Invest in Things You Understand

The art of investing, needless to say, is inherently difficult.

Not only is there uncertainty around the decisions you do make, there is the ever-nagging concern that you have failed to make a decision as a result of a seemingly limitless universe of available potential investment opportunities. The problem stems from the enormity of the investment world, and the fact that there is not enough time to master the intricacies of Healthcare, China, Energy, Derivatives, Bonds, Commodities, and the list goes on. The better course is to specialize-to develop insight in an area where you can focus, learn, and make better decisions. But how do you choose?

For a private investor, I would suggest focusing on an area accessible to you. If you have a deep technical background, that may be high-tech startups. But, for most of us, investing in the next pre-revenue 3D Printing Company isn't an area where we can honestly provide insight. One area worth looking at: consumer packaged goods ("CPG") companies (Disclosure: My business, CircleUp, focuses on CPG).

Here's why:

The importance of understanding trends: First, the more research and purchasing data available for business forecasting the better. What's interesting about consumer products is this: individuals may be fickle and diverse, but as consumers en masse they become quite predictable. As a result, short-term demand forecasting at CPG businesses allows companies to manage pricing and inventory more efficiently than many other industries. This translates to more visibility for investors as well, who can use industry research to inform where to allocate their capital, and how best to diversify their portfolio given changing consumer trends. That's not to say there won't still be ups-and-downs, but as others have recently pointed out, consumer product companies tend to reward shareholders who understand long-term trends and hang on for the ride.

The value of downside protection: With an uptick in recent stock market volatility, many investors search for strategies to hedge their downside risk. This can quickly lead to costly put option schemes or complex variable annuities that attempt to provide a consistent stream of moderate and predictable income on the downside, while still allowing you a chance to play in the equity upside. A much simpler solution can be found by re-examining your portfolio. Some businesses have natural downside protection, such as those with valuable long-term tangible and intangible assets. National telecom players and energy pipeline operators come to mind. But when it comes to consumer products companies, however, history suggests that there's nothing like a well-established brand to fall back on in tough times. Since September 2007, while the S&P 500 has declined (4.3 percent), the Dow Jones U.S. Consumer Goods Index has shown a 19.1 percent increase in value and the Dow Jones Retail Index is up 31.9 percent.

The power of information and transparency: Asymmetry of information between parties in private company transactions can put potential investors at a serious disadvantage, creating process inefficiencies and lowering the likelihood of successful deals. In any buy-side process, there will always be a limit to the amount of diligence a potential investor can complete before serious negotiations. But in some industries, this phenomenon is even more dramatic. High-Technology comes to mind, where the value of protected intellectual property sometimes makes it impossible for investors to get a glimpse, and therefore a better understanding, of the value of their potential investment. The CPG industry, on the other hand, benefits from a much greater level of transparency, with vast amount of industry data at the disposal of potential investors. And if that's not enough, the investor can always walk into a retail outlet and grab something off the shelf, or turn on the TV to view the latest advertisement. For a business, it makes strategy execution much more challenging. But for an investor, it minimizes the likelihood of misrepresentation and unforeseen shocks.

The dangers of complexity: Complex financial schemes and investment theses lend themselves to inefficiency and un-internalized risks. Even the most sophisticated investors can underestimate their exposure when using derivatives and other financial products. Underestimating exposure can often be attributed to a lack of personal independent financial research, coupled with a proliferation of complex financial products. The consumer products industry offers a clear and distinct alternative to these complex products. Individual consumers and sophisticated investors alike should be able to look at a CPG business and understand the fundamental sources of value and potential growth. If you don't understand that exotic rainbow derivative your broker told you about, then it's likely you also haven't truly internalized the potential risk embedded in that investment. It might sound obvious, but there's no simple substitute for thorough financial research and investing only in businesses you understand.

That's why investors may want to take a look at consumer products. As consumers themselves, they "speak the same language."