‘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.