“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” — Benjamin Graham
One of the biggest mistakes investors can make is not understanding the business they’re buying into. As the godfather of value investing, Benjamin Graham tried to teach the world, a share is part of a business, it’s not a lottery ticket. Would you buy a coffee shop hoping to flip it at a higher price without looking at the company, understanding how it works and if it’s profitable? Of course not, so why would you do the same with a share?
You Must Know Your Business Inside Out
Li Lu is one of the world's greatest value investors. He managed money for Charlie Munger and has been tipped as a possible candidate to take over from Warren Buffett when he leaves Berkshire Hathaway.
In a rare lecture to students at the Colombia Business School in 2010, Li spoke on the subject of value investing and how important it is for investors, who want to succeed, to know and understand the businesses they own:
"So how do you really understand and gain that great insight? Pick one business. Any business. And truly understand it. I tell my interns to work through this exercise – imagine a distant relative passes away and you find out that you have inherited 100% of a business they owned. What are you going todo about it? That is the mentality to take when looking at any business. I strongly encourage you to start and understand 1 business, inside out."
This is Li's advice to students. It's imperative to study and understand each business inside out. Most investors fail at this first step, they may find it too hard or not completely understand why it's required.
"Most people don’t take that first concept correctly and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading.You would really seek out knowledge on how it should be run, how it works. If you start with that, you will eventually know how much that business is worth."
The purpose of understanding each business inside out is to protect against the market's gyrations. Stocks will go up and down but if you know and understand the business, you won't have a desire to sell just because the shares have fallen 20% in a single day. If the underlying business remains sound, and you know how the business operates, the chances of you making a silly mistake selling out early are substantially reduced:
"This is really where that insight and temperament comes in. In a sense, you have to have a certain confidence in your own judgment and not be swayed by other people’s views. It is not easy. But that is life. It is just a given. It happens to everyone."