In the last article, we looked at investing from a business perspective. In this article, we will look at something called the “Circle of Competence”.
The famous Warren Buffett wouldn’t go near a company with a ten-foot pole if he cannot understand what business it is involved in. For example, in 2000, he avoided technology stocks even though the stocks were going through the roof. He did not understand technology at all and simply avoided them.
On the other hand, Buffett loads up on companies that he understands intimately. He was willing to purchase a large stake in Coca-Cola because he understood the company’s products and its business model. Therefore, he could valuate the company easily as compared to Yahoo!, for instance. Buffett calls investing in what he knows as “Circle of Competence”.
He once said, “You don’t have to be an expert on every company, or even many. You only have to be able to valuate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
When investing, we must always invest in businesses that we can understand. We can understand what business Starhub, Singapore Press Holdings (SPH) and DBS are in. Starhub is a telco company, SPH is a publisher of a wide range of daily newspapers and magazine. DBS is the largest local bank in Singapore with 4 million customers and wide distribution network. All these businesses are easy to understand as we come across it almost every day in our lives.
What other businesses do you understand, other than the three listed above? To answer that easily, think of the following:
- What do you love to do?
- What are you good at?
- Where do you earn and spend your money?
Maybe you love travelling, going for movies and watching and playing sports. You might be really good at playing basketball and badminton. You worked as a physiotherapist and do not mind spending money on good food and doing things you love. A common theme for the answers to all three questions is sports. One such listed company in the sports arena is Nike. You can then research into Nike to see if it fits your investing criteria. Or since you love movies, you can look into Dolby Laboratories.
You can go to http://biz.yahoo.com/p/ for a list of public companies according to different categories.
By looking within the circle of competence, we are able to research into the businesses that we understand and thus, we will more likely to love investing in those wonderful businesses. The businesses will have meaning to us as well.
Once you have identified the business that you like, you have to look into the business model. The following questions will help you:
- What industry does the business operate in?
- What products or services does the business provide?
- How does it make money from the products and services it provides?
- Are the future earnings predictable?
- Who are its competitors?
- Is the business sustainable? Will the products or services the company provides be obsolete in 5 – 10 years’ time?
In summary, we must always invest in things that we know and can understand. Peter Lynch says that one should be able to explain their investment thesis in three sentences or less and in terms an 11-year-old could understand. If you cannot do so, investing in the business is a no-go.
To know more about Value Investing …….
Sudhan, Business Analyst
Mind Kinesis Value Investing Academy