Circle of Competence is Key to Successful Investing

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If you have ever felt overwhelmed by information when investing, you are not alone.

As investors, keeping up with this constant flow of business updates is important in deciding if you want to buy, hold or sell a stock.

If you own many stocks, monitoring multiple businesses can be a daunting task.

But there’s a better way to go about it.  

Back in 1996, Warren Buffett, one of the world’s best investors, coined the term “circle of competence” in Berkshire Hathaway’s (NYSE: BRK.B) annual shareholder letter.

The circle of competence is defined as useful knowledge of businesses and industries you have picked up through experience or study over the years.

When investing, defining this circle is important as it has implications for how you allocate your money.

Buffett said that the size of this circle is not too important.

Instead, he emphasizes that you will need to know its boundaries so that you can stay within this circle.

Understanding the business

Some businesses are easier to understand than others.

When building your investment portfolio, easy-to-understand businesses are more likely to fall within your circle of competence.

Understanding how the business works means you can more easily track the financial and operating aspects of the company when it reports its earnings.

Take Sheng Siong (SGX: OV8) for instance.

The retailer owns a chain of 68 supermarkets spread across Singapore’s heartlands.

Sheng Siong sells a wide variety of merchandise including fresh and chilled food, necessities, and essential household items.

The economics of the business are straightforward – the retailer purchases goods from its suppliers and sells them to customers like you and me.

As an investor, you can also visit a Sheng Siong outlet to browse through its merchandise or observe the store’s layout and crowd.

In short, it is an easy business to understand and follow.

Raffles Medical Group (SGX: BSL) is another easy business to wrap your head around.

The integrated healthcare player owns Raffles Hospital in Singapore and three hospitals in China.

It provides a wide range of healthcare and diagnostic services to its patients and employs doctors and nurses to deliver these services.

Like Sheng Siong, Raffles Medical Group represents businesses that have a physical presence that you can observe.

Investors who own these companies should have no problems keeping track of the business as it will fall within their circle of competence.

And as time goes by, the continuous monitoring of these businesses will help you understand them more intimately.

From my personal experience, it may take up to a year or two to fully understand a business and the factors that contribute to its success.

The key is to remain within your circle of competence.

In doing so, you can shorten your learning curve and quickly get up to speed on the nuances of the business.

The “too hard” pile

Not every business is worthy of your attention. 

You may assume that with Buffett’s stellar track record, there is no business that he cannot analyse.

The reality may surprise you.

Buffett’s business partner, Charlie Munger, has stated that they place all the potential investments they review into three buckets – yes, no, and “too hard”.

“Too hard” refers to investments falling outside their circle of competence for which Berkshire Hathaway does not have an edge.

This is a key point you don’t want to miss. 

You will be wise to do the same when evaluating investments for your portfolio by tossing certain companies into this category.

Complex businesses that are filled to the brim with jargon or require specific technical knowledge can be considered “too hard”.

An example would be pharmaceutical companies.

Investors need to trudge through a smorgasbord of medical jargon just to understand the drugs that each pharmaceutical company manufactures.

Notwithstanding this, they also need to review numerous pipeline drugs that are undergoing different phases of clinical trials.

Unless you are a specialist who has intimate knowledge of the medical industry, it is best to avoid delving into such companies.

Conglomerates may also fall into the category of “too hard” as they contain disparate divisions that are time-consuming to analyse.

Some examples of conglomerates include Boustead Singapore Limited (SGX: F9D) and Straits Trading (SGX: S20).

Boustead Singapore consists of four distinct divisions – energy engineering, real estate, geospatial, and healthcare.

Similarly, Straits Trading also has four divisions with its resources division comprising tin smelting taking up the lion’s share of group revenue.

While these conglomerates can give you exposure to different industries, it may take significant time to understand.

Hence, such businesses may not be every investor’s cup of tea.

Cyclical businesses could be another type that falls into the “too hard” bin.

Investors who find it tough to comprehend either the commodities or semiconductor cycles may choose to avoid stocks related to these sectors.

As you exclude more businesses, there’s good news at the end of the process. 

By filtering out businesses you find too difficult to understand, you will end up with a smaller selection of stocks.

This approach allows you to better focus on what you feel comfortable with, thus saving you time and effort when sifting through potential investment ideas.

Expanding your circle of competence

While it is important to stay within your comfort zone, it’s no excuse to be stagnant in gathering knowledge.

Reading voraciously helps you to expand the boundaries of what you know and allows you to slowly enlarge your circle of competence.

There are several benefits.

By understanding a wider range of businesses, you can slowly open yourself up to new opportunities to allocate your money.

Widening your circle of competence also helps you to grow alongside the companies within your portfolio.

A great example is iFAST Corporation Limited (SGX: AIY).

The financial technology company went public back in December 2014 with just S$5.4 billion in assets under administration (AUA).

Back then, iFAST operated a platform mainly for the buying and selling of unit trusts and exchange-traded funds.

Fast forward to today, and its AUA has more than tripled to S$18.8 billion as of 30 June 2023.

In addition, the fintech also bagged a Hong Kong ePension project and acquired a digital bank in the UK while offering stocks and bonds on its platform.

iFAST was equipped with the technical capabilities to develop its platform from the ground up and also snagged licences in financial markets such as Malaysia, Hong Kong, and China.

By leveraging its strengths and reputation, it was able to expand into new markets over time to position itself as a successful wealth management platform with the ambition of building a “truly global” business model.

Adjust your allocation accordingly

So, what have we learnt today? 

First, we have established that it is a good idea to stick with companies that are within your circle of competence.

Not only do you save time and effort, but it will also be easier to track their progress over time.

Second, you can consider dipping your toes in businesses that fall outside your circle of competence by starting off with a small allocation.

This ensures that these unfamiliar investments take up a small chunk of your overall portfolio.

By having skin in the game, you will also be motivated to learn more about the business to slowly expand your circle of competence.

And if something does go wrong, you can minimise the losses that you suffer.

Staying within your circle of competence helps to reduce your investment search efforts, thus giving you more time to explore other types of business to gradually expand this circle.

Over time, not only will you grow in knowledge as an investor, but you will also find yourself richer for your efforts.

Note: An earlier version of this article appeared in The Business Times.

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Disclosure: Royston Yang owns shares of Raffles Medical Group, iFAST Corporation, and Boustead Singapore Limited.

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