Showing posts with label circle of competence principle. Show all posts
Showing posts with label circle of competence principle. Show all posts

Saturday 11 January 2020

Business valuation is a complex process yielding imprecise and uncertain results.

1.   Many businesses simply cannot be valued intelligently.
Many businesses are so diverse or difficult to understand that they simply cannot be valued.

Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing.


2.   Wait for the right pitch to swing
Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor's results. 


3.   Stay within your Circle of Competence
For every business that cannot be valued, there are many others that can. 

Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.

Wednesday 26 September 2018

Understanding Your Circle of Competence

If Buffett cannot understand a company's business, then it lies beyond his circle of competence and he won't attempt to value it.

He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology.

On the other hand, Buffett continued to buy and hold what he knew.

Although it might seem obvious that investors should stick to what they know, the temptation to step outside one's circle of competence can be strong.

Buffett has written that he isn't bothered when he misses out on big returns in areas he doesn't understand, because investors can do very well (as he has) buy simply avoiding big mistakes.

He believes that what counts most for investors is not so much what they know but how realistically they can define what they don't know.

Circle of Competence and Sector Concentration.

If you are investing within your cicle of competence, your stock selections will gravitate toward certain sectors and investment styles.

Following the fat-pitch strategy, you will naturally be overweight in some areas you know well and have found an abundance of good businesses.

Likewise, you may avoid other areas where you don't know much or find it difficult to locate good businesses.

However, if all your stocks are in one sector, you may want to think about the effects that could have on your portfolio.

Monday 12 June 2017

Good Proxies of Risk

Risk is embedded in how much you know about the business and how confidently you can predict the future outcome.

Circle of Competence:  The more certain you are about the business outcome, the less risky it is.

Time Horizon:  Shorter the time-horizon, higher the risk.  Benjamin Graham:  "In the short term, markets are a voting machine but in the long-term, it is a weighing machine."

Quality of Business:  The higher the likelihood that business can keep earning above average returns, the better the business.

Quality of Management:  Is Management looking after minority interest.


[Standard Deviation and Beta are NOT good proxies of risks.]

Monday 16 May 2016

WHAT to Buy by Buffett


Buffett Quotes on Great Businesses & Competitive Advantages

Investors can be divided into two broad categories:
  • Bottom up investors
  • Top down investors
Top down investors look for rapidly growing industries or macroeconomic trends. They then try to find good investments that will capitalize on these trends.
Bottom up investors do they exact opposite. They look for individual investment opportunities irrespective of industry or macroeconomic trends.
Warren Buffett wants to invest in great businesses. He is a bottom up investor.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
Buffett prefers to invest in businesses that have differentiated themselves from the competition. Commodity selling businesses don’t have a differentiator (unless they are the low cost producer).
“Stocks of companies selling commodity-like products should come with a warning label: ‘Competition may prove hazardous to human wealth.’”
Commodity business (in general) are not quality businesses for long-term investors. The reason is because competition will erode margins and make investing in the business a zero-sum game.
Commodity businesses that have found a way to survive are not great businesses. The analogy below emphasizes this point:
“A horse that can count to ten is a remarkable horse—not a remarkable mathematician.”
Don’t invest in horses that can count to 10. Invest in businesses with a strong competitive advantage that allows for large excess profits…
And make sure that company’s competitive advantage is durable.
“Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me.”
Chewing gum doesn’t change much. Neither does Coca-Cola (KO), or banking with Wells Fargo (WFC), or Ketchup at Kraft-Heinz (KHC). Buffett invests in slow changing businesses because they will compound growth over the long run. 
Businesses in rapidly changing industries have shorter periods of time in which they can compound investor wealth.
Now that we have covered what to buy, it is time to see Warren Buffett’s thoughts on when to buy.

http://www.suredividend.com/warren-buffett-quotes/#circle of competence

Wednesday 24 July 2013

Reading an annual report of a company a day is probably the best use of your time allocated for investing.

It only takes about 2 minutes to know if a person is well versed with equity investing.  The majority are not and they should rightly invest through funds run by good professional managers.  They should know the limitations and costs of investing in mutual funds too.

For the few who are knowledgeable and comfortable to invest safely on their own, how can the time they allocate for their investing be optimally utilized?  

Probably, an hour a day set aside to read the annual report of a company of your interest is the answer, for me.  These annual reports are easily available through the internet.   Through discipline and hard work, you can then develop a good knowledge on these companies and their related industries.  

Over time, you will have deep understanding of many companies.  These companies that are within your circle of competence are monitored to benefit your investing.  

Monday 10 September 2012

Evaluating a Company - 10 Simple Rules

Having identified the company of interest and assembled the financial information, do the following analysis.

1.  Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?

2.  Do you understand how the company works?  Do you have intimate knowledge of, and experience with using the product or services of the company?

3.  Is the company conservatively financed?

4.  Are the earnings of the company strong and do they show an upward trend?

5.  Does the company allocate capital only to those businesses within its realm of expertise?

6.  Does the company buy back its own shares?  This is a sign that management utilizes capital to increase shareholder value when it is possible.

7.  Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.

8.  Is the company's return on equity (ROE) above average?

9.  Is the company free to adjust prices to inflation?  The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.

10.  Do operations require large capital expenditures to constantly update the company's plant and equipment?   The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.


Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options.  Let the market price determine the buy decision.  

Wednesday 11 April 2012

Worthy of a look?


Not sexy, high growth or hot stock.

Warning:  May not be in your "circle of competence."

Look at things that are temporary out of favour.

You wish to buy when the prices are falling or close to the bottom.

You should have a tough time trying to buy something that is NOT near its 52 weeks low.



Worthy of a look?


Moat?Thumbs Up

Cheap?Thumbs Up

Margin of safety?Thumbs Up

Inside my circle!Thumbs Up


Outcome:

No list
Watch list
Yes list

A large percentage of companies are too difficult to analyse, they are outside your circle of competence.  

Circle of Competence

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.

Warren Buffett

Saturday 25 February 2012

STICKING TO WHAT YOU KNOW


CORE BUSINESSES

Warren Buffett likes to invest in companies where management focuses on activities that are within the expertise of the company and not wander off and spend shareholders’ money in going into areas that they know little about.

Keeping a company on track is obviously an attribute of sound company management and is a sound investment principle.

UNDERSTANDING THE BUSINESS

This is really just an extension of Warren Buffett’s investment principle that one should not invest in a company whose business one does not understand. If it applies to direct investment, it also applies to indirect investment and an investor is better off investing in a company that uses its capital in areas of its own expertise.

Tuesday 7 February 2012

Top 10 Things to Do Before You Invest

Top 10 Things to Do Before You Invest
by Michele Cagan, CPA

1. Pay off every penny of credit card debt. You'll earn sky-high (18 to 22 percent!) returns just by paying your credit card balance in full rather than making the minimum monthly interest-laden payments.

2. Build yourself an emergency fund. Start a separate bank account for this purpose alone. It should have enough money to cover at least three to six months of living expenses.

3. Set up and follow a household budget. Keep track of where your money comes from and (even more important) where it's going.

4. Set clear financial goals. Whether you want to save for a new car this year or retirement twenty years from now, you need to know why you're investing.

5. Determine your time frame. How long your money will be working for you plays a key role in designing the best portfolio.

6. Know your risk tolerance. Investing can bring about as many downs as ups, and you have to know just how much uncertainty you can comfortably stand.

7. Figure out your asset allocation mix. Before you start investing, know what proportion of your portfolio will be dedicated to each asset class (like stocks, bonds, and cash, for example).

8. Improve your understanding of the markets. That includes learning about the big picture, such as the global political and economic forces that drive the markets and affect asset prices.

9. Set up your brokerage account. Whether you decide to start out with a financial advisor or take a more do-it-yourself approach, you'll need to have an open brokerage account before you can make your first trade.

10. Analyze every investment before you buy it. Buy only investments that you have researched and fully understand; never risk your money on an unknown.

http://www.netplaces.com/investing/planning-for-success/top-ten-things-to-do-before-you-invest-1.htm

Saturday 19 November 2011

Margin of Safety Concept as explained by Warren Buffett

The margin of safety has little to do with price but more to do with the quality of the business (durable competitive advantage and economic moat) and its management.




Buffett:   "In investing in securities, you can change your mind tomorrow and sell it if you feel you have made a mistake. When you buy a business, we buy businesses to keep. So .. our margin of safety is not in the price we pay .. it's in crossing the threshold of being virtually certain of buying into a business with durable competitive advantage, that is, one with good economics ... and we are buying in into people with a passion for the business and who are going to run it in the same way the year after they sold it to us the year that they run it the year before. So our margin of safety gets more into the qualitative characteristics than the quantitative aspects that you probably refer to in terms of the Ben Graham's standard of buying a business for .... he would say buy a stock .. if you think a stock is worth $10 .. don't pay $9.90 for it but $8.00 or something like that. When you are buying businesses, it's a different criteria, you are buying to keep and you better make sure that you are buying both the businesses that you like 10 or 20 years from now and the management that you are going to love 10 or 20 years from now.

We don't look for specific sectors, but we do look at businesses that I can understand. That means where I feel I have a high degree of confidence in my ability to see what they are going to look like 5, 10 and 20 years from now. It isn't that I don't understand, say the software product in general of the Microsoft but I don't know how that industry is going to develop 10 or 20 years. I didn't know that Google was going to come along in terms of search .. and all kind. So, anything that is rapidly developing, has lots of change embodied in it, by my definition, I won't understand. It may do wonders for society. It may have what appears to have a bright future, but I don't bring anything to that game that I know. Not only I don't know more that the other fellow, I do not know as much as the other fellow in evaluating what the industry will look like in 10 years. So, besides the things I look at businesses are reasonably easy to evaluate where the products .. how they will fit in with the economic picture .. how their economics will look in the 5, 10 or 20 years period. (2.40 minute)...Take an extreme example, I can understand Nestle ............................."

Thursday 30 December 2010

Staying within your Circle of Competence

Here are some excerpts on "The Meaning of Focus" from a good blog.

"Personally I feel that there is no reason for me to divert my time on something I am not familiar with, while I am confident to survive and be one in the 5% group, and not in the 95% herd. I know that many investors/traders like foreign market, but for me, it is the same as far as gains are concerned, but the costs of trading in foreign market will be much higher. The learning process will be longer as it will involve also exchange rates."

"Focus simply means that I would not adopt a shotgun approach hoping that if I am wrong in 4 stocks, I can be right in right in 6 to make a gain. I would rather take the strategy to aim accurately to shoot at the target. In this respect, the rational analysis concept will surely help."

"Personally I am not afraid of sharks and market manipulators, as their activities can be shown in the volume and price actions, and this skill I have been learning for two months, and now I think I know how to spot the sharks to follow their tails. As for fraud and accounting irregularities, I will have no way to know, but a thorough fundamental analysis including looking at the management team, the Board board, the shareholders and financial data abnormalities will lesson this risk, but this is the risk that I cannot control. But should fraud and accounting irregularities detected, the chart will quickly tell me to exit with lower loss. Therefore knowing technical analysis would likely reduce any loss due to the resulting share price decline due to accounting fraud. That is why I have turned to a technician from a fundamentalist."

Read more here ...

Saturday 25 December 2010

Knowing a Business Leads to Investing Success. Act Like an Owner

Knowing a Business Leads to Investing Success
Written by Greg Speicher on September 29, 2010

Great investing may be simple, but it is not easy. It requires that you master not only a number of analytical skills, but also your own emotions.

One of the mistakes that investors make is spending too much time studying investment philosophy and process, and not enough time studying businesses. Investment philosophy and methodology will never be a substitute for knowing a business inside out.

When you come across a “millionaire next door”, he or she probably made their money by mastering a small corner of the business world, not spending endless hours studying management theory or entrepreneurship.


Think Rose Blumpkin. She had an advantage over her competitors because of her relentless focus on the furniture business.

Read more ...

Wednesday 22 December 2010

Do you invest in what you don't understand?

Principles of value investing have helped create legends of the likes of Warren Buffett and Peter Lynch. The principles are simple and easy to understand. Pick a sound business that is available at cheap valuations. And then hold it till such time the value is realized.

But the most important principle is to invest only in what you understand. This means to stay within your own circle of competence. As Buffett puts it "Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle." As simple as it sounds, it is the most difficult principle to follow. And wandering away from it can cause investors the biggest harm.

A case in point for this is that of the emerging market guru, Mark Mobius. While Mobius has enjoyed tremendous success with his investment techniques in Asia, his emerging market fund has not done so well outside of the region. In fact, the geographically diverse Emerging Market Fund has ranked only 103 out of 236 funds over 10 years in total returns.

So does it mean that Mobius has changed his style of investing? No he has not. He still sticks to his principles of picking value buys. However, it may be possible that he has just stepped outside his circle of competence.

Do you stick to your own circle of competence while choosing your investments?


http://www.equitymaster.com/

Friday 16 April 2010

Buffett (1994): Investing can be done successfully even without making an attempt to figure out the unknowables.


Staying within one's circle of competence and investing in simple businesses were some of the key points that were discussed in Warren Buffett's 1993 letter to shareholders. Now let us fast forward to the year 1994 and see what investment wisdom the master has to offer in this letter.

Are you one of those guys who are quite keen on learning the nitty-gritty of the stock market but the sheer size of literature that is on offer on the topic makes you nervous? Further, with the kind of resources that the institutions, the ones that you would compete against, have at their disposal, it is quite normal for you to give up the thought without even having tried. Indeed, things like coming out with quaint economic theories, crunching a mountain of numbers and working on sophisticated spread sheets should be best left to professionals. While it is definitely good to be wary of the competition, in investing, one can still comfortably beat the competition without the aid of the sophisticated tools mentioned above. All it needs is loads of discipline and patience.

Thus, for those of you, who in an attempt to invest successfully, are trying to predict the next move of the Fed chief or trying to outguess fellow investors on which party will come to power in the next national elections, you are well advised to stop in your tracks because investing can be done successfully even without making an attempt to figure out these unknowables. Some words of wisdom along similar lines come straight from the master's 1994 letter to shareholders and this is what he has to say on the topic.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

Infact, the master is not alone in his thinking on the subject but has an equally successful supporter who goes by the name of 'Peter Lynch', one of the most revered fund managers ever. He had once famously quipped, "If you spend 13 minutes per year trying to predict the economy, you have wasted 10 minutes".

Indeed, if these guys in their extremely long investment career could continue to ignore political and economic factors and focus just on the strength of the underlying business on hand and still come out triumphant, we do not see any reason as to why the same methodology cannot be copied here with equally good results.

Buffett (1993): Staying within one's circle of competence and investing in simple businesses


A key mistake of investors was they never tried to fathom the relationship between the stock and the underlying business.
One should stick with the ones that can be easily understood and not subject to frequent changes.
"Why search for a needle buried in a haystack when one is sitting in plain sight?"

---

In the darkest days in the stock market history, there is no better time than this to imbibe the lessons being imparted by the master in value investing, a discipline or a form of investing that we think is one of the safest around.

One of the key mistakes the investors who suffered the most in the recent decline made was they never tried to fathom the relationship between the stock and the underlying business. Instead, they bought what was popular and hoping that there will still be a greater fool out there who would in turn buy from them. We believe that no matter how good the underlying business is, there is always an intrinsic value attached to it and one should not pay even a dime more for the same. Alas, this was not to be the case in the stock markets in recent times for many 'investors', where no effort was being made to evaluate the business model and the sustainability or longevity of the business.

In his 1993 letter to shareholders, the master has a very important point to say on why it is important to know the company or the industry that one invests in. This is what he has to offer on the topic.

"In many industries, of course, Charlie and I can't determine whether we are dealing with a "pet rock" or a "Barbie." We couldn't solve this problem, moreover, even if we were to spend years intensely studying those industries. Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly evolving businesses? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?"

As is evident from the above paragraph, an investor does himself no good in the long-run if he keeps on investing without understanding the economics of the underlying business. Infact, even when one is close to cracking the industry economics, some industries are best left alone because they are so dynamic that rapid technological changes might put their very existence at risk. Instead, one should stick with the ones that can be easily understood and not subject to frequent changes.

Monday 5 April 2010

Buffett (1989): Human beings have this perverse tendency of making easy things difficult and one must not fall into such a trap.


In his 1989 letter, we got to know Warren Buffett's views on growth rates in a finite world and the mischief being played by investment bankers and promoters in order to justify a rather 'difficult to service' fund raising.

As the years have gone by, we have noticed that the master's letters have become lengthier and have come packed with even more investment wisdom. This has however, made it difficult to incorporate all the wisdom from one particular year in a single article.

In a section titled 'Mistakes of the First Twenty-five Years', the master has reviewed some of the major investment related mistakes that he has made in the twenty-five years preceding the year 1989. Let us go through those and try our best to avoid them if similar situations play themselves out before us:

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie (Buffett's business partner) understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."

"Good jockeys will do well on good horses, but not on broken-down nags. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand."

It should be worth pointing out that in the early years of his career, the master bought into businesses based on statistical cheapness rather than qualitative cheapness. While he experienced success using this approach, the difficult time faced by the textile business made him realize the virtue of a good business i.e. businesses with worthwhile returns and profit margins and run by exceptional people. According to him, while one may make decent profits in an ordinary business purchased at very low prices, lot of time may elapse before such profits can be made. Hence, he feels that it is always better to stick with wonderful company at a fair price, as according to him, time is the friend of a good business and an enemy of a bad business.

"Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers."

The master's reluctance to invest in tech stocks during the tech boom is legendary and perfectly sums up what he intends to convey from the above paragraph. Invest in companies whose businesses are within your circle of competence and keep it easy and simple. According to him, human beings have this perverse tendency of making easy things difficult and one must not fall into such a trap