Why Warren Buffett won’t invest in many profitable companies

As an investor, one often hears about companies tipped for greatness. Exactly what they do may be a bit mysterious or difficult to understand, but with fast growth and profitability such companies can be tempting. Legendary investor Warren Buffett is pretty clear on what he would do in such a situation. 

What Warren Buffett looks for in companies

In his 2007 shareholders’ letter, Buffett laid out clearly the criteria he and his partner used when considering companies to buy. He said they “look for companies that have a) a business we understand; b) favourable long-term economics; c) able and trustworthy management; and d) a sensible price tag”.

There is a lot of investing wisdom packed into a few words there. But what’s most interesting for me is the fact that Buffett’s first criterion is that he understands the business.

Why does this matter? After all, if a company performs well financially, couldn’t that on its own make it attractive?

Speculation versus investment

Buffett clearly doesn’t think so. I think his approach makes sense for me as an investor too.

If I put money into a business I don’t understand, it’s basically a form of speculation. Even if the company has respectable management, ubiquitous advertising, a long financial track record, and strong financial results, it’s still speculation. I am putting money into an opportunity based on its momentum, rather than any sort of fundamental understanding.

In my mind, that isn’t what investing is about. Instead, investing is a way for me to put money to work in shares of a company that I think has a bright financial future. Such future prospects can be hard to assess. So to do so, I typically look at a company’s financial reports and try to form a view of how the business performance may be in coming years and decades. But I can’t do that if I don’t understand the business.

For example, consider a company such as Argo Blockchain. Its shares performed spectacularly at points over the last year. But a lot of investors piled into Argo purely on the basis of its share price performance. That’s just speculation. If I didn’t understand key elements of Argo’s business – such as  what competitive advantage it may have in mining and how its planned North American data centres will impact its productivity – then I wouldn’t even consider buying its shares.

Circle of competence

This is part of Buffett’s focus on his “circle of competence”. He doesn’t invest outside the area of his understanding.

The good news is that one’s circle of competence isn’t static. It is possible to learn more over time. In that way I could start to understand businesses which previously baffled me. But that takes time and effort. Until then, I’d choose to stay away from such businesses. Like Buffett, I think staying inside my circle of competence is more likely to improve my investment performance. That means only investing in companies I understand, even though that means letting some potentially lucrative opportunities pass me by.