Lawrence A. Cunningham’s Quality Investing: Here’s the one time when it’s OK for you to fall in love with a stock

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On my daughter’s 10th birthday, her grandmother gave her $100. 

“What should I do with it?,” my little girl asked. 

“Why not invest it?” I suggested.

“But how do I know where to invest it?” she said.

“Think of a company that makes something wonderful that you really like.  Chances are if you really like it, so do a lot of other people.”

“I can think of a few,” she said.

We did some research together and picked a stock within what I call my daughter’s “circle of fondness.”

The circle of fondness is how some quality shareholders describe one aspect of the investment process: only consider buying stocks of companies whose goods and services you are fond of.  Depending on one’s taste, that may rule in or out certain sectors, such as alcohol or gaming, and certain niches, such as within the food or luxury goods space.  

Note how the circle of fondness compares to other such edicts. For instance, Warren Buffett advises investors to avoid any company outside their circle of competence. This is a defensive concept that excludes sectors an investor lacks the ability to understand. A company may be in your circle of competence but outside your circle of fondness.

Peter Lynch, legendary manager of Fidelity Magellan Fund, is often mistakenly thought to have advised investing in “what you know.” That oversimplifies his point, which is to use your specialized knowledge to analyze companies within your wheelhouse, such as those in the industry where you work.  Again, such companies may be within your circle of knowledge but outside your circle of fondness.

Circles of competence and knowledge speak principally to one’s skill, whereas circles of fondness focus on one’s taste. That’s closer to Phil Fisher, another revered stock picker who talked about viewing companies as restaurants offering a menu of corporate practices. From fine dining to fast food — invest in what you like, Fisher said, in terms of company motifs from corporate culture to capital allocation.

Investors have always had enough choices to apply both of these screens. For instance, Buffett once had the opportunity to buy a significant stake in a tobacco company at a deep discount to value.  Such a consumer business, along with its pricing power given product habituation, was within Buffett’s circle of competence. But he passed on the investment because tobacco’s health risks put the company outside his circle of fondness.

Buffett’s circle of fondness is also defined by character: he advises only going into business with people you like, trust and admire. He avoids investing in companies whose managers make his stomach churn, as he once put it, in favor of those he’d be happy to have his daughter marry.  Berkshire has avoided or sold some attractive businesses solely because of the person running them.  

Discriminating investors can apply the circles of competence or knowledge and the circles of taste or fondness to all elements of an investment: companies and their offerings, as well as management and their philosophy.  Individual investors can apply the circle of fondness beyond individual stocks to mutual funds, exchange-traded funds, SPACs and other offerings.

The circle of fondness highlights one downside to index investing. Index funds and their customers own a portion of all stocks in an index. That leaves no discretion for taste, whether in company products or managerial character.  Quality shareholders, in contrast, are stock pickers at heart and patient to a fault. They have a clear advantage in this dimension of investing. They only invest with people they like, trust and admire and only in companies that enable them to sleep at night.

The circle of fondness does not mean investing is all style. Investing remains a financial matter, but one that appreciates there are a lot of ways to make money, and not all of them will suit your tastes or preferences.  In my daughter’s case, she is staking her birthday gift on something likely to pay many happy returns.  

Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group, and publisher, since 1997, of The Essays of Warren Buffett: Lessons for Corporate America. Cunningham owns shares of Berkshire Hathaway. For updates on his research about quality shareholders, sign up here. 

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