When it comes to picking individual stocks, many new investors are more lost than that time I tried to find the g-spot. Experts have responded with some simple advice, telling people to buy what they know. Basically, you should buy shares in companies that you buy stuff from. If you’re a big fan of overpriced coffee, buy shares in Starbucks. If you hate paying bank fees, buy the shares of the bank. If you just can’t get enough of ebooks on your Kindle, buy shares in Amazon. Just kidding. Nobody should ever buy shares in Amazon.
I remember once a female friend telling me about watching Jim Cramer on The View. He explained stocks to the girls, they all had their periods together, (except Barbara Walters, who hasn’t had a period since 1976) and he left the gals with one big piece of advice, buy what you know. Lisa Ling immediately went out and bought some shares in Starbucks, which probably turned out to be a pretty good buy. Well played, Lisa Ling.
Is this really such good advice? If you read the title of this post, you’d probably be under the impression I hate it, perhaps even more than my well documented hatred of pants. Nah, that’s not the case. I have a pretty big problem with it, which I’ll explain using chips. FINALLY, A CHIP REFERENCE ON FINANCIAL UPROAR.
My favorite kind of chips are Jalapeño and Cheddar Doritos. I don’t eat a lot of chips anymore – because as soon as you have an unlimited supply of something it immediately becomes unappetizing – but I still enjoy the occasional bag of Jalapeño and Cheddar.
Because they were my favorite, I took every opportunity to sell them into every store I could. If I needed some Doritos to fill a hole on the shelf, my default was always those ones. After a little while, the guy training me noticed, and we had the following conversation.
“Dude, do you have a hard-on for Jalapeno and Cheddar Doritos?”
“What? They’re awesome.”
“True, but they don’t sell worth a [crap].”
“Yeah, you’re gonna have them coming out of your ass in about a month.” (Meaning I’d overloaded the stores and I was in danger of them going outdated.)
It’s been a few years since I had that conversation, and I still have to constantly guard against ordering too many of flavors that I really like.
The comparison to investing is simple. Just because you think a company is great doesn’t make it great. It might not even make it pretty good.
Essentially, investing boils down to buying future cash flows. The price an investor is willing to pay for a stock today is based on the market’s best estimate of that company’s future cash flows. Why do you think the price/earnings ratio is so popular? Even though I tend to pay more attention to mispriced assets, I still essentially do the same thing, since I expect the assets to recover and start spinning off predictable cash flows again.
How, as a customer of a company, are you supposed to figure a damn thing about future cash flows? Or the value of the company’s assets? Unless you are investing Batman, you’re gonna need to pore over some financials.
I swear, we have the same conversation about once a month. Financial statements are more boring than that time you stumbled upon
cricket soccer on the sports channel. It takes education to be able to read financials accurately. AND MATH IS HARD, DAMMIT. I understand all of that, but you’re never going to be a good investor if you continue to treat stocks as impulse purchases.
Here’s another problem with buy what you know. For the most part, the shares of huge multinational companies are fairly valued. They’re covered by all sorts of analysts, they’re liquid enough that any hedge fund can buy them, and they’re on the radar of most everybody. For the most part, you deal with big mega cap companies. Congratulations, you’re conceding yourself to average returns by buying what you know.
As I’ve explained before, the real bargains of a market are in the small cap names. If a company trades for $2.00 per share and there’s only 20,000 shares exchanging hands each day, it makes it incredibly difficult for a hedge fund to take a large position in the stock. Besides, a hedge fund generally doesn’t want to own more than 5% of a company, since a hedge fund has to report any ownership past that magical level to the SEC.
Hedge funds just won’t bother with small cap stocks. That’s where a smart investor can swoop in and get market beating returns.
This method requires some research. My stock watch list is filled with companies too small to be on anyone’s radar. It takes work, but the internet is filled with the information you need to make an informed decision. It’s up to you to track it down and process it. Sorry in advance for making you read.
So sure, buy what you know isn’t terrible advice, but just remember that you can always research a name and get to know it. I know every stock I buy, most of the time I acquire that knowledge.