Finance 101 – Buying Into Booming Businesses

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Buying Into Booming Businesses

Every decade there are innovations that radically change the way we live our lives. From combustion engines to computers, these innovations spawn some of the largest companies in the world, meaning that there’s money to be made for investors. Optimism about the growth of these industries is the fuel for most investment bubbles. In the late 1990’s there was speculative fever about the potential of the internet, in the 1980’s there was speculative fever about the potential of the Japanese economy, in the 1920’s there was speculative fever about the potential of electrical utilities and the radio, in the 1840’s there was speculative fever about the potential of railway, in the 1720’s there was speculative fever about the potential of transoceanic trade. In each of these cases, investors correctly identified industries with strong growth prospects, yet the vast majority of them lost a bunch of money – why?

Imagine if you had a friend who wanted to open a Vietnamese restaurant in Cabramatta and asked you to invest in it. You’d probably ask a few questions before pulling out your chequebook, the most pertinent being why your friend thinks the restaurant would make money. There are lots of Vietnamese people in Cabramatta, so there is ample demand for the product. But there are also dozens of Vietnamese restaurants in Cabramatta, so there needs to be a compelling reason to think those customers will choose your restaurant over the others. It’s not enough to be in a growth industry, you also need to be a top performer.

But what if nobody had ever thought of opening up a Vietnamese restaurant in Cabramatta? Imagine the growth prospects – there would be customers lining up for hours for a taste of home! You’d probably jump at the chance to invest. The issue is that your friend would probably be offering equity to other investors, meaning you’d have to engage in a bidding war in order to get your slice of the pie. If the business makes $500,000 a year, what’s a fair price to pay? A million dollars? 20 million dollars? It doesn’t matter how good the growth prospects are, if you get too enthusiastic and pay a billion dollars for the only Vietnamese restaurant in Cabramatta you will most likely lose money.

There are plenty of industries to get excited about today, from solar energy to biotechnology to cultured meat. We will have opportunities to invest in these industries, and there will be the potential to make eye-popping returns. Before parting with your money, you should ask:

  • Why will this particular company do well? Are you investing in Facebook or MySpace?
  • Are you paying a fair price? What you pay is more important than what you buy – even the best assets can become too expensive

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