Circle of Competence

The concept “Circle of Competence” has become familiar to value investors already many years ago. At least most of us have heard it used often by great Warren Buffett. Originally Buffett means that investors should focus on only operating in areas they knew best. You don’t have to be an expert on every company or market. You only need the ability to correctly evaluate selected businesses. Circles of competence vary from person to person. Our circle of competence can be widened over time, but the size of that circle is not eventually very important. You just need to have deep knowledge of factors that make operating businesses work well and if possible, you know more than others do about a particular area.

Regardless how broad or narrow your investing field is investor’s circle of competence can include following special areas:

  1. Company size
  2. Industry of the company
  3. Business model of the company
  4. Geographical location of the company

 

Company Size

Market cap of the company greatly affects its operation. Big companies are more actively followed and their pricing is more efficient. The volatility of the stock of small companies are on average higher and they might be more often mispriced. Fewer people are looking at them and among these ignored companies you might find more star performer. Contrary to common belief the industries the small companies are in can be quite stable. If you can find a company doing well, it’s more likely it can sustain that advantage over time.

It is substantial greater possibility to be able to ad value by research into a small cap companies. You simple have a lot less competition. Therefore, it’s easier to uncover new and previously unknown facts. Also, with small cap companies market reactions get more extreme. Even the slightest bad news can cause a strong overreaction. And vice versa, there’s often more room on the upside when a small company grows out of a turnaround.

Small-cap investing can be more labor intensive due to the large number of companies, but at the same time most of these companies are easier to understand and analyze. You can more quickly know just about everything you need to know about a company to make an investment decision.

When investing in small-cap companies, you need to ensure the following things:

– you want to only invest in companies with good fundamentals and reliable financials

– you have to take a long-term view

– you should buy them at a bargain price

– and your portfolio need to be reasonable diversified

 

Industry of the company

Not all industries offer the same investment opportunities. Already Warren Buffett said, “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Investors have to be very selective about which industries and companies will earn place in their investment portfolio.

We all have our own personal circle of competence and things we know more about or less about. You have to be comfortable with your investment targets and stick to them. Often, hard earned experience would appear to be the most impactful teacher here. What suits one may not suit another.

As long as you can find good quality business selling at an attractive price you can sleep well at night – but it’s not always easy. Sometimes it’s easier to describe what kind of companies you should avoid. In this case, you must be able to forecast the future. It’s not enough that the company is doing well now. It must operate in a stable and if possible growing industry. Only then it’s probable that profits will increase for the next 5 to 15 years.

But the cyclical industry can also be a good investment. By their nature they repeatedly experience boom and bust periods that create opportunities for investors. You just have to pay careful attention to supply and demand economics, and believe in mean-reversion. And remember with cyclical companies you also have to sell your stocks – and know right time to do that.

 

Business model of the company

As we go even deeper, company analysis ultimately determines which stocks we will purchase. The things that an investor emphasizes can vary much. Everyone has to find own style and use their strong points. You can find your edge in many ways.

One of the most effective methods for a privat investor is finding securities selling low asset value. The idea is to buy a company so cheaply that even if the business detoriorated, the investor could still stand to profit from the investment. These companies can have a low book value or even better their prices are below the value of the net current assets of the company. But this kind of bargain hunting is not for everyone.

For many investors the most workable methos is buying good companies for fair price. Then again you have to be right about company’s future. The company must have sustainable competitive advantage for many years to go. Their industry needs to grow and the company’s share of the business also. Companies without heavy reinvestment needs are worth a look. They have more to invest in their business, or to give back to shareholders. That’s huge advantage that people can’t always correctly evaluating. It makes a lot of sense to spend time focusing on businesses that are widening their moats and growing their intrinsic value.

Then some investors find their sweet spot from different kind of special situations (like spinoffs, risk arbitrage and merger securities, bankruptcies and restructurings etc.) or even short selling stocks. Certainly not for everyone, but it can be rewarding if you can do it well.

The best and most versatile investors can even master all these ways of investing. But remember that you only need to be very good at one thing to succeed.

 

Geographical location of the company

Many times, small and obscure markets tend to be less efficient than big markets (like US and England). Booms and busts can happen faster and more often. Emerging markets can be riskier, but uncertainty can create also nice bargains. And best of all, emerging market economy can offer quite different growth opportunities.

Where the company is headquartered may not necessarily tell much anymore because nearly all large companies operate on a worldwide basis. Some companies do more business abroad than in their home country. The investor should research it by company specific.

You just have to take care of that you can believe the financial statements and there’s not too much risk of the rules being changed after the investment. Mostly it means that we should avoid investing in politically troubled countries or places where the rule of law doesn’t really prevail. A good example could be Russia where you will think you own asset and then Mr. Putin decides you don’t!

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