those things. We don’t say, “Well, we don’t know what’s going to happen. Therefore, we’ll discount some cash flows that we don’t even know at 9 percent instead of 7 percent.” That is not our way to approach it.9
How does such strict adherence to his circle of competence greatly help Buffett in investing? He explains: “If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.”10
If you know things you don’t know—your circle of incompetence—you will automatically get to what you do know—your circle of competence. Once you have defined your circle of incompetence, draw your personal circle, just as Buffett did. Buffett’s investing process involves creating three lists of companies—in (simple and easy-to-understand businesses), out (difficult to understand), and too hard (so complex that it is not worth devoting any time to understanding them). Buffett once said that 99 percent of the stock ideas that came to him fell into the too hard category.
Just think about that for a minute. In Buffett, we have arguably the greatest investor who has ever lived admitting that he does not understand 99 percent of the businesses he comes across. The next time you feel you know it all, reflect deeply on that fact. A genuine and honest adherence to one’s circle of competence is a deeply humbling experience. Let me share a personal example, to illustrate. In January 2018, I came across the most recent edition of Indian Economy & Market magazine, which contained investment thesis reports on “75 Hidden Gems,” many of which had been written by my respected seniors and peers. I could properly understand only one name out of seventy-five. This is perfectly acceptable. Remember, it is not a competency if you don’t know the edge of it. Venturing outside these edges is what gets investors into big trouble.
Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points. People chronically misappraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant [emphasis added].
—Charlie Munger
One sign of emotional intelligence is the ability to admit error. A mistake denied is a lesson not learned. Reflect deeply and objectively evaluate your performance. It is only through an honest self-assessment that an investor can discover his or her circle of competence. A key benefit of emotional intelligence is the intellectual honesty to view the world as it really is, not as one wants it to be, hopes it to be, or wishes it to be. My investing strike rate improved significantly once I acknowledged what I do not know and stayed within my circle of competence.
The basic idea behind the circle of competence is so simple it is embarrassing to say it out loud: when you are unsure and doubtful about what you want to do, do not do it.
If you can’t find businesses within your circle of competence, don’t hurriedly step outside that circle because of the fear of missing out, which is often the case in a bull market. Instead, spend time studying industries and companies outside your circle before crossing the boundaries. The biggest advantage of developing one’s circle of competence over time is that different industries and types of companies are in favor at different stages of the market cycle. Having an expanded opportunity set at one’s disposal to choose from can prove to be highly profitable at such times.
Again, it’s not important how big your circle of competence is. What is critical is to clearly know where the edges are.
It’s not a competency if you don’t know the edge of it.
—Charlie Munger
Now you may well ask, “But how do I expand those edges so that I can enlarge my circle of competence?” There is a simple way to do it.
It’s simple but not easy.
Read. A lot. That is the only way you can expand your circle of competence.
For example, read a book called Analyzing and Investing in Community Bank Stocks and then read the annual reports of a few community banks. These are relatively easier to understand and value. Or pick an industry in which you have some expertise and begin reading the annual reports of the companies in that industry.
I learned early in my career that if you read the annual reports, you’ve done more than 90 percent of the people on Wall Street. If you read the notes to the annual report, you’ve done more than 95 percent of the people on Wall Street.
—Jim Rogers
In investing, the person that turns over the most rocks wins the game. There is no alternative to hard work. In life, relationships, business, or investing, nothing will work unless you do. And there is no intelligent reason for an investor to settle for an inferior track record in a marketplace filled with companies with outstanding fundamentals.
I’ve always said that if you look at ten companies you’ll find one that’s interesting. If you look at 20, you’ll find, two; if you look at 100, you’ll find ten. The person that turns over the most rocks wins the game…. It’s about keeping an open mind and doing a lot of work. The more industries you look at, the more companies you look at, the more opportunity you have of finding something that’s mispriced [emphasis added].
—Peter Lynch
Buffett once remarked:
Back in 1951 Moody’s published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world.11
Buffett’s story reminds me of a few of my experiences. Every day, I diligently review all of the corporate announcements on the Bombay Stock Exchange (BSE) website. It is a painstaking exercise for many, but for me, it is like an intellectual treasure hunt wherein I may strike gold at any time. Every day, I create numerous opportunities for serendipity to find me.
My personal investment opportunity set has significantly expanded over the years, with time and experience in the markets. Initially, it was restricted only to secular growth stocks at reasonable to expensive valuations. But now it covers multiple areas of the investment universe, including commodities, cyclicals, deep value, and spinoffs, as well as loss-making companies that are turning around, as reflected in slow, gradual changes (low contrast) in their improving balance sheet, working capital, margins, or a significant positive change in their industry dynamics. Instead of being restricted by my personal, biased views to a small opportunity set, as was the case during my early years, I am now able to invest in a variety of industries and situations, wherever I find mispricing of value and a highly favorable risk-and-return trade-off.
Markets continually change. It also reminds me to look for investment opportunities in different markets, rather than keep going back to a well that is dry.
—Robert Kiyosaki
No single strategy works all of the time and in every kind of market. That’s why it’s essential to build up one’s investing arsenal to be able to hunt for value from within different areas.
Over
