Circle of Competence and Investing
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I hope everyone has had a great week! If you follow the stock market closely, you have probably been waiting on a Santa Claus rally.
If you didn’t know, a Santa Claus rally is when the stock market has a big increase either the week leading up to Christmas OR the week after Christmas.
The Japan central bank unexpectedly raised interest rates this week, so the momentum of a Santa rally was put on halt on Monday.
In this newsletter, I will talk about how important investing within your circle of competence is. I will discuss how to identify your limitations, how to grow your circle of competence, and how you can use this information to become a better investor.
Warren Buffett coined the term “circle of competence” and it simply means to invest in what you understand. This seems like a very simple concept, right?
However, individual and institutional investors invest in stocks that they do not understand on a daily basis.
"What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on 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."
In theory, Warren Buffett sums up this entire newsletter in a lot more eloquent and simpler way than me. He urges any investor to fully understand a business before you invest in it. Before you invest in a stock, you should have a total understanding of how a business makes money, how it spends its money, and what variables impact its operation.
He goes on to say that it doesn’t matter the size of your circle. The important part is knowing your circle’s boundaries and never crossing these boundaries. Therefore, you should always know what companies you are able to understand and which ones you are not.
For example, if you gamble on sports every single weekend, there is a good chance that sports gambling companies will fall in your circle of competence.
If you are a pharmacist, there is a good chance that most biotech companies will fall in your circle of competence.
If you go to starbucks every single day, there is a good chance that you will understand their business model.
My family has been in the funeral industry since 1947, therefore, I have a great understanding of Death Care stocks.
The 3 Circles
When explaining circle of competence, I believe that it is best to break it down into 3 different categories.
The Outer Circle
The circle on the outside are the companies that you do not understand at all.
If you ever invest in a company in your outer circle, it is usually because you got a stock tip from your uber driver or friend who just recently started investing.
Many people have no clue how most pharmaceutical, energy, or genomics companies operate. Therefore, they should never invest seriously into these companies.
The middle circle is when you invest in a company that you think you understand, but you actually do not.
This is the circle that gets every investor in trouble. I personally have fallen into the trap of the middle circle, and it is never fun.
Just because you read an article on Seeking Alpha, heard about the company from Jim Cramer, or from a friend does not mean you understand the company.
When you do this, you do not have a good understanding of the business and its industry from analyzing its financials or from trying to value the company.
You need to understand every aspect of the business from their financials to their management team, competitors, and the industry outlook.
Therefore, even if a company I'm analyzing has great financials and forecast growth, I would still hesitate to invest in the business if I could not understand the company and its industry thoroughly.
In short, if you want to be successful at investing over the long run, you should avoid investing in the middle circle. You might have some short term success, but this will not hold up over the long haul.
The inner circle is your circle of competence, which includes the companies that you are capable of understanding thoroughly.
It does not matter the size of your circle, but it does always help to keep expanding the size of your inner circle.
The Bitcoin Mining sector is a sector that my newsletter talks a lot about, and I feel like a lot of my readers have a good understanding of this sector.
It is also very easy to understand:
If it costs $5,000 to mine 1 bitcoin, and the current price of bitcoin is $20,000 then that company has made $15,000 in profit. If they are mining 10 a day, they are making $150,000 a day in profit. (Just giving a hypothetical example)
Starbucks is a great example that people usually have a pretty good understanding about.
How To Invest Within Your Circle of Competence?
On the most basic level, you invest in companies or industries that you understand.
You should look at your career, your hobbies, and products/services that you regularly buy.
Here are some questions that you can ask yourself to determine whether you fully understand a company or not:
What products/services does the company sell? Who is their target market? What makes them profitable?
Is the company growing? If so, why?
What is their team like? Are they competent? Are they buying the stock or selling the stock?
Who are the competitors? Are they the leader in the sector?
What are the company’s cost? How do they keep these low?
What are the risks of investing in this company? Why would this company fail?
You will be able to find all these answers by reading the company’s 10-K annual report.
If you forgot, I wrote a newsletter about how to read a 10-k annual report.
If you can answer all these questions, there is a good chance that the company is close to being in your inner circle.
How to grow your circle of competence
The best way to grow your circle of competence is by studying the industry.
If I wanted to invest in small banks, a small segment in the massive financial services industry that is likely a lot less complicated than big U.S. banks like Bank of America (BAC), The Goldman Sachs Group (GS), and Wells Fargo & Company (WFC), I would follow the approach below:
Read the most recent 10-K annual reports: I would focus on the biggest players in the small banking industry. This will give you an idea on what "normal" looks like, what small banks are over-performing and why, all the revenue streams and divisions of small banks, and what small banks are doing now to grow in the future, among many other things.
Subscribe to industry publications: Although this may cost you, this can provide you with an insider look from analysts or individuals who know a lot more than you on the small banking industry.
Listen to earnings calls: If you listen to company earnings calls, read the transcripts, or read the earnings reports (which are all open to the public), you will have a better grasp on where the company and small banking industry is headed and what challenges they're currently facing.
Follow authors that discuss small banks: These authors may provide you with new information that you can look into further, or at the very least, provide a fresh perspective on the small banking industry.
Read shareholder letters: If you read shareholder letters over the past 5+ years for multiple small banks, you will learn a lot about problems and/or challenges within the business, how the CEO discusses the company and its stock price, and other management-related insights.
If you have any questions, feedback, or just wanna say hey, email me at email@example.com
P.S. Follow along on Instagram, TikTok and Twitter for more recommendations, inspiration, and giveaways.
Stay Hungry, Stay Long,