3 reasons why you should stay within your circle of competence
‘You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.’ — Warren Buffett
The concept ‘circle of competence’ is termed and popularized by Warren Buffett. Three years ago, I bought into Courage Marine, a shipping company with its primary business in transporting commodities such as coal. I had no in-depth knowledge of the shipping industry and it cycles but I invested anyway solely based on someone else’s analysis.
Last year, I was abandoned in the middle of the sea for being too ‘courageous’ and I sold off my stake in Courage Marine at a 30% loss. I had no one to blame except myself for straying too far from what I knew and understood. This unfortunate event of mine carries an important lesson – always stay within your circle of competence.
How do you identify your circle of competence?
For most people it starts with your very own job or profession. Your profession gives you an innate understanding and behind-the-scenes knowledge of how your industry and the companies in it operate and function. This can be highly valuable when it comes to investing within your industry; you know which companies are the best to pick out of the bunch and you know which ones are dead-in-the-water and you simply must avoid.
Another way to identify your circle of competence is how you spend your money. If you are an informed consumer of any product/service you frequently use, you might possess some in-depth knowledge of which companies are more likely to succeed with consumers and thrive in any given marketplace.
Here is an excerpt from my book, Value Investing in Growth Companies published by Wiley:
‘Others that are not related to work could be products or services that you use in your daily life, which might include products that you use when you wake up, such as toothpaste and razors, or trains that bring you to your workplace, or the Internet that keeps you connected with friends. This could also be the newspaper that you subscribe to with Singapore Press Holding, or the products and services you pay for every day or month. This could also be the food courts, like Food Republic, where you head for lunch. Or think about your shopping habits. Perhaps you often head to Cold Storage or even 7-Eleven to get some snacks for yourself. If you feel like getting a luxury watch for yourself, you might go to The Hour Glass or Hengdeli to take a look. When you need a wisdom tooth extracted, you may go to Q&M Dental for screening. At night, you may want to party and grab drinks manufactured by F&N. And what are you wearing right now? It could be clothes from Adidas or TopShop (under Wingtai Asia) or Padini. When you are travelling, which airline do you travel with? Is it Singapore Airlines (SIA) or Airasia? As you might have guessed, some of these companies are listed on the SGX, while others are listed on HKE or Bursa Malaysia. As an investor, it is your job to find out more about these companies and determine how profitable they are.’
3 reasons why you should stay within your circle
1. You possess an informational advantage over others. If you are a property agent, your area of expertise is in the property industry. You are more likely to know how market sentiments affect property prices, where the best locations are for investments or how much a piece of land is really worth. For example, you could capitalize on information you know and invest in a company that owns multiple pieces of valuable real estate. The stock market could have underpriced the company’s stock and may be selling it below its net tangible assets. With more knowledge and experience over others in your given area of expertise, you should focus and concentrate your efforts on it. Your odds of success will be higher!
2. It narrows down your stock selections. According to World Federation of Exchanges, there are over 46,332 companies listed worldwide. In Singapore alone, I’m spoilt for choice with over 700 stocks to choose from. If I took a month to deeply analyze each one, it would take me over 58 years just to finish the entire Singapore stock exchange! I specialized in the aerospace engineering field and so I promptly looked at those publicly listed companies that fell within my area of expertise. I shortlisted two companies, SIA Engineering and ST Engineering and I was able to quickly analyze these businesses and get up to speed immediately.
3. You make fewer mistakes. One and a half years ago, a generous friend of mine shared with me an investment idea, Civmec Limited. Civmec is largely involved in the mining, oil and gas industry of which I know nothing about! Due to the hugely optimistic mining outlook in Australia, where Civmec largely operates, the management was confident of their business growth and that its share price would hit $2 and up. At the time, the stock was trading at $1.20 which signified a potential upside of 66%. Unfortunately (or fortunately for me!), its stock is now trading at 75 cents – a massive 37.5% drop. Staying within my circle of competence helped my dodge that bullet. You make much less mistakes if you stay with something you understand and are familiar with.
Seek to expand your circle…
In closing, while you should always stay within your circle of competence, at the same time you should always seek to expand it. As you become a better investor and gain competence in one area, you can start to push yourself a little further. There are undervalued investment opportunities everywhere and the larger your circle of competence grows, the more of them you have access to. Just one thing… remember where your boundaries are.
If this article existed 3 years ago, I would have save a lot of money by not investing in some penny stocks… Thanks!
it’s never too late to learn from it now. As long as we don’t repeat them, we increase our odds of success in the stock market moving forward. All the best to you!
Hi Rusmin, thanks for the reply! Anyway, will you be able to write an article on Penny Stocks? Most of my friends are investing in Penny Stocks thinking that if the stock moves 1 cent, they will be making a fortune. However, there is a huge misconception revolving around Penny Stocks because most investors do not look deeper and realise that the earnings per share is pathetic.
Haha, I was actually thinking of writing that! Really. It is one of the most common mistakes in investing. Stay tuned for that article.
Browsing the Annual Reports of some Bursa Malaysia listed companies reported that some Independent Non-Executive Directors [‘INED’] who are also holding memberships of AUDIT COMMITTEES were also voted to benefit from the Employees Share Option Schemes [ESOS]. It is common that the exercise price of ESOS shares is generally at a discount which in some cases can be substantial. These ESOS shares when sold in the open market will provide substantial capital gains to the Directors/Others which are generally tax-exempt in Malaysia.
Just for example in one financial institution the market price of the share was over RM7.00 whereas the ESOS rate was RM3.46. This particular Director who was also holding the post of CEO had 55m shares under the ESOS which exercise he could over a five years period or 5.5m per year. Of course the ‘INED’ may not have the ESOS in tens of millions but could still be in some millions. The potential tax exempt capital gain can still be substantial.
Under these situations are the ‘INED’ who may also be on the Audit Committee not face conflict of interest?
The only response has been denials and assurances but can this be accepted without any irrefutable proof?
Another observations made is that sometimes the Audit Committee members include members who may not have expertise relevancy to the core activities of the companies some of which include Construction and Property Development companies in which I am a shareholder.
Here again the response to questions is ‘Not to worry as the AC members are all highly qualified and experienced’ but no direct reply is provided.
Shareholders do not have any option but to take the risk and invest blindly. May be this is common and standard in most countries.
I have not been able to get a str
All the more reason why it’s vitally important to assess a company’s management team. If we’re uncomfortable with anything, we get out! 🙂
Hi Rusmin,I am a housewife and I am not working for the past 15 years. How do I know what is my circle of competence? I bought your book recently and I like it very much. But do you have a simpler guide? The numbers making me quite confused.
I’m sure being a housewife can offer you an unfair advantage too. In fact, have you ever read about how Peter Lynch’s wife assisted him in picking one superb undervalued stock?
What happened was this:
His wife brought home a pair of leggings from L’Eggs which she bragged about to Lynch! He subsequently invested in the company and since then, the stock has gone up 30-fold!
It is an amazing story and an incredible investment sparked off by his wife. Just like her, you have the most direct access to how consumers think and their buyer behavior. So look at the products/services you use daily and see if you can start from there.
For example, are there any specific food or home products you use and like? Check which company manufactures the product and see if they are listed on any stock exchange.
I definitely understand your frustration. The numbers can be draining for someone who has little or no financial knowledge yet quantitative analysis is truly important and can’t be ignored if you want to invest successfully.
In The Investment Quadrant, we have a video webinar that explains how we look at a company’s financials to help with your understanding. On top of that, we are also in the midst of producing several elementary financial videos an average Joe can grasp and understand easily. I’m confident once you master this, analyzing a stock will become as easy as 1-2-3!