Do What You Do Best
By Chandler Lutz
March 5, 2008
Firms, countries and people are always best off doing what they do best and outsourcing things they do not excel at. We see this everywhere in world today. Johnson & Johnson is one of the greatest drug makers in the world who employs some of the smartest scientists around, but it is unlikely that J&J is designing all of its information technology applications in house. Similarly, Google undoubtedly has some of the best programmers the country has to offer, but you don’t see the tech giant trying to develop medications whenever one of their workers starts developing carpel tunnel from too much time on the keyboard. Both of these firms stick to their core competencies and this allows them to achieve the highest returns on invested capital.
The same is true for countries. For years after their independence from the United Kingdom, India completely closed themselves off from the outside world in an attempt to completely develop numerous nascent industries all at once. This led to disastrous results and widespread poverty for the country of over a billion people. Economic growth for India did not ensue until the country opened up their borders which allowed them to concentrate on particular industries. The same is true for China.
Some people are better at some things while other people are better at others. Economists call this phenomenon competitive advantage. You could say a country, firm or person has competitive advantage in a certain activity if they are relatively more productive at the given task compared to everyone else. According to economic theory, everyone has competitive advantage in something and when people stick to the task in which they enjoy competitive advantage they are always better off, and so is society as a whole.
This just makes intuitive sense. For example, I know I can’t draw or paint so I’m going to stay as far away from a blank canvas as possible. Similarly, I’m sure there are many artists out there who loathe math and you find them signing up for any calculus or statistics classes. Hence, I'll do the math and the artists can do the painting, the way it should be.
Since countries, firms and people generally adhere to opportunities where they have a competitive advantage it is a mystery why so many investors (both professional and amateur) place their money with so many companies in which they don’t possess this wonderful edge. This just doesn’t make any sense to me. If you don’t know anything about the production of semiconductors you wouldn’t go out and try to get a position in the R&D department National Semiconductor Corp. (NSM); so why would you invest in the stock?
It is only logical that you invest in companies in which you have a competitive advantage or that are easy to understand. This will allow you to make the highest returns on your money and eliminate your the biggest losses.
Some people may worry that this strategy will drastically limit the number of public companies available for their investment funds. Clearly, it will, but this is not a bad thing. There are over 28,000 public companies and you have to narrow it down somehow, so it is only reasonable to throw out the ones you already don’t know anything about.
Also, some may argue that this strategy will hamper diversification, but many investors overemphasize this ubiquitous concept. There is no reason to invest in a stock just to diversify. In fact, most academic research on the topic has found that investors can achieve significant diversification by owning just two or three securities. If these firms reside in different industries then you will achieve nearly complete diversification.
The question becomes how many stocks should you hold? As the number of securities increases in a portfolio the amount of time that is required to follow these firms increases right along with it. If you are managing your own money and not devoting 100 percent of your time to the task, the right number of securities is typically around five. This will provide you enough diversification, but also enough focus to monitor these companies and evaluate their prospects. In fact, Warren Buffett has stated that if he had less than 200 or 300 million dollars to invest he would likely only own just five firms.
Overall, buying firms using your competitive advantage will not only improve your returns, but will also simplify the investment process and eliminate the need for excessive diversification.
Chandler Lutz does not own shares in any firm in this article at the time of publication.