SPENCE Asset Management

Know What You Know February 2010

Every January, our research team takes some time to review all of the equity trades we’ve made since 1999. With the benefit of hindsight, we try to diligently reflect on the reasons for owning the positions we closed, the reasons for selling them and the quality of those decisions.

Some of the positions we closed out need more time before we can fully determine if we’ve made the right decision and others, time has made the realities of those decisions completely obvious.

Peter Lynch, who is one of our favorite investment heroes, suggests investors invest in what they know. In his book, One Up on Wall Street, he encourages his readers to look in their own backyard for investment ideas and take ownership in shares of companies that are a part of their daily lives.

Turning to another investment hero, Warren Buffett insists on investing in businesses that are simple and understandable. This requirement will often include those businesses that touch our lives each day, but may include some that do not. Either way, they must be fully understood.

Thus, we prefer to invest in what we know but to also know in what we invest.

As much as we would like to invest in some local banks run by what we consider to be top notch management, or as much as we would like to pour some money into stock of a local favorite custard provider that boasts long lines every warm summer night, investing in what we know requires us to greatly broaden the boundaries of our own backyards.

No matter how broad these boundaries become, we are resigned to the fact that there will never be a perfect government policy environment. We could look high and low and only invest where flawlessly efficient governments that favor nothing but growth from its businesses and prosperity for its investors, but we would be left with nothing but money market in our portfolios. This being said and only relatively speaking, thirty years after culture transforming policies were instituted, China’s population and leadership remain squarely focused on scientific education, hard work, self-reliance, saving, and sacrificing for the future, making China the clear rising economic power of the world.

Unfortunately these remarkable cultural biases come at a steep price and that price is censorship and restricted freedom. In China, the internet is censored. In China television and the news media are censored. How a Chinese citizen is allowed to express opinions about all of this censorship is censored. If we embrace the favorable business environment there, we must accept the negatives associated with the penchant of the Chinese government to suppress and jail dissenters. We may not agree with it, but we must understand it.

What we learned this year from our annual closing transaction review is that our definition of what it means to fully “understand” a business must be broadened. We simply must also verify that we have a full understanding of the industry in which a particular business competes as well as a careful examination of the industry’s market cycle. If there is some seasonality within the industry, we must try to pinpoint when can we expect a replacement cycle, and what scenarios could be catastrophic to the industry.

A thorough understanding of an industry must also be accompanied by an understanding of the political policy environment. We must understand how current leadership feels about a particular industry, its players and entrepreneurial enterprises in general. Thus, in China, we must recognize the boundaries that are set for an industry by the government and the effects of such laws changing significantly. And again, agreeing with it is not a prerequisite, but understanding it is a must.

Our closing transaction review process is sometimes painful. As we lament missed opportunities or remind ourselves of how we over-estimated the durability of a competitive advantage the ego takes a beating. But the self-evaluation process is crucial. Each year we learn more from this particular exercise than from any other single research project.

However, year in and year out, no matter how big our backyard becomes, we return to the core of our strategy which is to invest in what we know and to know in what we invest.

—Jim Spence, Eric Walton

Spence Asset Management, Inc.
2455 E. Missouri Ave. Suite C Las Cruces, NM 88001 575-556-8500

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