It ranks right up there with the worst cliches that your mother repeated ad nauseam.
“Take a sweater, or you’ll catch a cold!”
“You lose 90% of your heat through your head!”
“You can be anything you set your mind to!”
“Your father and I don’t love you anymore.”
At best, these expressions are BS half truths and don’t tell the whole story. At worse, they’re just blatant lies that have no business being uttered. No, you can’t be *anything* you might want to be. I’d like to be the starting 1st baseman for the Toronto Blue Jays, but Edwin Encarnacion can do that job much better than I can, even in my wildest fantasies.
Another logical fallacy we need to put to bed is this garbage that you should “buy what you know.”
The theory goes like this. It’s hard to beat the market and get one step up on other investors, so you should take a look at the company you work for, the places you shop, the technology you buy, and the fast food you eat to determine what shares you buy. After all, if you like a company, so should millions of others, resulting in portfolio outperformance. It’s such good advice I once heard Jim Cramer give it to the ladies on The View, because if there’s anything I enjoy, it’s a show about women celebrities chiming in on the latest happenings with ISIS. They seem qualified to give opinions on that.
But here’s the problem, by the time morons like us figure out that a company is doing a good job, millions of other people have figured it out first. Your wife likes Lululemon? Yeah, well so does every other wife and most girlfriends too. By the time your wife catches onto the craze, chances are it’s pretty much over. Sorry, but being able to pick out a shirt than goes with those pants doesn’t exactly make her a fashion dynamo.
Buy what you know doesn’t factor in valuation either. Take the Wal-Mart vs. Costco example.
Everyone LURVES Costco. Vanessa and I got a membership here in Korea, because the store is about a 10 minute car ride away and we can get most of our American staples there for cheaper prices than specialty shops, even after the Korean government tacks on a 10% duty because they hate freedom. We intend to continue this membership when we get back to Canada, even though the closest Costco will be an hour away from where we plan to live.
We are not very smart people, apparently.
Meanwhile, everyone hates Wal-Mart. They regularly take their employees to the back room and beat them with shovels, all while paying them $40 per hour less than minimum wage. They won’t give anyone full-time hours, because then they’d be forced to shell out for health insurance. All they sell is cheap junk made in sweatshops in the crummy part of Bangladesh, where employees work until they die, and the carcass is eaten by the guy who takes his place.
So we have a world where Wal-Mart and Costco are selling the same milk, diapers, lettuce, and cans of beans, but Wal-Mart’s version of doing it is somehow evil, while Costco’s is good. Okay, fine. I won’t try and understand this, I’ll just go with it.
But when it comes to investing, these beliefs are a problem.
Because everyone loves Costco, its shares have surged more than 150% over the last five years, compared to just 52% for Wal-Mart. This puts the stock at a price-to-earnings ratio of nearly 30x its trailing twelve months earnings of $5.12 per share. Sure, Costco is growing revenues at 7% per year, but that’s still an expensive multiple.
One of the advantages everyone talks about Costco having is the membership system. At the end of 2013, it had 72 million members who collectively paid more than $2 billion in membership fees. Those fees are pretty much pure profit, since it only takes someone about 5 minutes to sell you a membership.
But delving into the numbers reveals something interesting. In 2013, Costco made $2 billion. If it wasn’t for those membership fees, it wouldn’t be making any money at all. Looking at it from that perspective, maybe Costco isn’t such a great retailer.
Wal-Mart, on the other hand, is only growing revenue at about 2% per year, because it’s hard to grow a company that does half a trillion in sales by more than a token amount. But here’s the interesting part. Out of its $486 billion in sales, Wal-Mart recorded a net profit of $16.3 billion, for a net margin of 3.4% even without the benefit of selling memberships. That’s almost double Costco’s net margins, and you’re only paying 16.8 times earnings for Wal-Mart stock.
After digging into both companies, I pretty easily found a thesis that questions the validity of investing in Costco. There’s probably more if I kept digging, but nuts to that. I have pretty much zero interest in both companies at this point.
Your chances of stumbling upon a great investing idea by going about your life is minimal. Your chances of finding a great investing idea when you actively look for one is far greater. Costco might be a great company, but is it a great investment? You can’t tell that until you research it.
I can read an annual report and come out knowing more about a company than I can by shopping at their stores or consuming their product. And if it’s a complicated company, maybe you might want to spend some time googling other people’s analysis. But the point is this — you can learn about other companies.
Limiting yourself to the largest companies in the land is a good way to become a closet indexer. There’s nothing wrong with indexing; I think most of the people reading this would be better off if they indexed. But it’s silly to try and build your own better index using the largest 100 stocks in the world. When it comes to large-caps, you’re never going to get a knowledge advantage. So stop trying.
Buy what you know is actually great advice, just not in the way it’s presented. You should “know” every company you buy, even if you have no intention of being a customer. But there’s no reason to think you have an edge because you pick up your groceries at the same place as 50 million other soccer moms.