It's Good (and Bad) to Invest in What You Know

LONDON -- A cornerstone of Peter Lynch's investment philosophy is that you should "invest in what you know." Most investors can follow this strategy as they will have acquired specialized knowledge of one or more industries over the years, most probably through work.

The problem is that simply knowing a lot about an industry and/or a company doesn't necessarily make it a great investment. Unfortunately, some investors operate under the mistaken assumption that because they like a company's products, its shares are a bargain. If I assumed this, drinks group Diageo would probably form more than 50% of my portfolio!

So if you're aware that company X's newest product is much better and cheaper than the competition, this doesn't necessarily mean that X's shares are cheap. Indeed, it's quite likely that the market has already built your knowledge into X's share price.

The dot-com crash
At the height of the dot-com boom in the late 1990s, it became very fashionable for people who worked in the information technology industry to invest in technology shares because they had "specialist knowledge."

Wall Street did what it always does and fed the public's demand with a selection of increasingly overpriced companies, such as, which was going to dominate the world of pet supplies by selling cat litter and pet food over the Internet. The problem was that the supermarkets were already selling these goods at such low margins that's shipping costs ate up all of its profits. So the more it sold, the more it lost.

Product knowledge doesn't automatically translate into business and investment knowledge. We saw a good example of this in May when Facebook (NAS: FB) came to the market on a tidal wave of hype that encouraged some users to buy the shares simply because they were very familiar with the product.

The buyers ignored things such as Facebook's profitability, the high price put on the company, the competition, its prospects and the chance that one day it could easily suffer a fate similar to that of MySpace. Facebook's shares have fallen by more than 40% since they started trading.

No news is bad news
I know a fair bit about the newspaper business, which in its heyday was a license to print money thanks to regional monopolies over classified advertising and the general lack of alternative sources of information.

Since I realized that competition from the Internet and the 24-hour news channels was heating up, I've avoided the industry like the plague. Britain's biggest newspaper publisher, Trinity Mirror (ISE: TNI.L) , has been a major casualty of the changes and its shares now trade on a P/E of less than 2, having fallen by more than 90% in the last five years.

Now it's quite possible that Trinity Mirror qualifies as what Benjamin Graham called a "cigar butt investment" (that is, something with a few puffs left in it). Graham's most famous student, Warren Buffett, clearly thinks the industry has a future since his company, Berkshire Hathaway (NYS: BRK.B) , has bought several newspaper publishers this year. I'm not so sure of this thinking, but then few people have made money betting against Buffett.

Circle of competence
Buffett says that investors should stick to their "circle of competence" -- that is, only those industries and products they understand. If you don't understand something, then either don't invest in it, or study it to the point where you can add that something to your circle of competence.

Knowing a lot about both the oil industry and global politics led me to buy shares in Dragon Oil (ISE: DGO.L) in the early 2000s. Back then, Dragon's reserves of more than 500 million barrels of oil in Turkmenistan were being valued by the stock market at less than 10 pence a barrel instead of the $1 to $2 which you'd normally expect to see for a frontier nation.

Once I realized that Turkmenistan wasn't the worst place in which to do business, and that Dragon, was on course to rapidly increase its production (I found that out by reading the annual reports) its shares turned out to be a bargain.

Small oil company shares are notoriously volatile and while I've made more than 5,000% on Dragon Oil, I've also had my fair share of losers in the sector. To learn more about how to select oil and gas shares with the potential for multibagging profits, I strongly recommend you download the latest special free report from the Motley Fool, "How To Unearth Great Oil & Gas Shares."

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Watch and learn
Among Yogi Berra's more famous sayings is that "You can observe a lot by just watching." Back in 2008 I followed his advice by selling my J Sainsbury (ISE: SBRY.L) shares and putting the proceeds into Tesco after having noticed that there were a large number of mostly empty shelves in several of Sainsbury's stores.

It turned out that this was an early warning signal that Sainsbury was having severe problems with its computerized stock-control system. Its shares fell soon afterward and they're currently trading at less than 75% of the price I received even though the problem has been fixed.

In investing, as in life, one of the best pieces of advice comes from the second Dirty Harry film, Magnum Force: "Man's got to know his limitations."

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Tony owns shares in Berkshire Hathaway, Diageo, Dragon Oil and J Sainsbury. The Motley Fool owns shares of Berkshire Hathaway, Tesco, and Facebook.Motley Fool newsletter serviceshave recommended buying shares of Facebook and Berkshire Hathaway. The Motley Fool has adisclosure policy.
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