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Mohnish Pabrai: Invest in Companies That You Understand

Warren Buffett (Trades, Portfolio) has said that in order to invest well, you must target companies that you find easy to understand and analyze. One of his more prominent disciples, Mohnish Pabrai (Trades, Portfolio), agrees. In his book, "The Dhandho Investor," he explains why investing in simple businesses is an easier route to success than digging around in companies that you struggle to understand.

Simplicity is beautiful

The key problem with analyzing a complex business is that it's difficult to predict whether it will continue growing or whether it is reaching a plateau. Pabrai uses the example of Alphabet Inc.'s (NASDAQ:GOOG)(NASDAQ:GOOGL) Google to illustrate this point:

"If we were to look at a business like Google, it starts getting very complicated. Google has undergone spectacular growth in revenues and cash flow over the past few years. If we extrapolate that into the future, the business appears to be trading at a big discount to its underlying intrinsic value. If we assume that not only is its growth rate likely to taper off, but that its core search business monopoly may be successfully challenged--by Microsoft, Yahoo, or some upstart--the picture is quite different. In that scenario, the current valuation of Google might well be many times its underlying intrinsic value".

With so many moving parts, it is difficult to see whether Google will continue to grow, either by expanding its core business or by expanding into other industries like hardware or cloud computing. Of course, this is not to say that accurately projecting out Google's future is impossible. But for the vast majority of us who lack insight into the various ways in which its subsidiary businesses interact, it is certainly a daunting task.

Accordingly, Pabrai recommends that investors sidestep the issue altogether by only investing in companies that are easy to understand and in which conservative assumptions about future cash flows are easy to figure out. What constitutes "simple" is up for interpretation, but generally speaking, you can go two ways: either invest in industries where your experience gives you a certain edge (if you are a doctor, invest in pharmaceuticals, if you are a mechanic then automobiles, etc.) or invest in consumer staples, real estate or some other sector where your day-to-day experience informs your decision-making.

"Simplicity is a very powerful construct. Henry Thoreau recognized this when he said, 'Our life is frittered away by detail . . . simplify, simplify.' Einstein also recognized the power of simplicity, and it was the key to his breakthroughs in physics. He noted that the five ascending levels of intellect were, 'Smart, Intelligent, Brilliant, Genius, Simple.' For Einstein, simplicity was simply the highest level of intellect. Everything about Warren Buffett's investment style is simple. It is the thinkers like Einstein and Buffett, who fixate on simplicity, who triumph.".

While there wasn't enough information available to investors in the past, it now seems like we have the opposite problem - too much noise and useless data. You might benefit from cutting through the noise and focusing on the things that are easy to understand and that actually matter. Making money is hard enough as it is. Be sure that you aren't making it more difficult than it needs to be.

Disclosure: The author owns no stocks mentioned.

Read more here:

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  • Warren Buffett and Charlie Munger: What Does the Ideal Business Look Like?
  • Warren Buffett and Charlie Munger: Become a Better Investor by Using Feedback Mechanisms

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This article first appeared on GuruFocus.