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We have already covered the importance of investing in companies with a wide economic moat. Today, I would like to take a look at the second component in the series of 10 Things To Look For When Buying A Stock. Number 1 can be found here.

Easy To Understand Business

Warren Buffett loves to invest in companies with an easy to understand business model. He often jokes about the fact that he isn’t smart enough to understand the business models of many companies. Buffett’s three largest investments are Coca Cola (NYSE:KO), Wells Fargo (NYSE:WFC), and American Express (NYSE:AXP). He shies away from many technology companies with complicated business models. If the world’s greatest investor avoids companies that are too complex to understand then so should you. You should only invest in businesses in which you can quickly identify exactly how they make money.

Take Best Buy (NYSE:BBY) and Walmart (NYSE:WMT) for example. It’s very easy to see how both companies generate revenue. These large retailers have a simple and straightforward business model. They make money by buying products at a lower price and selling them to consumers at a higher price. Investors can easily judge their results by looking at the companies margins and same store sales(comps).

Complicated Business Models

Conversely, General Electric (NYSE:GE) participated in so many different business segments that it became increasingly difficult to understand how the company actually made money. The company’s financing arm GE Capital became a larger component of GE than its industrial division. It took a decade, but the company is finally selling off many of its divisions and getting back to basics. A company should derive the bulk of its revenue from its main business.

Area of Expertise

Always stick to your area of expertise. If you understand how a company makes its money then you can be on the lookout for future growth opportunities. It also helps you to watch out for future impediments to growth. I always use my investing experience with Krispy Kreme (NYSE:KKD) as an example of investing in an area that I did not understand. I thought the company was a good buy because of its doughnuts and did not look at the company’s business model. The company’s same store sales were horrible and they only made money by getting royalty fees from new store owners. Once Krispy Kreme stopped opening new stores, the company’s sales plummeted.

If you cannot understand the business model then you will not be able to recognize if a company’s stock is a good or bad investment. Companies with extremely complex business models may actually represent a good investment opportunity but I would rather not take the chance.

Source: Be Like Buffett, Invest in Businesses That Are Easy to Understand