I should have never invested in Global Crossing ( GBLXQ). That's clear in retrospect, of course. In hindsight, it's equally clear that the company's revenue numbers weren't to be trusted. But even without the virtue of hindsight -- even without knowing then what investors know now about how Global Crossing manipulated its revenue numbers -- I shouldn't have invested in the stock. Buying Global Crossing violated one of the most important rules for protecting and growing your capital: invest in what you know. At market tops, some investors stop thinking of stocks as real-world entities and treat them just as financial instruments. In 2000, many investors weren't thinking of Global Crossing shares and other hot stocks as investments in specific businesses, but rather as tickets to a ride. In addition, many investors who remembered that owning shares means receiving partial ownership in a business were too optimistic about their ability to understand that business. At market tops, when everything is working, we all fall in love with our own analytical abilities. For example, I thought I understood Global Crossing's business. What hubris! I was completely out of my league when it came to pitting wits with the guys keeping the books at that company. Global Crossing even hired the accountant from Arthur Andersen who had warned the company about violating the rules on counting revenue from some of its deals and put him in charge of making sure that the deals followed the letter of the law. For a while, anyway. I bring all this up not to relive the past, but because "invest in what you know" is the best strategy I know for navigating the post- Enron market. I'd add one twist to this strategy: Put more emphasis on a company's books while we continue to unwind the accounting excesses of the stock market bubble. The result, which I'd rename to "invest in what you can understand," is an approach to investing that I think is especially valuable at a time like this when so many investors are asking whom they can trust in the financial markets. The ultimate answer to that question is investors can only trust themselves -- and "invest in what you can understand" is a reassuring way to approach what can seem a daunting task. (The two books by mutual-fund superstar Peter Lynch and John Rothchild, Beating the Street and One Up on Wall Street, are still the best common sense introductions to "invest in what you know.")
Invest in a Business You Understand
A simple but attractive product sitting on the supermarket shelf may be the starting point for Lynch's investing process, but his focus quickly shifts to understanding the business that makes that product. Easy-to-understand products often -- but not always -- come out of easy-to-understand businesses. But investors need to remember that the two don't always come together. To understand a company's business, you don't need to know how it makes what it makes. Nor do you need to understand so much about its offerings that you could go out on a sales call. The important point is to understand how the company makes its money -- and what factors determine whether the company will make more or less money. That means some technology companies that produce complicated products that most investors understand only in general terms can actually be simple businesses. I'd argue, for example, that Intel ( INTC) is a simple business. At its core, the company makes its money by selling the chips that go into PCs. The amount of money the company makes rises and falls with demand for PCs and the profit margin that Intel makes on each chip. Intel constantly fights to take costs out of its manufacturing and to introduce new chips with better features and higher selling prices to keep prices as high as possible. Get the demand and the average selling price right, and you should be able to predict what Intel will make. On the other hand, some companies that sell simple goods or services are actually very complicated. Consider Blockbuster ( BBI), for example. The company's business seems completely mundane, doesn't it? What could be more obvious than making money from selling and renting videotapes and DVDs? Well, it turns out that the economics of selling and renting tapes and DVDs is complicated. DVDs now account for about 30% of rentals at Blockbuster, with the rest coming from the company's bread-and-butter videotape market. And rentals of DVDs more than tripled in the fourth quarter, according to the company. With some 16 million new DVD players projected to be sold in 2002, according to Blockbuster, all the trends would seem to favor increased sales and profits at the chain. Maybe. It turns out that the margins on all this new DVD business are tough to predict. Blockbuster traditionally has had revenue-sharing deals with the Hollywood studios that produce tapes; the studios let Blockbuster buy at wholesale for its rental market and then charged relatively higher prices to buyers of the tapes. The studios gave Blockbuster this concession in exchange for it delaying the release of tapes in the rental market. But Blockbuster has been slow to sign up studios for revenue sharing on DVDs. And it's not clear whether or not that's been a good thing. On the one hand, because DVDs retail for lower prices than tapes, even without the agreements Blockbuster has been able to improve its margins in the DVD business without the revenue-sharing agreements. On the other hand, some Hollywood studios, principally the Warner Bros. division of AOL Time Warner ( AOL), seem determined to keep more of the revenue from DVDs for themselves instead of sharing it with Blockbuster. For AOL Time Warner, that has meant keeping purchase prices low on DVDs to encourage sales because sales yield bigger profits to the studio than rentals do. It's by no means clear how this battle will turn out -- three studios have signed revenue-sharing deals on DVDs with Blockbuster -- or what arrangements make the most money for Blockbuster at what volumes. That makes it tough, in my opinion, to understand Blockbuster's business.
Invest in a Business Catalyst You Understand
Of course, just because you understand a business doesn't mean you want to own a piece of it. Simple, easy-to-understand, declining businesses aren't good investments. Nor are simple, easy-to-understand, stable businesses that are so stable that they show the potential for a declining dividend over time. What you want is a business that looks likely to produce more cash in the future than it does today, so you as an investor can book a gain either from a rising dividend or a rising share price. Maybe even both. Sometimes the potential future catalyst is remarkably simple. At Johnson & Johnson ( JNJ), for example, it's a simple product cycle story. The company's new drug-coated stents are likely to send sales soaring -- a promising catalyst when worldwide growth in the company's Cordis medical devices division came to 27% in the fourth quarter of 2001 without the full contribution of the new products. Having received Food and Drug Administration approval in the fourth quarter of 2001 for one type of new stent, Johnson & Johnson is on track for April approval and launch of other types of coated stents in Europe and approval in the U.S. in the last quarter of 2002 or early in 2003. Johnson & Johnson is so confident of U.S. approval that it has pressed ahead with its manufacturing plans and now looks likely to be ready to manufacture and launch in the U.S. by October 2002. Just in case approval comes early, you understand. And sometimes it can be markedly more difficult to understand or predict the catalyst even in a similar company. Eli Lilly ( LLY), for example, has been hammered by the financial markets as generics eat away at the company's Prozac franchise. The fourth quarter of 2001 marked the first full quarter of declining Prozac sales due to generics. That decline knocked a full 100 basis points (100 basis points equal a percentage point) out of Lilly's gross margins for the quarter. Lilly's pipeline of new drugs -- Cialis for erectile dysfunction from the company's partnership with Icos ( ICOS), Duloxetine for depression, Atomoxetine for attention-deficit disorder -- all due for FDA approval this year was supposed to be the catalyst that would fix the Prozac problem. But the FDA has slapped Lilly with a warning letter about problems with the manufacturing standards at one factory that makes injectable drugs. As part of that warning, the FDA's letter said that there could be delays in approving Lilly's new products if the quality problems at Lilly's factory aren't fixed. Is that simply FDA boilerplate or a real threat? The stock market doesn't really know, and shares took a beating -- dropping 7% from the beginning of the year through Feb. 7 before recovering slightly -- on fears that Lilly's catalyst wouldn't kick in on schedule.
Invest in Financials You Understand
I'm adding this element to the two, more traditional "invest in what you know" points above because it's especially difficult to understand financials these days. Historically, as markets top out, the quality of company financials declines. For example, companies take on more debt because they believe that demand will expand forever -- and then have to get it off their books any way they can when the demand doesn't materialize. Company management gets so hooked on producing ever-faster sales and earnings growth that the pressure to resort to gimmicks to keep the growth going -- at least on paper -- becomes almost irresistible. (That's especially true when management is paid in stock options.) I don't know if every company cheats at a market top, but it certainly seems like that at the moment. So at market tops, you get financials like those produced by Global Crossing, a company that decided quite clearly to push the envelope on what counted as revenue. The issue at hand: IRUs -- short for Indefeasible Right of Use. An IRU in this case was essentially a long-term lease of capacity on a telecommunications network. According to the accounting rules, the sale of an IRU counts as revenue, but the money spent to buy an IRU isn't a cost. Instead that money counts as a capital expense -- with the costs spread over many years -- because the IRU is actually a long-term asset. The problem is that IRUs are just begging for abuse if two companies decide to collude on what's called a round trip. In a round trip, two companies essentially swap IRUs for the same amount of money. That has the effect of generating revenue for each company -- but not of increasing their costs by a similar amount because the money spent qualifies as a capital expense and becomes an asset. Can an investor tell a bona fide IRU that is really generating revenue for a company from a round trip that is simply creating bogus revenue numbers? Most of the time the answer is no because the only way to detect such round tripping is by matching sales and purchases of IRUs between companies. I don't know whether Global Crossing actually broke any accounting rules or laws in its use of IRUs, but I sure do know that the company's financials were so complicated that no analyst really knew what revenue numbers to use to figure out the company's state of health. Global Crossing is an extreme case. Most companies didn't push the envelope quite as far in this market. But almost every company's books that I've looked at recently raise some issue that investors need to be sure they understand before they invest. For example, Krispy Kreme Doughnuts ( KKD) -- and what product could be simpler than a doughnut? -- recently decided not to use a financing technique called a synthetic lease to raise money for a new plant. A synthetic lease would have had the effect of removing the cost of the plant from the company's balance sheet. Is that as bad as the off balance sheet partnerships that Enron set up to hide debt and losses from investors? I don't think so. But such transactions certainly make it hard to figure out the financial health of a company. It's important to remember that "invest in what you can understand" is a subjective strategy because each investor comes to the game with a different knowledge base and various research skills. Whole Foods Markets ( WFMI) wrote off $5.5 million to write down the value of the company's investment in Internet shopping channel Gaiam.com and $14.1 million to cover losses at wholepeople.com; do those write-offs count as financials that you don't understand? Not for me -- but then I covered the venture capital industry for almost 10 years, and these kinds of losses seem fairly straightforward. But if you can't get your mind around the numbers, by all means find an investment that you do understand. (And if you want to invest in an industry sector that you feel is promising but that you don't understand, consider a mutual fund or similar vehicle with a solid track record that shows that its professional managers do understand the businesses.) I certainly wouldn't scorn any stock just because it's easy to understand, either. Complexity doesn't have any patent on above-market investment returns. Wal-Mart ( WMT), Johnson & Johnson, Walgreen ( WAG), and Dell ( DELL) -- all simple to understand -- have demonstrated that investing in what you can understand pays off well over the long term.