In addition to his impressive pile of wealth and wisdom, Warren Buffett is famously known for avoiding investments in industries he does not completely understand. The Berkshire Hathaway (NYSE:BRKA) CEO has managed to avoid peer pressure and the desire to find the next hot stock by simply investing in his circle of competence — a crucial lesson all investors should keep in mind.
Buffett seeks to invest in companies that have a significant amount of certainty. This makes it easier to predict future earnings and the value of a business. By sticking to what he understands best, Buffett reduces his risk by not having to rely on the opinions of others. “We are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now,” Buffett wrote in his 1996 letter to shareholders. “A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”
Buffett adds: “I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.”
The technology industry is a prime example within the stock market, where certainty is in short supply. The Internet transformed the way we live our daily lives and paved the way for new goods and services, but it has been painful for some investors venturing outside their circle of competence. This was most evident during the dot-com bubble, a portfolio slayer that kept Buffett safely on the sidelines. Today, uncertainty among well-known tech names still remain.
Intel (NASDAQ:INTC), the world’s largest semiconductor chip maker, has faced several challenges in recent years due to mobile computing gaining more popularity than personal computers. Last week, the company confirmed plans to reduce its workforce by more than 5,000 jobs this year. Other former tech giants, such as Hewlett-Packard (NYSE:HPQ) and Dell, are also in the process of restructuring their business operations due to their economic moats running low.
Retailers dependent on the technology industry have also been plagued with a great deal of uncertainty recently. Shares of Best Buy (NYSE:BBY) plunged 35 percent in only two days last week after the retailer reported disappointing holiday sales and a lower-than-expected margin forecast. Shares of GameStop (NYSE:GME), the world’s largest video game retailer, fell 20 percent in a single trading day on similar concerns.
Even new technology names have taken investors on a roller coaster of emotions. Before gaining investors’ confidence, shares of Facebook (NASDAQ:FB) lost half their value from the initial public offering price in less than four months. Twitter (NYSE:TWTR), which went public in November, seems to receive upgrades or downgrades on a daily basis; it trades about 15 percent below its high made in December.
Despite the horror stories on Wall Street, Buffett is comfortable enough to invest in one very well-known tech giant. In early 2011, he started buying shares of International Business Machines (NYSE:IBM). According to the most recent filing, Berkshire Hathaway held more than 68 million shares of IBM at the end of September. Unlike many tech companies, IBM is heavily weighted toward the service sector and consistently meets financial goals through long-term planning. Founded in 1911, IBM also has a very long history.
“I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders,” Buffett said in his 2011 annual shareholder letter. “The company has used debt wisely, made value-adding acquisitions almost exclusively for cash, and aggressively repurchased its own stock.” He added, “In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.”
More From Wall St. Cheat Sheet:
- 3 Vital Steps to Protect Your Investments in Today’s Market
- Let Warren Buffett Guide You on This Investment Vehicle
- The Millionaires Club: Congress Loves These 10 Stocks
Follow Eric on Twitter @Mr_Eric_WSCS