You don't need to be a rocket scientist to make money from shares.
Before investing in a company, I like to understand the business, and some businesses are easier to understand than others.
But you don't win an extra prize for extra effort -- getting to grips with a labyrinthine corporation, which makes stuff you didn't know existed, doesn't necessarily mean your investment will grow more quickly.
When I consider complicated businesses, I'm thinking of how diversified they are, and the complexity of their products or services:
Diversified companies
The 1950s and '60s was the era of the large conglomerate, diversified in every possible direction. These were largely broken up in subsequent decades, as investors realised that they could successfully diversify themselves, and tailor their portfolios by buying a basket of more focused companies without the overhead of a central headquarters.
But even today, there are many diversified companies on the market. For example, BAE Systems
(LSE: BA)
makes everything from submarines to missiles to electronics, and until the divestment of its Airbus stake is also involved in civil aviation. For an investor, understanding the impact that each of these divisions will have on the business is quite a challenge. And while the business has more legs to stand on, it also has more to trip over.
Also, even relatively focused companies can have horrendously complicated structures -- how many investors in Enron really had a clue about the subsidiaries and what they were for?
Complex products
Warren Buffett understands what Coca-Cola
(NYSE: KO)
and Wal-Mart
(NYSE: WMT)
do, and he wouldn't own them if he didn't; you can have a working knowledge of those businesses in a few minutes.
Now consider the typical tech company -- you may understand the basic demand they are filling, but how much do you really know about the threats and opportunities they face?
If you have shares in WolfsonMicroelectonics
(LSE: WLF)
, you probably know that they have a chip in Apple's
(NASDAQ: AAPL)
iPod, but in the market for digital to analog converters (DACs), what's their competitive advantage over, say Analog Devices
(NYSE: ADI)
? I'd suggest that's something you should have an opinion on, and it would take much more than a few minutes to figure it out.
As the complexity of the product or service increases, so does the number of unknown unknowns, at least to the average investor. These are not all negative -- you can be surprised on the upside -- but they increase the risks of holding the stock. For that reason, even Bill Gates has commented that tech companies should trade at a discount to their more boring but predictable peers.
I'm not suggesting that we should avoid technology companies or diversified businesses. It's partly a question of degree -- most companies make more than one product and sell it in more than one country, and even a simple product can have complications when you get into the details.
However, there is no reason to believe that complicated businesses are better value, and we can make life a little easier for ourselves by choosing investments that we can easily understand.
