May 17, 2008

Circle of Competence

Buffett talked at length about investing within your "circle of competence". Warren has never let himself get excited about a deal that he doesn't understand. In the height of the tech boom in the late 90's Buffett stayed out of tech companies. Media have wrote him off as a savvy investors as illustrated by Barron's headline "What's wrong Warren?". He understands his weaknesses, limitations, and the types of businesses that he gets. He said that it is critical that investors clearly recognize what they don't understand, and place their time on businesses that allow them to bet big on what they do understand. He said that it's
... not so important how big the circle is, but it's important that you know where the perimeter is, and when you're outside of it.
So in my investment journey I need to articulate what is it that I am comfortable with and what should I stay away from. I think every investor should do an inventory and articulate that list, it will be very rewarding.
What I am not good at:
  • Spotting undervalued businesses with growth potential. Unlike Buffett and others, I am not able to find these business like Buffett find in railroads and BNI. As a result I need to have an event to trigger the idea like spin-offs, restructuring, and other corporate events. Other ideas can come from copying other investors smarter that I am, but I have to go through the process of valuing these businesses on my own and understand for myself why I am owning it.
  • I have time and resource limitation to analyse large businesses and understand them, so I try to avoid large cap businesses with different operating line of businesses and complexities. I will always strict myself to businesses in a single industry.
  • I am not good at realizing or discovering new emerging trends to profit from.
  • I have no knowledge of complex industries with technical details as I have limited knowledge in technical fields. As a result I will refrain from investing in pharma, bio-tech, technology and other related fields where science is key factor.
  • I have limited knowledge of legal implications and details so my ability to understand and asses risks in certain events will be limited. As consequence I will avoid investment opportunities where legal issues are paramount to valuation like bankruptcies.
  • I am not comfortable in forecasting revenues and analysing growth prospects, so I will always look "down rather than up". Risk is easier to assess and can be derived from good information rather than looking at your magical ball to arrive at growth forecasts.

What I am comfortable with:

  • Accounting and analysing financial statements.
  • I have knowledge of good valuation methodologies and their pitfalls.
  • I have a background in few industries that I can leverage to assess the business. I have good knowledge in commercial real estate, consumer businesses including retail and transportation businesses.
  • I think in scenario and what if situations, so that should be the basis of my evaluation for any business.
  • I understand equities more than debt and derivatives, so my portfolio focus will be in equities.

The list of competencies are much shorter than what you are not good at. It is only logical that you have fewer things that you know and you should ground yourself in that fact. Another thing is the amount of effort, time and energy to learn a new discipline is much more involved than to strengthen and deepen your understating of what you know. Therefore I will not try to learn new industries rather I will focus to deepen my knowledge of what I already know.

Probably my list of what I am not good at will grow with time. Do you know the edge of your circle of competence?

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