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Many readers have asked me to delineate the exact criteria I use for fundamental analysis. That's a somewhat difficult question to answer generally; while there are a lot of common factors like "wide moat" and common techniques like discounted cash flow analysis, I use different criteria for analyzing different companies across different industries.

What I can do, however, is offer some investing adages you can follow when constructing your portfolio. Most or all of them will be twists on classic adages. Today, we'll start off with:

Skyler's Investing Adage #1: Don't Buy What You Don't Know

This adage is obviously based on the now-famous Lynchism "Buy What You Know." Even though Peter Lynch may not have meant that phrase literally, many investors have taken it to heart and bought only stocks they "know." This has led to unfortunate events like retail investors lining up to buy into the wildly overpriced Facebook (NASDAQ:FB) IPO.

To me, a more appropriate rephrasing that probably better models what Lynch really meant is the same statement with two negatives: don't buy what you don't know. Another way to phrase it: make informed decisions.

This is an especially important consideration in the current market. In the past few years, many fairly exotic classes have popped up and gained mainstream popularity. There are leveraged ETFs, which aim to double (or sometimes triple) the daily performance of a given underlying index. There are mREITs like Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), which use leverage to capture returns based on the interest rate spread between short and long-term debt. There are tax-advantaged Master Limited Partnerships, now available through the Alerian MLP ETF (NYSEARCA:AMLP). There are ETNs like the iPath S&P 500 VIX Short-Term Futures (NYSEARCA:VXX), which allow market participants to directly bet on volatility rather than prices. There's emerging market debt, which has recently garnered a lot of attention.

There's nothing wrong with any of these, necessarily. I personally hold a small stake in an emerging market debt mutual fund. However, it's important to make sure that you're not buying any of these products if you don't know what they are.

Example: I've communicated with several people who bought mREITs simply because "they had a 12% dividend yield." mREITs certainly do have strong dividend yields, but investors expecting stable 12% compounding returns forever will likely be disappointed. Both the dividend yield and price of mREITs are notoriously volatile.

NLY Dividend Yield Chart
(Click to enlarge)

NLY Dividend Yield data by YCharts

As far as I can tell, the market's recent fascination with some of these more exotic asset classes can be attributed to two factors:

  1. Yield-chasing due to abnormally low Treasury yields
  2. A desire for diversification - the more asset classes, the better, right?

Each of these reasons is flawed. As for the first, "picking a lesser poison" is a terrible idea - being surrounded by nightshade doesn't make hemlock any less poisonous. Second, "diversification" can be achieved by exposure to a few different asset classes and markets, and there is such a thing as overdiversification. Beyond a certain point, there's no advantage to collecting more asset classes, especially if you don't know how they function. Investing isn't a Pokemon game - you don't have to "catch them all."

Not Buying What You Don't Know: How To Determine If You Know Enough To Invest

There are several "hurdles" that you should be able to pass if you are planning to invest in (or are invested in) any particular asset class. You should be able to explain your answers to a reasonably intelligent bystander with no prior knowledge of the subject.

1: What's the "Business Model?"

I use "business model" inside quotation marks because for things like emerging markets debt and volatility futures, there really isn't so much of a business model. The basic point here is that you should be able to explain what exactly you're investing in. If you don't know, why are you investing? Think about it this way: if someone wanted to sell you their business, would you buy it if you didn't know how it worked? Just because something is traded on an exchange doesn't automatically make it a worthwhile investment.

Your answer doesn't have to be uber-detailed - you don't need to know every single step in the supply chain or the name of every director - but you need to have a general idea of how the business works. For example, Target (NYSE:TGT) is a retailer that buys wholesale and sells at higher prices to individual customers. Their source of profit is that narrow profit margin, but it's relatively stable because people will always be buying groceries, jeans, etc.

2: What's Driving Returns?

This is slightly different from part 1. While there are hundreds of beverage companies out there, few come close to asserting the dominance of Coca-Cola (NYSE:KO). The historical chart shows that Coca-Cola goes up and up and up, but that alone is no reason to buy it - tech stocks were going up and up and up in the late '90s, and we all know how that ended. Before investing in Coca-Cola, you should understand why they have had long-term returns. It turns out that Coca-Cola offers a fairly low-cost product that consumers love and are very loyal to, and consequently, Coca-Cola does well through good times and bad. In the case of the Internet bubble, the returns were through rapid P/E multiple expansion.

3: What Are The Risk Factors?

Individual asset classes have different risk profiles, and it's important to understand the exact factors that could affect your investment. Example questions you would need to be able to answer: what would happen to mREITs in an environment with rising interest rates? What would happen to returns from local currency debt if the exchange rate with the dollar changes significantly?

4: Are There Any Special Factors To Consider?

Municipal bonds are generally exempt from federal, state, and local taxes. Thus, there's no reason to hold them in a tax-deferred IRA or tax-exempt Roth IRA. A similar argument applies to tax-advantaged MLPs. A holder of VXX would need to understand the effects of contango and backwardation.

5: Why Am I Buying This?

Where will it fit in my overall portfolio strategy? If you don't know, don't buy.

If You Can Answer These Questions, Then You Can Invest

Don't follow the crowd. Peter Lynch always conducted fundamental analysis and analyzed the points above. Don't buy what you don't know.

The corollary to this statement is don't buy (on your own) if you don't know enough. While I've examined why mutual funds are generally bad for dividend growth investors, they do have uses in some areas. For example, while I can answer the four questions above for emerging markets debt, I still don't feel I know enough about individual companies in various emerging markets to construct my own bond portfolio. Thus, I turned to the Fidelity New Markets Income mutual fund to gain exposure to emerging markets debt - but only after I answered the five questions listed.

As always, comments/thoughts are appreciated. What's your "knowledge threshold" as an investor? How thoroughly do you analyze asset classes before investing in them?

Source: Modern Investing Adages, Part 1: Don't Buy What You Don't Know