Circle of competence is key to successful investing

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

There is a better way to go about it. In 1996, Warren Buffett, one of the world’s best investors, coined the term “circle of competence” in Berkshire Hathaway’s 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. In 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. But what he emphasised was the 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 portfolio, easy-to-understand businesses are more likely to fall within your circle of competence. When you understand how the business works, you can more easily track the company’s financial and operating numbers in its earnings reports.

Take Sheng Siong, for example. It owns a chain of 68 supermarkets spread across Singapore’s heartlands, which sell 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 suppliers, and sells them to customers. 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 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 into these companies should have no problems keeping track of the businesses as they fall within investors’ circle of competence. As time goes by, continuous monitoring of the 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 outside their circle of competence for which Berkshire Hathaway does not have an edge. This is a key point you do not want to miss.

You would be wise to do the same when evaluating investments by tossing certain companies into this category. Complex businesses that are filled with jargon or require specific technical knowledge can be considered “too hard”.

An example would be pharmaceutical companies. Investors need to trudge through medical jargon just to understand the drugs that a pharmaceutical company manufactures. 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 such companies.

Conglomerates may also fall into the too-hard category as they have disparate divisions that are time-consuming to analyse. Examples of conglomerates include Boustead Singapore and Straits Trading.

Boustead Singapore consists of four distinct divisions – energy engineering, real estate, geospatial and healthcare. Similarly, Straits Trading also has four divisions; its resources division comprising tin smelting generates the lion’s share of group revenue.

While these conglomerates can give you exposure to different industries, they 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.

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

Staying within your comfort zone should not be an 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. A wider circle of competence also helps you to grow alongside the companies within your portfolio.

A great example is iFast Corporation. The financial technology company went public in December 2014 with just S$5.4 billion in assets under administration (AUA). At the time, 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 at Jun 30, 2023. it 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 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

We have established that it is a good idea to stick to companies 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. You may also consider dipping your toes in businesses outside your circle of competence by starting off with a small allocation.

This ensures that unfamiliar investments take up a small chunk of your overall portfolio. By having skin in the game, you will be motivated to learn more about the business and slowly expand your circle of competence. And if something does go wrong, you can minimise the losses that you suffer.

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

The writer owns shares of Raffles Medical Group, iFast Corporation and Boustead Singapore. He is portfolio manager of The Smart Investor, a website that aims to help people invest smartly by providing investor education, stock commentary and market coverage.