Value Investing And Circle of Competence

Value Investing And Circle of Competence

Play Quizzes 4

I’m no genius. I’m smart in spots – but I stay around these spots.

Tom Watson Snr, Founder of IBM

Followers of Warren Buffett, myself included, would be familiar with the concept of “Circle of Competence”. They key to his philosophy is to encourage investors to stick to what they know best, evident from his Shareholder’s Letter.

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What an investor needs is the ability to correctly evaluate selected businesses. Note the word “selected”: You don’t have to be an expert at 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.

The concept is simple. To invest successfully, one need not bother themselves with technical, such as beta, capital asset pricing models, modern portfolio theory or option pricing. As an investor, one should simply purchase a company that we understand at a reasonable price. Hence, what many investors should know is how to value a business and market psychology.

Last year, I strayed from this theory, buying Vard (then called STX OSV) and sold off my stake at a 30% loss. I had no one to blame but myself for trying to buy a business that I was completely clueless of. When news of the company having delays in the Brazilian market resulting in profit guidances, I did not know how to react especially with the stock price in free fall. That said, everyone makes mistakes, even Berkshire. In 1960s, they too wandered off from their circle by purchasing departmental stores. Also, Dexter Shoes is another example of failing to stick with their circle of competence resulting in Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) getting badly burnt.

It is important to stick within our circle because it gives us an extra edge over others. With that additional information of the business, it allows us to make better, more informed decisions and reduces the mistakes that we would commit. Outside of this circle, we are complete amateurs. In times of uncertainty, it would result in us panicking like the other 99% of the market, selling the stock before analysing the facts laid out before us.

Furthermore, we must never confuse familiarity with competence. Someone who may constantly be flying on the airplane does not mean that he is competent enough to be investing into the airline industry. Whilst many of us may use Facebook, YouTube or Twitter every day, this does not mean that we are able to understand how social media should be successfully managed.

What separate what we do know and what we think we know is a very fine line. It is crucial for us to define our circle’s boundaries, enabling us to improve our odds of success in stock pickings and actually in almost all other aspects of our life. This circle can be widened, however, it is not something achievable overnight and requires constant reading and talking to people whose competence lies in such other areas.

Circle of Competence by TL, The Value Edge

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I developed my passion for investment management especially equity research at a relatively young age. My investment journey began when I was 20, at a point in time where markets were still recovering from the Global Financial Crisis. My portfolio started from money I saved over the past years and through working during the holidays. I was fortunate to have a good friend with common investing mentality to began my journey towards value investing. To date, we still research and invest in companies together, discussing valuations and potential risks of a company. To date, I manage a fund with a value investing style. Positions are decided upon via a bottom-up approach or smart speculation (a term I came up with when buying a stock for quick profit due to a mismatch in prices in the market due to takeovers/selling of a subsidiary or associate). Apart from managing my own portfolio, I enjoy sharing my research with family and friends, seeking their opinions and views towards the stock. Reading Economics in London, I constantly keep up with the financial news in Singapore & Hong Kong. Despite my busy schedule, it has not stopped me from enjoying other aspects of life. I enjoy a variety of activities in whatever free time I may have – endurance running, marathons, traveling, fine dining, whiskey appreciation, fashion. Lastly, I enjoy meeting new people, discussing ideas and gaining new perspectives towards issues in the world.
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