GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Familiarity: Stretching Your Circle of Competence

July 25, 2013 | About:
Geoff Gannon

Geoff Gannon

410 followers
Two of the first factors I look at when deciding whether to follow a particular stock “lead” or not are conspicuous cheapness – which I wrote about yesterday – and circle of competence. I’ll be writing about that today. The term is obviously Warren Buffett’s. I’ll also use “familiarity” to mean much the same – but not quite the same – thing.

Here’s how I think of it. You have a web of ideas in your mind. In the center of that web there are a few key ideas you know really well. They have a lot of strings shooting out of them – and a lot of strings attach to them. There are dense connections here in the center. So, when I talk about stocks you’ve owned for years and years, industries you’ve analyzed a few times before, places you’ve worked, etc., these are in the midst of your web and connected to many related ideas.

When I say “familiarity” I mean these strands shooting off from this idea and connecting it to all these other ideas. I’m talking about relations. You can see how some idea relates to others. You can see how some company relates to others.

Now, a company is a complex thing. So, we can often think of a company not as a single object with a single aspect – but rather a single object with several aspects.

Think of the face of someone you know. Maybe you can talk about the face generally. But you can also break it down into eyes and ears and mouth and nose. And especially the way those parts are different – unusual, noteworthy – from similar elements of other faces.

Stocks and companies can be like that. But if you noticed I didn’t say “parts” or “elements;” I said “aspects” of an object. Why would I think about familiarity in terms of aspects? What does that mean?

To me, an aspect implies a bit more subjectivity. It suggests the presence of something – sure – but it also suggests a way of looking at that thing. Companies – and stocks – are too complex to be broken down into the same few parts every time. We can’t carve them up analytically leaving nothing out and carefully considering – in equal measure – all the parts we have separated out.

Instead, we have to come to each company, industry, etc., with a few key things we focus on. I don’t want to put any magic number on how many aspects we’re likely to consider. However, five to 10 is a lot more likely than 50 to 100. If you think you’re keeping 50 to 100 ideas in your mind at once when considering a stock – you’re doing it differently than I do it.

Now, you may consider something like 50 to 100 different issues for a moment when analyzing a stock. If you do, you are probably doing this in a checklist fashion – and not at the same time. You aren’t trying to see how 50 different items relate to each other. Rather, you are – one at a time – ticking off 50 different rote concerns you have with stocks generally (what is total debt to EBITDA, what is the F-Score, how long has management been at the company, what is R&D spending as a percent of sales, what is market share, etc.). You can’t really be relating all those ideas in any ways. You’re just – at that point – running through a list of independent questions.

That’s not what I’m talking about when I’m talking about familiarity. Familiarity – circle of competence – is above all a way of framing things, of seeing things.

One of the biggest differences between situations within your circle of competence and situations outside your circle of competence is the extent to which you can work at a higher level. When looking at situations far outside your circle of competence you definitely can tick off 50 or 100 possible problems. But you can’t put them together.

When you’re working inside your circle of competence you tend to work much more with analogs. You tend to see how this situation is similar to other situations you’ve seen before. And you tend to take whole chunks of relations – mostly unaltered, but perhaps slightly reshaped – from other situations you’ve seen and apply them to this one.

Basically, you use metaphors.

The best metaphors are always the ones you come up with yourself. These are the ones you shouldn’t doubt. They are unlikely to be bad metaphors because people are lazy and rarely invent terms of their own to use in situations where a technical jargon they know already exists.

Take this article for instance. I’m using Warren Buffett’s idea of a “circle of competence”. That should make you worry. It’s his idea. Not mine. I’m stealing from him. Is that good or bad?

Generally, it’s bad. While it’s good to steal ideas from other people – other people’s ideas aren’t as internalized for you. You have the definition of what they mean. You may even have some examples in mind. But, let’s face it, Warren Buffett knows “circle of competence” better than you do, because Warren Buffett kept bumping up against the idea in his work – kept turning it over in his mind, sharpening his thoughts on the subject – till he invented the term. So Buffett knows circle of competence better than you do.

I use lots and lots of ideas that were invented by other people – circle of competence, moat, hidden champion, margin of safety, etc. This is fine. But you want to be careful. Using the accepted jargon of a profession – like value investing – is not really a sign you understand what you’re talking about.

When you find situations where you can’t quite articulate your ideas in that jargon – but have to rely on past examples from your own analysis of companies – that’s where you probably are closer to the center of your circle of competence.

Familiarity to me is about how far you have to take an idea – a bit of knowledge – from the place where it’s all connected right now to the place you’re learning about. In other words, how hard is it to take this idea sitting near the center of my web of relations and move it over to this new stock I’m learning about?

Understanding is transferring old ideas to new situations.

When I say you’re familiar with a company – I don’t really mean you know that company well. Generally, we’re talking about companies, industries, etc., that aren’t as well known to you as stocks you already own. That’s just how investing works. Otherwise, you’d be going over the same stocks again and again.

What I’m saying when I say something is familiar is that it’s got some strands of thought connecting it to stuff I do know. These strands can help me work by analogy and take something on the edge of my web of knowledge and tie it in to the stuff at the center.

Let’s use the examples I mentioned in a recent article:

· Thermador

· Logistec

I said Thermador (THEP) was more familiar to me. I don’t know either stock. But, if I had to start with one – since they are both conspicuously cheap – I’d start with the one I thought I could get to know faster. That was Thermador.

Why?

I’m an American. So, you’d think that a company operating in Canada and the U.S. would be a shorter stretch for me. Logistec is that company. So why didn’t I pick Logistec?

First of all, it’s a port operator that doesn’t operate the ports I know best. I grew up in New Jersey. So, I know the “Port of New York and New Jersey” best. When I think port, that’s what I think. To be fair, so do a lot of people. It’s big and iconic. I think it’s one of the biggest natural harbors in the world. It’s still an important economic area today. And, historically, it was of immense importance.

If you say “port” to me, I start with my ideas about New York (really New Jersey since that’s the side I’m from). Some of you might. A lot of you won’t. If you’re from Asia – I don’t think you will (there are plenty of big Asian ports to think of). If you grew up near a port, I’m sure that’s the one you’ll see in your brain – whether it’s Baltimore or Miami or wherever – you won’t start with New York.

I’m not saying that when you say port, I say the words “New York” or “New Jersey”. I’m saying I start with that idea. Then as you describe the size, location, type of cargo, etc. I alter my idea (which is really just the port of New York) and shave away at it till my round peg fits in your square hole. I go as far as needed in altering my idea to make it congruent with what you seem to be describing to me. I take an existing example and then resolve the clashes.

That’s what I mean when I say we think in metaphors.

This brings me to the next important topic. When we talk about an idea we often define it. That’s okay. But it’s somewhat misleading.

Think of the word “grandmother”.

We can define it – I’m not using a dictionary here, so it may be a pretty bad definition – as “a woman who has a child who has a child”. That’s a grandmother.

It’s a clear, technical definition. It’s a rule. You can either pass or fail when put up against it. I am not a woman. You don’t need to know anything more about me to know I’m not a grandmother. A woman without a child fails the test immediately as well. And so on. It looks like the definition works.

And it does. But it also hides something about how we actually think about “grandmother”.

Can two people – both demonstrably grandmothers by our definition – be unequally grandmotherly?

Yes.

If I gave you two names of grandmothers – one in her 50s and best known to you as a movie star – and one in her 70s and retired for many years, you’d definitely say the second one is more grandmotherly. You’d say this even as you acknowledged that they are both grandmothers. Both meet the definition of grandmothers, but one is more of a grandmother than the other.

This is true for almost everything. We can design experiments where we ask people to define a chair, show them two chairs, get them to admit both are chairs, and then find that a strong majority of the people – when forced to choose – say one chair is more of a chair than the other.

The fact they won’t split 50-50 is important. It proves an idea is more than a definition. It may come with a definition. But that’s not all it comes with.

This is much more important to investing than you might think.

Thermador and Logistec are good examples of that. The Value and Opportunity post says – explicitly – several things that bring analogs to my mind:

· Hidden Champion

· Boss Screener

· Wholesaler

I’ve talked about “hidden champions” many times. I’ve read the two books – the second is just an updated edition of the first – on the subject. I think it’s one of the best investing books out there (even though it isn’t marketed as an investing book). I think a “hidden champion” is a powerful idea. A good metaphor. So, I have a huge store of examples of hidden champions in my brain. And I’m always looking for more.

Boss screener is a term that’s specific to Value and Opportunity. I read the blog. So I know what kind of stocks tend to appear on that screen. So, immediately, when I hear a stock scores high on that specific screen – a bunch of ideas leap to mind. Basically, I have a stereotype of a “boss screen” company in my mind just like I have a stereotype of a “hidden champion” in my mind.

Finally, wholesaler. Now, I have to admit that this one is not explicit. I actually didn’t think “wholesaler” when I read what Value and Opportunity wrote. In my mind, I rejiggered what was said to fit “distributor”.

Why?

The bullet points that Value and Opportunity lists are more consistent – to me – with a company like say Parker-Hannifin (PH) than with someone like a wholesaler of computers, etc. to the federal government. Both are wholesalers – but their business is actually quite different.

Why?

There are a few reasons. The biggest is the number of customers. A distributor that might interest me is one that sells to a large number of usually smaller customers. Now, this gets a little complicated. In fact, the size of the companies is not what’s important. The size of their purchasing of specific product categories is important.

The next question is price or availability. A distributor becomes more interesting – to an investor – to the extent that wide selection, immediate availability, quick delivery, and integration with customer inventory systems increases. When all factors combine, you tend to have a very wide moat.

For a bunch of reasons, distribution tends to be a choke point. Within a local region – like France – one distributor, once established, can snowball in its competitive advantages.

Distribution often goes unnoticed by the general public. For example, the movie business – the studios – are based entirely on their distribution positions. But if you read about the movie business, you’re mostly going to be reading about production.

Again, this doesn’t mean Thermador is a good company to investigate. It just means that the combination of the blog post saying it’s:

1. A hidden champion

2. Ranked highly on the boss screener

3. A distributor

Triggered 3 different ideas for me. It brought up existing examples I could work from. It gave me a way to tie this new company to the web of ideas I already have in my mind.

That’s what I mean by familiarity. And that’s how you stretch your circle of competence. You take concepts you know and you look at things you don’t know, but that could possibly be tied to what you do know. Then you try to transfer the knowledge you’ve got in the center of that web along those metaphorical strands and connect new ideas to the existing web.

When you see lots of possibilities for making connections, you start with that company. Where you see few possibilities, you put that stock aside for now.

Ask Geoff a Question

About the author:

Geoff Gannon
Geoff Gannon


Rating: 3.4/5 (10 votes)

Comments

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK