6 Reasons Not To Buy The Stock
There are many reasons to not invest in a business.
Stocks are pieces of businesses. With that in mind, I posed the following question to the @charliemungerquotes community this week:
“If a business is __________, I will not invest in it.”
The top responses we received are below along with relevant notes and links.
Reason #1 — The business is hard-to-understand.
This is a great response because it acknowledges that we all have a circle of competence. Your circle of competence is the areas that you know.
What’s more valuable than what you know is knowing what you don’t know. Defining your circle of competence is impossible without acknowledging what you do not know.
Warren Buffett says it best:
“Defining your circle of competence is the most important aspect of investing. It's not important how large your circle is. You don't have to be an expert on everything. But knowing where the perimeter of that circle is… and staying inside of it is all-important.” (via YouTube)
If you understand the importance of staying within your circle of competence, then you see what Charlie Munger meant in this quote:
Reason #2 — The business lacks a barrier to entry.
A business can do something great, but if a bigger competitor can start doing what they do, that spells trouble. The barrier to entry concept is described as a “moat” by Buffett and Munger. A theme of most of the Berkshire Hathaway holdings is that they have some sort of durable competitive advantage; another business cannot just start doing what they do and be a major threat.
Apple. Costco. Amazon. They have moats.
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle.” —Warren Buffett (via CNBC)
I don’t believe it is a bad sign if other companies attempt to imitate. That is actually how you can find out if your perception of their moat is real or not. If the moat is real, the competitor won’t succeed in the long-run.
To hear Warren Buffett talk about moats, specifically related to one of Berkshire’s company’s (See’s Candies), the video below is all you need:
Reason #3 — The business is not idiot-proof.
Leadership is key, but what happens if the founder/CEO is no longer in the picture? If the business will crumble without him/her, you should avoid it.
Enjoying this post? Subscribe to never miss the latest:Reason #4 — The business is not innovating.
Innovation is key to enduring success.
Elon Musk says “the pace of innovation” is the moat of Tesla.
I was recently reading through the last 10 years of Domino’s 10-Ks to better understand how the pizza chain’s stock was one of the best performers of the 2010s.
Domino’s proves that innovation can come in all places:
“Our over 50 years of experience and innovative culture have resulted in numerous new product and process developments that increase both quality and efficiency. These include our efficient, vertically-integrated supply chain system, a sturdier corrugated pizza box and a mesh screen that helped cook pizza crust more evenly. The Domino’s HeatWave® hot bag keeps our pizzas hot during delivery.”
Reason #5 — The business is highly in debt.
Too much debt is bad. Too little debt can also be bad, too.
In general, if your debt-to-equity ratio is too high, it’s a signal that your company may be in financial distress and unable to pay your debtors. But if it’s too low, it’s a sign that your company is over-relying on equity to finance your business, which can be costly and inefficient. (via Harvard Business Review)
Reason #6 — The business is following the institutional imperative.
In 1990’s Berkshire Hathaway shareholder letter, Buffett air-quoted this term when discussing a mistake he sees the major banks make often:
“And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the ‘institutional imperative’: the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.” —Warren Buffett
What are we missing? Let us know in the comments.