Inside The 'Circle Of Competence'

If it were up to Peter Lynch, "Buy what you know" would be the only advice you'd need. And Fidelity's white-haired poster boy and former money manager did have a good idea. But somewhere along the way, buy what you know took on unintended meanings. Investors who followed it unthinkingly are now feeling acute pain.

What went wrong? Novice investors certain they had to be in stocks but unclear on where to start redefined "what you know." Suddenly it embraced everything from stocks everyone was talking about at dinner parties to shares in companies they were familiar with but failed to grasp as investments--an important distinction.

Lynch had it right. Investors who pick stocks for themselves must stay within a carefully drawn "circle of competence," deliberately setting down what they know and what they don't. Drawing that circle should be an investor's first task. Doing so shrinks the vast universe of publicly traded companies--more than 7,000, not counting penny stocks--to a manageable number.

Turning away from promising-sounding opportunities can be tough, especially when you hear a tip that makes you feel you know something about a company that others don't. This is especially tempting in the technology sector. But the more bleeding-edge a company's technology, the more likely it will be trumped by a sharper competitor or an unforeseen event. The more unproven its business--and the more unknown the demand for its products--the more vulnerable it is to economic downturns. Every step investors take outside their "circles" makes foreseeing trouble more difficult.

And investors may ignore potential blind spots because they think themselves expert: consider application service providers (ASPs), which rent ready-to-use software packages to businesses (the traditional alternative is buying software directly and installing it yourself). It was a new business model, and that was part of the ASP attraction. Corio and other ASPs quickly acquired market valuations into the hundreds of millions based on the cost-savings advantage ASPs supposedly offered clients. The problem was that the ASP customer base had too many dot-com firms in it. When these companies burned through their cash in the last half of last year, they stopped paying their bills. Demand from larger, more established firms wasn't there yet.

This phenomenon isn't purely the province of born-yesterday companies, however, and AT&T is perhaps one of the best examples of this in recent years. Long considered the proverbial "safe stock" because of its powerful position as the nation's leading provider of telephone services, last year it abruptly abandoned long-held plans to sell an all-in-one package of telecommunications services--from phone to Internet access to cable TV--moving instead to divide the company into a handful of separate companies.

AT&T's original plan was widely hailed as an aggressive move to take the company into the 21st century. It certainly seemed to make strategic sense, and the company was right to look for alternatives outside the long-distance business. Optimism about its long-term prospects helped its stock outperform the S&P 500 in the late 1990s, even as its debt load grew like kudzu.

But when AT&T suddenly realized that the potential for the business it was building wasn't as great as it hoped, the shares fell rapidly, leaving shareholders with a 10-year average gain of precisely zip. If the stock stays put for another decade, we may find AT&T stockholders still wondering whether "bundling" was the way to go after all, or if the company mortgaged its future on a fad.

Equally difficult when evaluating technology companies is deciding which are true revolutions in the making and which will be footnotes. Suppose that you'd heard a tip about Cidco. You researched it and thought you knew it. At one point last year it was worth more than $1 billion--nearly as much as powerful digital-device maker Handspring is today. Money managers touted the potential of Cidco's MailStation, essentially a typewriter that plugs into a phone jack and sends e-mail.

It was new, it was different. But the product was also bizarrely behind the times: targeted at the tech-averse, it never really proved that a viable market existed. Meanwhile, better alternatives--such as handheld, wireless devices and Web-enabled phones--were filling the void as demand for PCs slowed. Losses are mounting, and while the company has upgraded its product, it has also brought in an investment bank to help it move out of penny-stock land.

Does Cidco have a hope? Marketing copy on its Web site asks, "Who said the Internet has to come through a PC?" And its higher-end Mivo products are certainly an improvement on the MailStation in that they offer Web content specially configured to be accessed through their small, grayscale screens. But these devices cost more, and their monthly service fees approach those of traditional Internet service providers like AOL that offer full Web access. Once again, Cidco appears to be creating something that's new and different, but not necessarily better.

The opposite side of this coin is over-simplification. The temptation is to take Lynch's catchphrase and run madly around the house snagging stock ideas from each room: buying shares of Rite-Aid because you have a bathroom, Apple Computer because your kids have one or Motorola because you have a mobile phone.

Your needs make a fine place to start. Chances are, other people have those needs, too. Needs are what create demand. But understanding a company means knowing how it makes money, what its challenges and competitors are and how to tell if and when it's making the grade. Only at that point is an investor prepared to realize that Rite-Aid is carrying around boatloads of debt, or that Apple is reeling not only from a slowing desktop market but from overpriced high-end products and iMac delays.

And so an investor with a strong knowledge of the aforementioned industries might come to see that even if you don't live near a Walgreen's or a CVS, they're still tops in the business; that Dell has developed marvelous expertise in both the precision manufacturing and marketing needed to be a long-term force in the PC business, or that the best opportunities in wireless might not be the phone makers but firms like OpenWave, which hopes to be the standard bearer for wireless Web browsing and messaging.

All this doesn't mean Rite-Aid or Apple is a poor investment. Nor is there any guarantee that Walgreen, Dell and OpenWave will produce better returns over the next decade. Still, it should help illustrate the perils of overstating one's knowledge of a company based on familiarity--as well as the opportunities available to the informed investor.

Armed with real understanding, an investor can better decide whether a company is worth holding through tough times, or whether its prospects have soured and it's time to look elsewhere. Maybe it's time for one more gloss on buy what you know: know what you buy.