Warren Buffett has three criteria for his investments: high quality companies, at fair valuation, in areas that he understands. Of these three criteria the "understanding" threshold is the most nebulous. What does it mean to really understand a company?
This is a really difficult question, which is actually why I asked it :). I wanted to force myself to quantify what in my opinion is a the threshold of “understanding.”
In order to understand an investment you have to understand:
x) the business model x) the products x) the market opportunity x) the customers x) the competitors x) the company’s competitive advantage x) the history of the company x) the culture of the company x) the management of the company x) how much that’s all worth.
In order to truly understand an investment, you have to understand enough to have trust:
?) In the company’s future. ?) In management. ?) In yourself.
Warren Buffett is referring more to understanding how a company makes money. This rule of thumb does not mean you need to know the financial statements inside and out and be able to take over as the company CFO tomorrow. He is referring to it more in a broad sense. If you don't understand how a company makes money then how can you evaluate if it is a quality company or not. Starbucks sells coffee, Nike sells shoes and clothing and McDonalds sells hamburgers. The problem most investors get into is they look at a company or industry they don't understand and make an investment decision off of what the herd is doing or off of one metric, such as dividend yeild. This can sometimes lead to disasterous results. Enron is a great example of this. If you asked a common investor how Enron made money, they would have no clue. Mortgage REITS, some MLPs, and some other hard to define industries for the common investor are other great examples. Many investors look at a mortgage REIT and see the juicy yield, but they don't know how to evaluate the quality of the company management, the impacts of the housing market, interest rate risk, etc. I'm not saying any of these types of investments are bad, but you need to know how they make money so you can know how they are impacted by different enviroments. Buffett is merely making a broad statement on knowing how they make money.
As I'm sure you know, during the late '90's tech bubble, Buffett avoided buying tech stocks because he didn't understand them. As many investors learned the hard way, while tech fund managers pretended to understand the many tech companies with no real business models and justify their lofty valuations, Buffett was the like the little kid who shouted "The Emperor has no clothes." Buffett not only likes to invest in companies with business models he understands, he especially likes the ones that are easy to understand. Coke makes coke. Gillette makes razors. Pretty easy to understand. Of course, I remember when Peter Lynch loved Service Corp the funeral home providers. There's is an easy to understand, recession-proof business. Still, there was a time (during the go-go 90s) when its stock got cut in half about every week. So easy to understand and seemingly recession-proof does not guarantee indefinite profits.
In the truest sense, understanding a company means the following:
-How does it make money? -What is its business model? -Does it have a long term sustainable competitive advantage? -Does it have a wide and deep MOAT around it? -Will it able to sustain and grow its margins/profits over the longer term? -Will it's products always be in demand? -Is the company's business a fad? -Is it the subject of technological obsolescence? -Will the company continue to be professionally managed longer term, long after the initial founders are gone? -What is the company's culture and DNA?
Hope that helps answer your question, as it is the most esoteric and qualitative one to get your arms around.