Invest In What You Know: What Does This Popular Saying Truly Mean?

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There is a popular mantra in investing; “buy what you know.” This simple but powerful statement has been foundational for some of history’s most successful investors. Why is this strategy so effective and what does it really mean to understand a company in a way gives you enough conviction to invest? Narwhal’s president and founder, Matt Burton, joins the discussion to answer those questions and explain how this principle has influenced his investing career.

How would you describe the philosophy of investing in companies that you know?

Matt: “The idea of buying what you know sounds simple, but it’s actually a little more nuanced than you’d expect. The first person who introduced me to this concept was a guy by the name of Peter Lynch. When I got into the business, I didn’t know a lot about finance, so I spent a lot of time reading books. Peter Lynch had a book out called Beating the Street. Peter was a phenomenal mutual fund manager that crushed it year after year. The crazy thing was, he wasn’t really an analyst, he wasn’t a quant, he wasn’t a super brainiac, but he was very intuitive. In this book he talked about how the secret to his success was being aware that almost every product that we see in the economy, one way or another, is linked to a company that you can invest in. If we would simply be aware of the products that people are passionate about, we would notice a lot of quality investment opportunities that could generate profit. He told this one story that I’ll never forget; it was incredible formative for my investing career. Peter was snow skiing with his family back in the 80s and on a chair lift up to the top of a run he started talking to some guy, asking basic questions about what he did for a living, what his interests were, all that. The guy started explaining how he was very into computers. He was so passionate about these computers, so Peter Lynch kept digging and asking more questions. Somewhere in the conversation the guy mentioned a new company called Apple Computer. They get off the lift and Peter immediately skied to the bottom of the mountain to a pay phone, called his office and told them to load up on Apple. That was one of many success stories that he reflects on in the book. The moral of Peter’s writing is about noticing the products that people are passionate about and tracing those products back to a company you can invest in. That’s the first aspect of buying what you know; you do this by looking around you from a ‘boots on the ground’ perspective to see what people are passionate about. In this way of understanding an investment opportunity, you may not know the company on a broader level, but you understand the investment opportunity because of your familiarity with the end product and the effect it has on the consumer. You can see, firsthand, the level of passion they feel towards a product, and very often that indicates an investment opportunity. The second part of this concept of investing in what you know is focused at the company level. In order to confidently know a company, you have to understand how they are making money. That’s the big key. You have to be able to sift through all the fluff of a financial statement and get down to real-world profit. This approach also requires that you have an understanding of the product a company produces, but more from a business perspective. What product are they making, what need does it fill, why are people inclined to buy it? That understanding of the product from the other side of the equation is important. Those two aspects make up the overall idea of buying what you know. These are things that anyone can do because they are simple, but they require curiosity and a willingness to be observant, which can be difficult. If people put these ideas into practice, they would be pretty successful in stock selection.”

John: “Can you touch a little more on the idea of understanding how the company makes money?”

Matt: “Yeah, let me think of an example to illustrate the importance of it. Here’s one. I was around during the time that WorldCom was huge, but anyone that’s over the age of 40 will recognize WorldCom as being one of the largest frauds ever perpetrated on the stock market. There was another company called Global Crossing, and there was another company called ENRON. All three of those companies were loved by investors, they would show profits, but if you really dug into it and examined the numbers, you couldn’t get to a real-world profit. There were all sorts of adjustments that they made. If it was a simple lemonade stand, all three companies were losing money at the end of the day after selling lemonade. I will say this, of those three companies, I got out of two of the three and dodged major losses, thankfully, because I kept on falling back to the simple fact that I couldn’t see how they were making money. They posted huge revenue numbers, huge growth projections, all sorts of positive sloping curves that were indicating that we should buy this stock, but ultimately, I kept thinking, the money that they have in the bank today is less than they had a year ago. If you look at an investment opportunity and can’t figure out how the company makes real dollars, then get out.”

This seems like a commonsense concept, so why doesn’t everyone use this methodology to guide their investing?

Matt: “The simple answer to this is that people often get caught up in hype, they get caught up in the fear of missing out, they want to be early to the party and it can push them to make an investment that isn’t wise. It’s easier to jump in without doing any legwork, but it can be a very dangerous game. It’s so important to have knowledge of what you’re investing in before you commit. There are times where it can be tempting, but you have to remain disciplined.”

Do you have any examples that played out similarly to Peter Lynch’s example?

Matt: “I have an example that I like to share because it’s such a good illustration of this concept. When my kids were small, they each had a very small investment account. I had conversations with them and would ask them to tell me what products they were really interested in at the time. I would go off of their passion and go buy the company that produced the product they were passionate about. I remember asking Luke this question and he told me that he was getting into a new gaming console called Xbox, he liked collecting GI Joes, and he loved Marvel comics. So, I went out and bought Microsoft (the maker of Xbox), Hasbro (the maker of GI Joes), and Marvel Comics, which at the time was a standalone company with the symbol MVL. I bought equal weight in those three stocks in Luke’s investment account and for years his portfolio destroyed the market. At that time Microsoft still hadn’t taken off yet, Xbox was still in its infancy but since has blossomed into something that almost everyone is familiar with. Hasbro never turned into anything huge, but it was consistent because toys sell. Marvel was bought by multiple different companies over the time we owned it, and it has done incredibly well. That’s an example of how being aware and intuitive can be hugely beneficial. And those were leads that I would have never thought of if I hadn’t asked my kids. I was doing portfolio management at the time, but I was looking into big companies like Exxon. No kid is excited about buying gas, I’m looking at IBM, but again no kid is excited about mainframes, so their ideas gave me new perspective. These sorts of discussions help you generate new leads and force you to look places that you wouldn’t normally look, and sometimes you can find some really robust ideas.”

Do you have any examples of companies that you felt like you understood and were excited about, but the investment failed to materialize?

Matt: “Super early in my career I jumped on the technology train. On a scale of 1-10, 10 being someone that knew everything about all technologies before they hit the general public, I wasn’t a 10 but I was probably a 7. I made it a point to know everything I could about all technology. I don’t know it anymore, I’ve forgotten it all, now I’m like a 2, but at the time I was really up to date with the cutting-edge technology coming out. During that time, we had some investments in glass companies that were producing industrial and commercial grade glass for different applications. My desire to be on the cutting edge of technology and my growing exposure to glass companies led me to a company called Corning, symbol GLW. Corning was going through a massive transition moving from more traditional glass products into high end customized glass production. Their breakthrough product was a bendable glass that could be used in underwater fiber that was being laid across the US for a new product called the internet. I saw this and jumped in thinking it was going to explode, and it did decent, but nothing over the top. A little further down the road I hear about another Corning product called Gorilla Glass, which was a super strong glass that was going to be used on computer and cell phone screens. I was thinking that I just hit the jackpot, so I went big into Corning, but it never took off. What I didn’t understand at the time was that the market for a quality glass was so massive, and there was so much opportunity in this space, that the level of competition was insane, especially when it came to phone screens. At the same time Corning rolled out Gorilla Glass, Nokia started focusing on making their own unbreakable glass, so did Apple, so did Blackberry, so did Motorola. Gorilla Glass is still a thing, and they still make money off of it, but what I didn’t foresee was that glass is just glass, it didn’t take much to replicate it or even make it better. There was never an opportunity for Corning to make outsized returns because of how strong the competition was. You have to have the awareness to know when a market is too big and will have too many players. This realization puts you in such a hard spot because you’ve done all this work and found what seems to be a great investment, but eventually you have to swallow your pride and cut ties because it’s never going to work like you hoped. Being able to walk away is a hard thing to do.”

How do you keep the familiarity you have with a company from becoming a bias that affects your ability to think rationally about the investment?

Matt: “I think the biggest safety net with buying what you know is that you still need to buy it at a relatively reasonable valuation. Even if you are over the top excited about an opportunity, the valuation needs to make sense. That’s one thing that you can do to ensure that you don’t fall into a bad situation. But you are correct, sometimes you can lead yourself into that trap if you become too enamored by a company and lose context. For instance, there are very very specialized construction tools that have unique applications only in asphalt and quarrying. People who are in that business think these tools are awesome, and they are, but the market is very narrow. So, the caveat to buy what you know is that you need to buy what you know in the context of the entire market. Just because someone comes up with a sure-fire way to do something in the aggregate world doesn’t mean that its going to take off on a large enough scale to impact a stock. And just like in my previous example with Corning, just because you may be invested in a company that is on the leading edge of a trend doesn’t mean that there aren’t a bunch of other players in the same position.”

Any last thoughts you want to leave with the reader?

Matt: “My encouragement to the reader would be to go talk to your sons, daughters, grandsons, granddaughters, and find out what they are super passionate about right now. It might be something really goofy but follow the trail and see who owns the product or what companies benefit from that level of passion. If, at the end of the trail, you find a company that is set to profit off that passion and one that isn’t wildly overvalued, you might have found a great investment opportunity.”