Almost all investing heartbreak can be avoided if you stick to one simple rule of thumb: only invest in the stocks of companies that you understand. It is amazing how many people stray from this principle. I recently heard from a brand new income investor who told me that he has over 50% of his investable assets in Linn Energy (LNCO), and he was glad that he came across my blog so that he could learn about “defensive” investments.
No, no, no.
Look, I don’t own any Linn Energy, because there are a lot of things I don’t understand about the company, and there are some things I understand about the company but don’t like (for instance, right now, the LNCO distributions roughly mirror the LINE distributions because LNCO isn’t realizing GAAP income—if LNCO starts realizing GAAP income, it will have to pay a 35% tax, causing LNCO distributions to substantially lag LINE distributions. Shares would likely fall, triggering an option for Linn management to swap out LNCO shares and replace them with LINE. I doubt this new investor is aware of risks like that with the company).
But that is okay—this article isn’t about Linn Energy. It’s about this need that some people have to own stocks they do not understand by buying the companies that are hot at a given time or popular with a certain peer group.
One thing I hope you understand is that you are not harmed in the least by not owning the stocks that everyone is buying. For the past two years, I have listened to people buy Apple as the hot stock for inclusion in a portfolio. But I don’t own it because 60% of its revenues come from phones, and I am not at all capable of predicting the future cash flows of the phone industry, and I am aware of the troubled history of phones as long-term investments (because there is a certain ruthless competition in the nature of the phone industry that comes with a wipeout risk that you simply do not see in, say, the beverage industry).
Who cares if I miss out on that investment? I don’t understand the future cash flows of phone companies, so I stay away from them. I want to invest in companies that I do understand, and have a high likelihood of growing profits for decades while I reinvest the dividends and go about my life, generating more surplus capital to deploy elsewhere.
I have no idea where Apple or Linn Energy will be ten years from now. And because I can’t figure it out, I don’t invest in those companies. I stick to what I understand. I can figure out how Coca-Cola uses Coke, Diet Coke, Sprite, Fanta, Powerade, and 400+ other brands to make money. I understand how Procter & Gamble sells Tide Laundry Detergent and Gillette razors to make money. I understand how Johnson & Johnson sells Tylenol and Listerine to make money. So I stick with those. Bad things start to happen when you force yourself into investments that you do not understand, usually because they are “the hot stock” in a given moment or offer a higher dividend yield than the other stocks on your radar. Resist that temptation. Stick to the basics. Find what you understand, acquire an ownership stake, and hold that stock for the rest of your life as you let the dividends pile up. It takes almost all of the potential heartache out of investing.
Originally posted 2013-07-09 07:55:14.