Understanding the Business Behind a Stock (Not Just the Ticker)

“Know what you own, and know why you own it.”

—Peter Lynch, American investor and former manager of the Magellan Fund

Understanding the business behind a stock is one of the core principles of how I invest today. It’s the difference between owning a ticker symbol and owning a real business. Today, I wanted to share what this actually means and how it helped make me a better investor.

When I first started buying individual stocks, I didn’t think about the companies behind the stocks I was buying. Stocks were nothing more than random symbols to me. I didn’t view stocks as ownership in businesses. I had no idea how the companies made money or why they might do well.

By the end of my first year, I’d traded shares in dozens of companies I knew nothing about. I bought because the charts looked good—and sold for the same reason.

Everything changed when I switched to using fundamental analysis. Now, I limit myself to investing only in companies that I understand.

WHY UNDERSTANDING THE BUSINESS MATTERS FOR LONG-TERM INVESTORS

I no longer worry much about where a stock’s price will be one month from now. Instead, I’m focused on where the company itself will be 10 years from now.

Over the long term, a company becomes more valuable only when it becomes more profitable — and its stock price eventually follows.

If two companies sell the same thing, but one barely survives while the other compounds profits year after year, which one will be worth more?

The answer is obvious—and that difference starts with the business, not the stock chart.

While it’s not guaranteed, understanding the business helps you make reasonable assumptions about how successful a company could be.

How does the company make money? Is it in a line of business that is growing or shrinking? Who is its competition? What threatens its business? Does it still have room to grow its market share? What do its customers say about it? Where do I see this company 10 years from now? When you understand the business, you’ll have an idea why it might become more profitable.

You’ll also have an easier time riding out any dips in the stock price. Stock prices swing up and down like a roller coaster. Understanding the business helps you stay calm when others are selling shares in panic. You’ll know if the dip is temporary or when it might be a good idea to get off the ride.

WHY GETTING IN EARLY MATTERS LESS THAN BUYING GREAT BUSINESSES

You’ve probably heard someone say that the way to make money in stocks is to invest in startups. You have to buy up shares before everyone else knows about the company. Or so says conventional wisdom. The previous Adobe example certainly makes it appear that way.

But I learned that’s not really the case. Great companies will grow and be profitable for years, if not decades. Take Coca-Cola, a favorite company of investor Warren Buffett, for example. Coca-Cola has been around since the late 1800s and will probably be around for decades to come.

Finding great companies like Coca-Cola is more important than getting in early. And you find these companies by first understanding the business. It’s also a lot easier to understand a company and its prospects after it’s been in the trenches for a while and proven itself.

HOW TO FIND BUSINESSES YOU ACTUALLY UNDERSTAND

So how do you find businesses you understand, especially if you’ve never been an entrepreneur before?

Although it helps to be intimately knowledgeable of a company, knowing the basics of how it operates is plenty. And don’t assume simple businesses can’t be great either. Another famous quote of Peter Lynch is to “Go for a business that any idiot can run — because sooner or later, any idiot probably is going to be running it.”

To find simple businesses you understand, start by asking yourself the following:

• How do you earn money?

• Where do you spend money?

• What goods and services do you use?

• What are your hobbies and passions?

The answer to the first question will help you find companies in industries you probably understand very well. I, for example, worked in graphic design and printing for many years. Hence, I feel like I understand Adobe’s business. I’ve also worked in the retail and resort industries before, so companies in those industries would also be in my comfort zone.

Answers to the remaining three questions let you think as a consumer. Are there certain things you constantly spend money on? Do you see other people spending money on the same things? You might have found a company that you understand, and that also has a strong customer base.

Once you’ve identified businesses you understand, you might find that they’re in a very short list of industries. And that’s fine to have niche knowledge. You can always expand your knowledge later.

When I first started investing, I bought stocks in dozens of industries, from construction hardware to for-profit education. I didn’t know anything about most of those industries. Now I stick to only two or three industries I understand very well.

WHY COMMODITY BUSINESSES MAKE BAD INVESTMENTS

After you’ve found companies you understand, is it time to buy shares?

Not so fast! Just because you understand the business doesn't mean it’s a good investment. You want stock prices that grow, which means finding companies with growth potential.

A department store, for example, has a business that’s easy to understand. But it’s also a highly commoditized business. Different department stores sell the same mass-produced, branded merchandise. The only way the stores can differentiate themselves is by price.

When price is the deciding factor for consumers—like groceries and gasoline—you may be looking at a commodity business. Companies that must lower their profit margin to compete have a difficult time growing.

What you want instead is a company that can raise prices—a company with an economic moat.

But that’s for an upcoming post.

See you at the finish line!

---

Disclaimer: I may hold shares of some of the companies mentioned. I’m not a licensed financial professional. This blog shares my personal experiences and opinions around money, investing, and early retirement. It’s for informational and educational purposes only—not financial, legal, or tax advice. Always do your own research or consult with a qualified professional before making any financial decisions.