In his famous book, Beating the Street, the legendary manager of the Fidelity Magellan Fund, Peter Lynch, wrote "If you're prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won't get bored."
Good luck with that, Palantir (PLTR -2.52%) and Nvidia (NVDA -0.02%) owners.
Humor aside, Lynch's statement highlights the significance as an investor to know what you own.
While that sounds obvious, it's important to regularly remind ourselves that when we buy stocks, we are buying small slices of real business, not just ticker symbols.
A great exercise to test how well you know your companies is to run each stock in your portfolio through a series of two questions. If you have a well-researched thesis for each company, these questions should be easy. If you struggle to answer them, you may want to revisit why you own the company.
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First question: What does the company do?
As an early investor, I bought a lot of stocks at the recommendation of others. This included copying the purchases of well-known investors, as well as buying stocks because someone I respected in my personal life was bullish on the company.
Some of these companies did very well. But when push came to shove, I lacked the conviction to hold on to these stocks long enough to experience any material gains.
The problem with my approach was I knew next to nothing about the businesses I owned. Instead, I placed all my conviction in another person's knowledge of these companies.
At one point or another, all stocks go down; and when they do, your familiarity with the businesses you own will be one of your greatest assets. Being able to describe what the business does -- and more importantly, how it makes money -- is a quick first test of your knowledge of the company.
To learn what a publicly traded company does, read the "Business" section of its annual report, also known as the Form 10K. This will provide an overview of the products or services the company sells and will give you a picture of how it generates revenue.
One of the added perks of knowing what every company in your portfolio does, is it can limit your overall number of holdings. Diversification is very important so long as you can stay familiar with the business model of each company you are invested in. If you cannot quickly describe what each company in your portfolio does, then perhaps you should reduce your overall number of holdings.
Second question: Why do you own the company?
Aside from knowing what the company does, you should also know why you think it will perform well. Does the company have a competitive advantage? Is it disrupting a legacy industry? Or maybe it's a well-established brand that has a decade's long track record of high performance.
The term investors use to describe why they own a company is called a thesis; and you should be able to quickly summarize your thesis for each holding in your portfolio.
Documenting and regularly reviewing your thesis statements is key to portfolio management as it forces you to decide if you still believe in your original reasons for buying each stock.
But perhaps most importantly, knowing why you on a stock is what allows you to continue holding great companies during periods of price decline.
Take for example, the Brazilian fintech company, Nu Holdings (NU -0.18%). Warren Buffet's Berkshire Hathaway (BRK.A -0.09%) invested 1 billion dollars into the banking company, and since then the stock has declined over 30%. Had you bought the stock solely to emulate Warren Buffet, you would likely lack the conviction to continue holding this stock through its recent nose dive.
But had you developed a well-researched thesis for owning the stock, you would be able to decide if the recent decline disproves that thesis and is reason to sell, or in contrast represents a great opportunity to add to your position at a significantly lower cost basis.
Conclusion: Know what you own.
Lynch's call for investors to understand the companies they own suggests we all have unique advantages. Those advantages lie in our everyday lives. Whether it be the industries we work in or our experiences as consumers, the best way to be knowledgeable investors is to own the companies we have unique insights into. The more familiar you are with a high-quality business, the greater your conviction will be. And conviction is one of the keys to holding great stocks for the long term... the only term that counts.
