: Since most of the facts above are known by the average investor, it presented a huge opportunity to make a lot of money with relatively little risk when the stock dropped from 46 in late 1999 to 11.50 in early 2003. The stock then went up 400% over the next 4˝ years.
3 out of 4
These are usually companies where you understand the company and the industry but you don't know the industry well enough to have a pulse on changes happening in the industry. The companies in this category tend to be retail companies which you haven't had any direct interaction with. They tend to be mid-cap companies and, many times, fast-growing companies where investors are more likely to make an analytical mistake when it comes to constructing a valuation.
- Case Study #2: Cash America (NYSE: CSH).
- The Company: They are a payday loan company. They cash people's checks and take a fee. Their customers are poor people who don't have their own bank accounts. They are a medium-sized company.
- Conclusion: In early 2005, the payday loan stocks suffered an industry decline because there was talk about introducing regulation to keep the payday advance companies from taking advantage of customers that couldn't afford the huge fees the company charged. Because of this, the stock dropped 55% in month -- from 30 down to 13.40 -- but many investors didn't understand the dynamics of the industry well enough to see it coming.
- Case Study #3: Coach (NYSE: COH).
- The Company: The company makes high-end handbags.
- Conclusion: The company was historically thought to be a good company operating in a small niche. But most investors failed to accurately estimate the robust industry and company-specific growth that was a result of the big increase in spending on luxury goods as well as the large number of middle-class consumers "trading up". Consequently, the stock became a 20-bagger from 2001 to 2007.
2 out of 4
These are companies where you understand what the company does but you haven't had any personal interaction with and you don't really understand the industry much. In this category are wholesale companies, business-to-business companies, many foreign companies, and non-retail technology companies. These are companies where investors find stocks that are cheap "on paper" but there are reasons why the stocks are cheap. Many times, investors are surprised when they buy stocks in this category and they lose money.
The companies in this category can still be potential trades but overall they will not be that profitable, and they pose significantly more risk than investing in other companies that you know better.
- Case Study #4: EMC (NYSE: EMC).
- The Company: EMC is a large technology company that sells data backup services to large companies.
- Conclusion: EMC was a very popular stock in the mid-and-late 1990's. The company was growing very fast, operating in a great industry, and was a leader in its field. But most investors didn't understand that technology products commanded premium pricing in the 1990s because technology hadn't caught up to customers' technology needs. But as technology advanced, customers didn't need to always buy the best product available. The effects of increased competition like IBM and decelerating demand also magnified the drop in the stock. The stock dropped 96% -- from 103 down to 4.
The same thing happened in the retail storage space with Western Digital - the maker of hard drives for personal computers. Consumers in the 1990s were willing to pay $2,500 for a computer because the biggest hard the biggest hard drive available was only 1 GB. But 5 years later, they didn't need the 100 GB hard drives available and many of them spent less money for smaller ones. The stock dropped 95% in 2 years.
Many investors might be surprised to see EMC in this category but if you look at the criteria that determines whether you know a company well then you will understand. Most investors don't know anything about the products - other than that they are "storage products". If you asked a bunch of supposedly confident EMC investors what the #1 product that EMC sold was, I bet that at least 95% wouldn't be able to answer the question. And the customers are mostly large businesses where it is harder to determine the current state of business spending as opposed to retail spending which is easier to get a read on.
1 out of 4
These are companies that investors know very little about but investors tell themselves they know more than they do about the company's products and the industry. There are many times you'll see investors on message boards confidently posting their universally bullish comments while being completely unaware that their knowledge about the company doesn't have much depth and their opinion is based on nothing more than false confidence.
In this category are biotechs, smaller drug companies, and some tech stocks. These can be huge traps for investors because they are way more likely to make a mistake when valuing the company. And when something goes wrong they have absolutely no idea what will happen.
I would hypothesize that most investors' aggregate trades in this category have a negative alpha - and may even be money losers. And most investors who fall into this trap of buying companies they know absolutely nothing about tend to be bad investors.
- Case Study #5: Vaxgen (Nasdaq: VXGN)
- The company: The company was a start-up biotech company whose only potential product was a potential AIDS vaccine going through Stage III clinical trials.
- Conclusion: Many investors bought the stock because they thought the vaccine would be approved. All of the investors: overestimated the probability of the vaccine being approved, ignored the small company's operational inability to scale quickly, had no idea about the actual size of the market, overestimated management's ability to be successful, and misinterpreted some of the data being released. The vaccine got denied and the stock dropped about 80% in one day.