Recently, I shared with a couple of close friends when they asked what would be my best advice for any investor to minimize their risk after 17 years of investing?
My immediate reply; Stick within the Circle of Your Competence.
In my personal experience, it has 3 main characteristics. There are 3 main characteristics in Circle of Competence:
1. Knowledge Level
Where one begins to study everything surrounding the area of interest, starting from the Why, Who, How, What and When. It gets more interesting when we zoom in further with each sub-category, for example:
Why does the company exist?
Why do the talents want to remain in the company?
Why do customers buy from them?
Why are they able to maintain certain margins?
Who are the management, specific customers, suppliers, regulators, competitors?
Who sets the price?
How do they continue to remain relevant in the industry?
How do they attract, develop and retain talents?
How do they keep their peers at bay?
How do they allocate their capital?
What is the key differentiator in their product/service offering?
So what if they have this feature? (And keep asking until it leads to the next question)
What is the soul of their business?
When do they expand or consolidate (industry and company level)?
When was the last three crisis for them. What did they do to overcome it?
2. Level of Awareness on Limitations
The real danger of intelligence or cleverness in investing is that many clever people make risky and stupid decisions due to:
(A) Their own ego and blind spots
(B) Non-acknowledgement and understanding of their own limitations.
As an analogy; a weight lifter has true power only when he/she knows that he/she can lift up to a certain weight, 140 kg max. If a weight lifter tells me that he/she is powerful physically beyond the universe, he/she is either “Thor” or taking some kind of substance abuse. Hence, a wise investor is one who first identifies what type of industry or company type is beyond his/her limitation at that point even after analyzing all available materials on it.
By defining your perimeters well, you have the power of your circle of competence as it increases your margin of safety, because real risk comes from what you do not know. The interesting part is that most clever people do not know their blind spots.
When I first started value investing in year 2000, my only Circle of Competence is “SGX” because I used to work in a financial data company that does business with various exchanges. Later in 2003, it was “SPH” (sold it off in 2012 when we shifted all our advertising spending to online and social media) because I started an advertising and creative agency that helped my clients pay a lot of advertisement fee to this local monopoly.
As I grew with my Circle of Competence, I started to discover more badass, near-monopolistic companies in SG such as “VICOM” and “SATS” in 2007/08 before moving to our neighboring country, Malaysia for “Hartalega” in 2012.
At the same time, I will avoid cyclical companies such as Shipping, Oil & Gas, Commodities and Financial Companies, such as Banks, because I acknowledge my own limitations as I lost good money in them.
Hence, by acknowledging my own limitations, I constantly surround myself with other masters with their own circle of competence to learn from.
3. Predictability Level
This is where it separates good and great investors, even for Warren Buffett. It is because they know so much about their defined perimeter, they can even predict the future outcome of the business growth in term of free cashflow and earnings.
Usually, key business operators who invested decades focusing in their industry will be able to do well at this level. They can see a vision, execute it when most analysts or investors can’t understand it. That is why some astute developers like CDL would dare commit large pieces of land banking at a time where no clear trend has emerged yet. The founders/management has predictability competence. And their long track record will show.
Hope my limited personal experience has added some value to you in the area of Circle of Competence.
P/S: I have vested interest in VICOM and SATS since 2007/08.
8I Holdings Limited