Image source: The Motley Fool
Whether you’re just starting out or have been investing for years, it’s always a good refresher to read some of the advice Warren Buffett has given over the years.
Whether it’s reading a book he recommends or just following his advice, any knowledge and insight you can gain from the Oracle of Omaha will mean that you’ll be better off when making your own investment decisions.
One of the most important pieces of advice Buffett has ever given involves investors’ knowledge and understanding of certain businesses and industries. He refers to this as an investors circle of competence — that which you either already know or are comfortable learning.
Buffett recommends investing only in those companies and industries in which you can fully understand how profits are made, future growth drivers and potential risks.
For a long time, Buffett missed out on what Wall Street called easy gains: tech stocks.
One of the most famous cases was during the dotcom bubble, when Buffett refused to invest in any tech stocks and missed out on a ton of gains on the way up.
He stated that he didn’t understand how these companies made money, so he didn’t bother investing in them.
We all know how that turned out; many investors were left burned and lost tons of money, while Buffett escaped scot-free and I’m sure was buying at the bottom, while other quality stocks were being sold off.
For those who aren’t seasoned investors, you may think you don’t understand how any industry really works and although that should initially stop you from investing in companies you don’t understand, you can always try to understand the business and its economics.
That should be part of your due diligence anyway, and only after you’ve tried to understand the business should you pass on it for something that’s more in your circle of competence.
Take First Capital Realty Inc, which operates in the real estate industry.
There are always a few questions to ask yourself when analyzing a company that will help you to gain a better understanding of the company’s operations and growth drivers.
First and foremost, you must be able to explain what the company is and how it makes money. If you can’t even do that, you either need to do more research or the business is out of your circle of competence.
If you can answer it easily, then you’ll want to move on to some of the more advanced questions, such as who’s buying the product or service? What’s the motivation to buy the product or service, and is it a need or a want? What economic environment will drive higher growth and what will hurt the company’s future potential?
With a simple stock like First Capital, these are pretty easy questions to answer. Its portfolio of mixed-use real estate caters mostly to large corporations. As First Capital relies on the success of its tenants, one of the key factors that will drive the growth of its business is an increase in the population in the regions and neighbourhoods in which it operates.
Another thing that will help its stability is continued diversification of its tenants by company and industry; if one industry is hit hard, it won’t have a significant impact on First Capital.
The company is positioned for growth by having a number of its properties in high-income and high-population growth neighbourhoods, especially in major financial centres.
Another growth driver for the company is developments, which First Capital has spent more than $125 million already this year working to build its new super urban neighbourhoods.
First Capital is a top real estate company in Canada, and its business is relatively easy to understand.
No matter how great the company or stock seems, however, if you can’t articulate how it makes money, you should probably avoid investing in the stock.
