Sunday, November 14, 2010

Can One Expand Their Circle of Competence?

This has always been a very intriguing question for me, more so since I started on my journey on value investing. It is well-known by now that Warren Buffett has strong knowledge of the insurance industry, which is why he focused his efforts on GEICO and this is also how Berkshire Hathaway is able to obtain so much insurance “float” with which to invest. Outside of insurance, it is useful to note too that Buffett had somehow acquired a keen insight into the businesses of furniture (Nebraska Furniture Mart), soft drinks (Coca-Cola) and credit cards (American Express). So the question now begs to be asked – how does one go about expanding his circle of competence on businesses he may not know or know well enough? Is this even possible and should an investor even attempt to do so?

Each individual has their own unique expertise and knowledge culled from years of either working in a particular industry, or because of his profession, has access to industry knowledge which others may not be privy to. To give an example, an oil rig engineer may understand the inner workings of oil rigs and the O&G industry very well, while an IT technician or software programmer would be more in tune with the rapid technological advancements in the realm of software design or hardware configuration. One’s profession and area of study also bestows knowledge of certain aspects of businesses; an engineer is more likely to understand an engineering company while a quantity surveyor would understand the property development process more intimately. As the above examples demonstrate, one can already have latent knowledge of a particular industry or business unit based on one’s education or work experience; and this will form the backbone of his understanding with respect to businesses when he embarks on his investing journey.

Armed with this knowledge, investors will then seek out investments which fall within their respective areas of comfort, suitably termed “circle of competence”. The fringes of this circle must be very clearly defined as there could possibly be overlaps in certain industries or companies which may cause unfamiliarity to the investor, so even though he may proclaim that he “knows” an industry, he may be unaware of the minute aspects which could escape his attention. I guess the worst feeling one could have is a false sense of security, which is why I keep stressing on the importance of really knowing an industry before committing your funds to it. If an investor can have intimate knowledge of an industry which not many people are familiar with, this is a distinct advantage as he can then invest with lower risk and higher certainty as compared to other investors who may not be equipped with such knowledge.

So can one expand this knowledge? The most obvious method would be through intensive reading of the said industry, for example for O&G industry, one could delve into articles written on the O&G industry, industry reports, brokerage reports compiled for that industry, as well as news articles and commentaries on the industry itself. One should start to familiarize with the terminology and jargon used in the O&G industry, such as E&P (Exploration and Production) and BOP (Blow-out preventers). Another method one could use is to speak to executives and management to find out more about the intricate business aspects of an industry and how a company within the industry works. Yet another method is to closely observe and study some of the companies within the industry over a couple of quarters, in order to build up the requisite knowledge and understanding of the business cycle present (if any) and the industry dynamics. In short, one needs to conduct intensive research, undergo diligent studying and have patience and perseverance to expand his circle of competence.

I myself started out as a novice investor who was not familiar with any particular industry. Over time, my reading and intensive research have enabled me to understand the O&G industry, MRO industry and the cranes and heavy equipment industry; though of course it is still not as well as I would like. But the knowledge was sufficient for me to feel confident enough to make an investment in MTQ, SIAEC and Tat Hong respectively. For Boustead’s case, I read up extensively on water and wastewater treatment and margins (including the CEO’s interviews), and also on real estate (as Boustead has a real estate solutions division headed by Boustead Projects). So to summarize, I would say I had managed to increase my circle of competence fairly significantly compared to when I first started out.

Of course, one should only expand the circle as far as one feels comfortable. I acknowledge that there may be certain industries which are difficult to understand for certain people, so one should prod and find your “resistance” level to such information, and to seek out information which best suits one’s character and temperament. To put it in another way, seek out what you feel comfortable with and feel confident on engaging, and you will find that you are able to slowly (but surely) expand that circle of competence.

So, in short, the answer is yes – you can expand the circle through reading, research and talking to people. But this will require time and patience and cannot simply be achieved in say, a couple of months. So if you are just starting out as an investor, take your time to read intensively and gather knowledge for at least 9 months to a year before you commit any money to companies trading on the Stock Exchange.

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