“Buy what you know” is a common refrain you hear from some of the world’s most well-known investors. Warren Buffett, Chairman and CEO of Berkshire Hathaway, is one of the biggest advocates of staying within your circle of competence and buying what you know.
To do that, you need information. With initial public offerings (IPOs) and newly-public companies, you don’t always have as much to go off of. In those cases, can you truly buy what you know? Before we offer some answers to that question, let’s first look at what a circle of competence is.
What is a Circle of Competence?
Warren Buffett has regularly referred to the circle of competence concept over the years. In his 1996 letter to Berkshire Hathaway shareholders he wrote:
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
Think of your circle of competence as two concentric circles, the inside one being what you know and understand, and the outside one contains the things you don’t. Your circle of competence isn’t static, over the course of your lifetime it will grow naturally, but you can also expand it through your own efforts (education, experiences, mentors, etc.)
When it comes to investing, the idea is to start at the things you know while avoiding the things you don’t. If you’ve worked in the restaurant industry your entire life, you have no advantage in picking biotech stocks over a doctor, but you likely have specialized knowledge pertaining to the restaurant industry.
Using your own experience based knowledge can help you identify stocks that fall within your circle of competence as well as ones that don’t. This helps you to quickly eliminate potential investments as soon as you start getting into information you don’t understand, and don’t necessarily have a desire to learn.
Once you’ve narrowed down the pool of potential investments to what you know and understand, the next step is to research and analyze them to determine which stocks may work in your portfolio.
Buying What You Know: What About IPOs?
But what about when you don’t have as much information to help analyze a company? That’s often the case with IPOs and newly-public companies. However, just because there’s less history and information available compared to established, publicly-traded companies doesn’t necessarily mean you can’t stay within your circle of competence and buy what you know.
So what can you do if you’ve identified an IPO or a newly-public company that you believe falls within your circle of competence? You can analyze the company with the information available to see if it might be worth owning based on your investment criteria. The less information you have, the harder it can be to fully understand the business, and the more speculative (and risky) that investment might be.
If you’re not sure where to start when researching an IPO, a first step may be to review the company’s Form S-1, which is the registration form filed with the Securities and Exchange Commission prior to going public. This form includes information about how the company plans to use the capital it raises as well as an overview of the business.
Another step might be researching how similar companies traded in their first several months to see if there are any noticeable trends and dig into what was driving price movement in those stocks. An additional practice that could be helpful is to read a variety of opinions on the company, both bullish and bearish, to make sure you’re considering potential outcomes you might not have thought of.
If you’re not doing any research before investing, and just buying a company because they made you a delicious coffee, manufactured a phone you really like, or you just really enjoy their customer service, then you’re not buying what you know, you’re allowing personal preferences to guide you into making blind investment decisions, which is probably never a good idea.
Editor's Note: This article was originally published on The Ticker Tape.
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TD Ameritrade® commentary for educational purposes only. Member SIPC.
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