Andrew Kuhn May 27, 2020

Should I Specialize in an Industry I Know – Even if it’s a Bad One?

A 12-minute read

Hi Geoff,


I think you have touched on this before but I will ask a bit more detailed. Do you think it’s better to be an expert on one industry and the stocks within that industry vs knowing a little about many industries? What about if that industry is a “bad” industry like shipping? Would you still think an investor is better off knowing everything about that industry and the stocks vs being a generalist?

I guess that having a deep knowledge and circle of competence you would have an edge compared to other investors. Being a generalist you don’t really have an edge? 


I think it’s usually better for an investor to be a specialist than to be a generalist. If you look at some of the investors who have long-term records that are really excellent – I’m thinking specifically of Warren Buffett and Phil Fisher here – their best investments are in specific areas of expertise. Buffett’s biggest successes tended to be in financial services (banks, insurance, etc.), advertiser supported media (newspapers, TV stations, etc.), ad agencies (also very closely connected to media companies), and maybe a few other areas like consumer brands (See’s Candies, Gillette, Coca-Cola, etc.). Other gains he had came from use of float (which is a concept closely tied to insurance and banking – though he also used Blue Chip Stamps to accomplish this) and re-deployment of capital. At times, he liquidated some working capital positions of companies and put the proceeds into marketable securities (a business he knows well). Overall, the Buffett playbook for the home runs he hit is fairly limited. It is very heavy on capital allocation, very light on capital heavy businesses, and it is pretty concentrated in things like media, financial services, and consumer brands. There are some notable and successful exceptions. It seems that Nebraska Furniture Mart (by my calculation) was a very successful investment. However, Buffett’s other retail investments generally were not. By comparison, he hit several home runs in newspapers – Washington Post, Buffalo Evening News, and Affiliated Publications. Several home runs in non-insurance financial services (owned a bank, owned an S&L, invested in GSEs, etc.). Several home runs in insurance (National Indemnity, GEICO, etc.). If you look at Buffett’s record in holdings of more commodity type companies, when he held broader groups of stocks, etc. – it’s not as good. As far as I can tell, the retail/manufacturing parts of Berkshire today don’t have very good returns versus their original purchase prices. It’s not all that easy to be sure of this given the way the company reports. But, I don’t think there are a lot of home runs there.


Phil Fisher talks about how he focused on manufacturing companies that apply some sort of technical knowledge. This is interesting, because people think of him as a growth or tech investor – but, he thought of himself as investing in technical manufacturing companies. But, specifically – manufacturing companies. He didn’t like how he did when he ventured out of these areas. He says that you could apply the same ideas to retail, insurance, banking, media, consumer brands, etc. – it’s just that he didn’t focus on those areas as a young man, didn’t develop connections in those industries, etc. So, he was better off focused on the few industries he chose.


Should you focus on “bad” industries like shipping?


Maybe. If you have a big enough edge on certain investments in certain industries you can overcome the poor base rate of investments held for a long time in that industry. There are definitely big opportunities to make money in shipping, in coal, in a million other things. It’s just that it is harder to make fortunes in these industries over time by buying and holding the same business. Even the businesses in industries like that which have been successful have often been successful due to their own capital allocation – borrowing at the right time, buying assets at low prices, getting out at higher prices, putting the proceeds into better bargains etc. It can be done. Some companies have made a lot of money over the years in shipping, in milling, in a bunch of other industries that are generally pretty unattractive. Management may be especially important here. Knowledge of cycles may be more important. You may have to hold large amounts of cash for longer at times. It’ll be harder to be 100% invested all the time in industries with poorer long-term compounding records than in things like what Buffett invested in.


But, yes. I would suggest specializing wherever possible. Now, specialization doesn’t have to mean specializing on a particular industry. You can specialize in evaluating managers who are good capital allocators, you can specialize in evaluating managers who are founders/owners/operators only. You can specialize in turnaround situations, distressed situations, highly cyclical situations, etc. You can specialize in merger arbitrage, in spin-offs, in companies emerging from bankruptcies. You can specialize in specific countries. Or – actually, and/or – you can specialize in specific industries, like you said.


Buffett didn’t just specialize in certain industries when he hit home runs. He also specialized in certain ways of investing. Most commonly, he was looking for something where the competitive position of the company or the capital allocation of management had changed for the better. He bet a lot on business shifts around the skills of management he felt he could bet on continuing there for a while. I don’t know how much Buffett knew about defense companies – but, he bet on Bill Anders at General Dynamics. I think the only reason he was willing to pay such a high price for a stake in ABC/Cap Cities was Tom Murphy. I’m not sure he would’ve bought GEICO at the time of the turnaround if not for John Byrne. And then Buffett focused on – as “The Warren Buffett Way” likes to call it – relationship investing. He usually held positions for longer while backing management 100% and gently guiding them toward capital allocation decisions different from others in their industry. In particular, his “activisim” consisted of shifting great businesses away from acquiring other lesser assets in their industry (especially using shares) and towards buying back their own shares. Capital allocation shifts were a very big part of Buffett’s playbook. He was involved in re-allocating capital at a couple operating businesses in his partnership years, he took (partial, sort of) control of some closed end funds, he made investment decisions for insurers he controlled, he invested in a trading stamp company with float, he controlled 100% of capital allocation decisions at companies like See’s which greatly increased their value to him because he stopped them from retaining earnings that would’ve had lower marginal returns on retained earnings, and then he influenced the managements of companies he had large stakes in such that they acquired less and bought back more than their peers. All of this juiced his returns beyond what investors simply buying the same stuff – but not exerting any control over how earnings were retained and invested – would have gotten. So, the Buffett playbook is fairly specialized in the sense that it relies primarily on capital allocation and secondarily on long-term investments in a few select areas of Buffett’s expertise (mostly: insurance, banking, media, and brands). On a cumulative compound basis – amount of CAGR times number of years invested – there aren’t a lot of great Buffett investments outside of insurance, banking, media, and brands. I can think of some – but, those are either some kind of capital re-allocation or something that is really very close in principle to the categories I named. Nebraska Furniture Mart is an exception. Buffett isn’t skilled in retailing investing. But, he did well in that one.


Specialization can be about particular concepts, situations, etc. you understand better than other investors. Sometimes it isn’t even understanding. It is just a question of having the stomach for the situations. It can also be a process specialization that sets you apart. You could be very skilled in certain methods of investigation whether those are scuttlebutt approaches or doing extensive research in public available documents others won’t. As an example, you can make a lot of money – I’ve had several opportunities in my own investment career to do this – by finding fundamentally sound businesses that have been tainted by scandal, fraud, criminals, or just more generally “bad actors” associated with the company. Companies change. These people leave, get removed. Investigations end. Some turn out to be much, much worse than anticipated. Others not as bad as people assume. But, there is often – especially among smaller companies not well discussed in the press – a pretty long period where a cloud hangs over the company and the share price despite evidence or changes that should shift the category the stock is in from an absolute red flagged don’t touch at any price stock to a transitionary period that will eventually end with the company being viewed as perfectly normal and investable by the market. If you are good at evaluating all the evidence from regulators, auditors, courts, talking with management, scuttlebutt, earnings call transcripts, 10-K, etc. and can form opinions about whether messy situations are outright frauds, temporary and solvable problems, etc. – you can make a lot of money. Independent thinking can most easily lead to an edge in these situations – because, these kinds of companies result in the greatest consensus of “groupthink” among investors. At one point, everyone is fine with a company – often a compounder – that clearly has some serious problems in how it is achieving this compounding, who is running it, how they are communicating with investors, etc. But, the record is a good one. And there ends up being a bubble around it where people ignore the fact this company checks all the flags for a potentially really troublesome situation. It’ll trade at a higher than usual P/E, get a lot of good press, have a strong group of followers who ignore what the short-sellers say. In other stocks – and actually sometimes THE SAME stocks after the illusion has popped and they’ve plunged to earth – people have a problem with management, a legal issue, some past event, etc. and just won’t touch the stock. This is more common with very small stocks about which relatively little in known. For example, if you have SEC actions and stuff against a company that barely puts out press releases and such – the stock will tend to trade at a very low price regardless of how solid or shaky the core business is. This, in my experience, would be one of the best areas to specialize in. Very small companies some people think are fads, frauds, run by crooks, just in really yucky businesses, have bad auditors, don’t talk much on their own behalf etc. Most people should avoid this area of the market entirely because it is mostly land mines. But, public perception always mixes in some totally legitimate companies with some outright frauds. Since most people will drop investigation of a stock that could be a fraud very early on – exhaustive investigations of companies like this can provide really strong returns.


The reason I recommend specialization is that you need to – from time to time in your investment career – have some high conviction contrarian ideas. That’s basically what will make or break your compound record over time. Did you sometimes bet big and bet correctly against some extremely incorrect perception of the crowd? That’s the question. And without an edge, without specialization – that’s often hard to do. It’s not impossible. There are sometimes ways to bet big and correctly in a contrarian way with actually very little strong info, analysis, etc. The only way this happens is when people adopt a mass delusion that is easy to see. It does happen in some asset in some country every decade certainly. Every year? Maybe. But, I don’t follow enough assets in enough countries to recognize all those cases if they do. But, you have bubbles like Japan, like dot com, like housing, like oil, etc. that don’t require any information or analysis of any real quality. They just require taking the rational side against an irrational crowd. I think these are rarer events than most investors would need to make a steady diet of them. Pervasive undervaluation is more useful to an investor. That happens too. Often, it happens after the bubble bursts. There were a surprising number of tech related net-nets in the early 2000s, I did well in Japanese net-nets about 20 years after that bubble popped, etc. Contrarianism works. But, pure contrarianism based only on a general sense of psychology and no specialized information, analysis, etc. is only going to work for you at the extremely extreme extremes. The events I described above were obvious to everyone. No one living through the dot com bubble thought it was normal. Some thought it could go on – usually because their thoughts consisted more of feelings than back of the envelope sketches of the future using actual numbers – but, no one thought it was normal. These extremes aren’t common though. So, while you can make a lot of money by being a rational contrarian without any edge – you’ll have nothing to do for long stretches of time and then moments where you can pounce. In terms of process, I think that’s a really hard way for an investor to work.


So, I always suggest developing areas of expertise.


Most people define this as industries.


But, maybe the best way to think of it is as a web of familiarity. For example, I am not an expert on banking generally. But, I’m pretty familiar with banks that do far more C&I (commercial and industrial) lending than their peers. I don’t know a lot about energy lending. I know even less about commercial real estate. And I know nothing – compared to what others investing in these things would know – about residential real estate. So, if we imagine a bank’s loan portfolio as a spectrum between C&I lending (where I am most comfortable) to residential real estate (where I am least comfortable) – we can see that I ought to specialize on banks that skew way over on the C&I side of things. Likewise, I’ve discussed insurers to the point where I think people assume I would be comfortable investing in most insurers. I wouldn’t be. There’s close to no chance I’d ever invest in a health insurer. Your average reinsurer would be difficult for me to understand. I don’t think there’s anything I can possibly know about a life insurer that anyone selling the stock to me wouldn’t know. However, I could evaluate an auto insurer. And better than an auto insurer would be some kind of niche P&C insurer doing something very special (usually with a very low loss ratio – that is, high priced premiums relative to eventual likely payouts to the policyholder). So, is banking in my circle of competence? Is insurance? Do I specialize in banking? Do I specialize in insurance?


It gets even more complicated than that. There are very specific kinds of advantages I’m pretty good at noticing that others might miss. So, banks and insurers that are efficient in certain aspects are easier for me to analyze – primarily because these kinds of efficiencies at these sized companies tend to get overlooked by other investors – so that there might be an analytical edge. You could say an information edge. It’s kind of hard to define information. Because, if a datum exists but no one sees it – is it information? A physicist might say yes, a psychologist no. I think an economist would say no. That datum to become a bit of useful economic info has to actually be recognized as such by people who make decisions to buy and sell. If you can see something in the filings, in an interview, in a shareholder letter, etc. of a bank or an insurer or whatever other company that goes unnoticed by the rest of the market participants analyzing it – then, you have the equivalent of an information edge.


Specialization can do that for you. If shipping is the area you know – then start figuring out what makes some shipping investments work out great and others fail. There will be some obvious reasons. Those may work for you at the market extremes. But, when other investors are being pretty rational – the obvious stuff isn’t an edge. Obvious stuff sometimes can be exploited through an emotional – rather than intellectual – edge. But, this only really happens when the market kind of catches hysteria of some kind where obviously delusional beliefs spread. Specialization helps you with looking at the same data others and reading different information out of it. An information edge is really: 1) A message you get from data others don’t get and usually MUCH MORE IMPORTANTLY – the confidence level you have in the message. Its clarity to you. This tends to be the biggest advantage of specialization. Generalists tend to gain info from their studies that they are somewhat sure of. Specialists can sometimes find aspects of a business, a situation, etc. where they will have an off the charts confidence level that generalists would never have. This is the only way it’s possible to have someone like Buffett bet really big on GEICO in a turnaround or something like that.


If you ever noticing me making a very big bet on a situation that seems borderline on the usual numbers – EV/EBITDA, P/TBV, PEG, etc. – the explanation is likely to be there’s something about the industry, the stock, or the situation that I specialize in. There’s probably some concept at work that seems really certain to me. Like, it might be that the P/E is 15, but I’ve convinced myself – through recognizing a pattern in this company I feel like I’ve seen countless times before – that the “E” is going to really rise a lot in the years ahead without much capital added because prices will rise while costs will stay much more fixed. Stuff like that.


There are situations where a stock could look “normally priced” and actually turn out to be trading at like 1/3rd of what it’s really worth. But, these situations will tend to rely on some internal business facts that don’t show up (yet) in the P/E, ROE, etc. Sometimes you see something very core and inherent to the business – a “key performance metric” as investor presentations will call them – that is going to have some major momentum that creates a lot of value over time.


It’s important to recognize these things. And the only way I know of doing that is specialization. But, that term might be a little misleading. Because it’s really specializing in some specific microeconomic concept at work than necessarily the same industry. Like, Buffett specializes in “float” and in “capital allocation”. Are those industries? No. But, you could make an entire investment career out of just specializing in understanding economies of scale, recognizing them, and betting on them in all sorts of industries. Now, you’d need to learn how that more general concept – economies of scale – applies to specific industries. But, most investors don’t specialize in applying a couple concepts over and over again. They don’t really seek out “float”, “economies of scale”, “shifts in capital allocation behavior”, etc.


So, is it necessary to specialize in a single industry?


No. You could just as easily specialize in always investing 100% of your money only with CEOs who actually founded the company. You could specialize in being a “founder analyst” better than anyone else out there. I see no reason why that wouldn’t work just as well as specializing in a single industry. When I say you need to specialize – I mean you need to be able to confidently read meaning from data others find unintelligible, ambiguous, or just devoid of meaning.


Basically, you need to be able to see the same data others do and more confidently recognize a pattern others don’t recognize or don’t have confidence in. You then need to bet big on the pattern you’ve recognized. That’s what I mean by specialization and edge. You’ve studied some subject enough that you can almost instantly recognize what others haven’t yet been taught to see. That could be due to industry expertise. But, it can also be conceptual expertise, interpersonal expertise, etc. Honestly, it can also be – at least in very small stocks – due to just plain legwork. You can just study things longer, more deeply, and through direct personal experience more than others do. Sometimes, you can have firsthand experience where others have none. You can rely on primary sources where they’re using secondary sources. That can be your edge too.


The really cumulative edge is the conceptual stuff. Learning a few key ideas through seeing them repeated over and over again and learning that you should’ve swung at that kind of pitch in the past and you didn’t each time because you didn’t have a word for what made those set of common circumstances so attractive.