Expanding Your Sphere of Confidence and Competence

January 16, 2009 by Joe Ponzio

When it comes to buying stocks, there are a million different approaches, a million different ways to value companies, a million different charts to look at… You get the idea – it can be dizzying, especially if you are trying to learn how to invest and find some stable ground on which you can build your strategy and knowledge base.

That said, time and time again, the great value investors – Warren Buffett, Charlie Munger, Seth Klarman, and others – all teach investors one fundamental rule to intelligent investing: Stick with companies you understand really well…in industries you understand really well.

If you don’t know a company or industry really well, you have to choices: learn it or skip it. You should skip it while you’re learning. You should learn more so you have more choices and opportunities at your discretion.

Banks and Financial Services Companies

For years, I chose not to invest in banks and financial services companies because I didn’t understand them. My inability to understand them, it turns out, came from their “toxic assets.” See…understanding how banks and investment firms make money isn’t all that tough. You sell an investment or loan money…you get paid.

The problem was that I couldn’t expand my sphere of confidence and competence to include this sector because there were so many confusing assets and revenue streams that caused me to fail to understand their predictability.

I’m able to clarify my thinking in hindsight, of course. In August of 2007, just before the collapse, I had written this about US Bank and financial services companies:

Many financial services companies are difficult to value because they have so many diverse revenue streams that are tied to the performance of the stock market, the bond market, and/or the housing market. When a business has to rely on sales, it can control its growth (or losses); but, when a business has to rely on sales and uncontrollable forces, it forces me to lose some confidence in my valuation.

At the time, banks and financial services companies left me standing like a deer in the headlights; so, I didn’t invest. I couldn’t wrap my head around their businesses which, in hindsight, was because of their ridiculous investments (aka “toxic assets”). My ignorance caused me to miss a lot of profits in the mid-2000s; my ignorance caused me to miss even more losses in 2008.

Expanding Your Sphere

Of course, when blood runs in the streets, you again have a choice to make: stay on dry ground or get your hands dirty and look for opportunities. The fact that the streets are running red is not a reason to invest; rather, it’s an opportunity to expand your sphere of confidence and competence, and to determine whether or not you can find opportunities you understand really well…in industries you understand really well.

For example, the auto makers are getting crushed. I don’t bother looking because I know that the economics of their businesses are bad. I wouldn’t even look an auto maker as an ongoing entity until it hit critical failure and went into bankruptcy protection.

Over the past year or so, I spent a lot of time mulling it over – reading, studying, and understanding the financial crisis, banks, and the toxic assets. As the banks return to “normal” operations and lending practices and avoid stupid (er…toxic) investments, they become much more predictable and clear.

Buying Wells Fargo

So, on Wednesday, I added a 10% position to Wells Fargo at $23.41. (I guess I should have waited another day to buy it at $19 and change – who knew?) I have traditionally avoided banks; but, in studying them over the past few years, and in really coming to understand them (and their mistakes) in the past year, I feel much more comfortable owning Wells Fargo (though I wouldn’t be comfortable owning a financial services sector mutual fund or many other financial companies).

How did I end up purchasing Wells Fargo? I’ll post a more in-depth analysis in the coming days. For now, I’ll simply state this: Wells Fargo, like most banks, will have a tough few quarters and perhaps a tough few years. Still, when things return to “normal,” Wells Fargo will likely be a $100 to $150 billion company.

It’s far easier to tell what will happen than when it will happen.

Because of their strong position, I don’t expect Wells Fargo to be at the government’s bank window begging for a lifeline (though I wouldn’t be surprised to see them take TARP money – personal feelings about the bailout aside, a bank would probably be nuts not to borrow from the government on such favorable, easy terms).

How Do You Expand Your Sphere?

Read (and google what you don’t understand). Your “too hard” pile doesn’t have to be a black hole from which no company can escape. If you can learn enough about a business and industry to find the predictability and assess the value, you’ll begin to find opportunities where nobody else is looking.

Years later, you just might be amazed at your results.

To The Folks That Have E-mailed Me

I’ll respond this weekend – promise.

A Note From Joe Ponzio

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