understanding the business

Many investors equate understanding the business to understanding the product or service of the business. I certainly wasn’t too far from that line of thinking in my earlier investment journey. I was ignorant enough to think that Coca-Cola, MasterCard and Wal-Mart were without doubt within my circle of competence. I don’t drink Coke, but I certainly know what Coke is. Heck, better yet, I even know Cherry Coke and Diet Coke. I have two credit cards that have MasterCard sign on them and I use them very often. I also go to Wal-mart occasionally. How could I not understand these businesses? They are part of our daily lives.

It all changed when I heard the following message from Mr. Buffett in his talk to UGA students:

“I have an old-fashioned belief that I can only make money in things that I can understand. And when I say ‘understand,’ I don’t mean understand what the product does or anything like that. I mean understand what the economics of the business are likely to look like 10 years from now or 20 years from now. I know in general what the economics of, say, Wrigley chewing gum will look like in 10 years. ”

It was truly a "eureka" moment for me because I have taken it for granted that "understand" means understand what the product does. We all know how to use a credit card. But that doesn’t mean we understand MasterCard. For readers who think you understand MasterCard, I challenge you to answer the following questions about MasterCard. What is the business model of MasterCard? What is MasterCard’s gross and net margin and why? Why would banks issue credit cards with MasterCard, and why do merchants accept them?

... I hope by now, you can see the differences between understanding the product of a business and understanding the economics of the business and why it matters enormously to us. It is the difference between knowing the name of something and knowing something, which are two levels of understanding. Very often we understand both the product of a business and the economics of the business as our research moves along, but great danger remains when we mix up those two concepts, especially when it comes to the brands that are ubiquitous in our daily lives.

-- Grahamites