The best investment you can make is expanding your circle of competence. Warren Buffett (Trades, Portfolio) talks about a “circle of competence” as being something that separates the businesses you personally can understand well enough to value (those inside the circle) from the businesses you personally can’t understand well enough to value (those outside the circle). I prefer to think of the circle of competence more as a “web of familiarity”. How familiar are you with a given company? And then: how similar is a business you haven’t researched before to a business you have researched before? Generally, you want to focus on analyzing and investing in those businesses that you can understand better than most people who buy and sell that stock. That means you want to focus on those businesses you’re most familiar with.
Warren Buffett (Trades, Portfolio) bought Nebraska Furniture Mart. That business was in Omaha. And Buffett had lived most of his life – with the exception of some time in Washington, D.C. and New York City – in Omaha. The first insurance company stock he bought was GEICO. Buffett’s professor, Ben Graham, had invested in GEICO and served on the board. Buffett went down to GEICO’s headquarters to learn all about the stock. What he got was an hours long lecture about the insurance business and GEICO’s business model from the CEO of GEICO. The first insurance company Berkshire bought outright was Jack Ringwalt’s National Indemnity. It was headquartered in Omaha. Another early investment of Buffett’s was National American Fire Insurance. It was controlled by the Ahmanson brothers. They were from Omaha:
“I found National American Fire Insurance…NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from (where) I was working as a broker. None of the brokers knew about it.”
The point I want to make here is the line where Buffett says “this company was located right here in Omaha, around the corner from where I was working as a broker. None of the brokers knew about it.”
Why didn’t any of the brokers know about it? Because they were too busy thinking about stocks that were far away. You want to combine your unique local knowledge and your unique knowledge from your non-investing life with the general knowledge that all other investors have access to (like the 10-K).
Let me give you an example of this from my own teen years.
One of my best early investments – as a teenager – was in a company called Village Supermarket (VLGEA, Financial). That company operates Shop-Rite supermarkets in New Jersey. I’m from New Jersey. Most of the Shop-Rites in my local area were run by Village. And I worked as a cashier at a Village Shop-Rite as a teenager. That have me the confidence to research and invest in the stock. At the time, the stock was probably trading at less than book value and less than 7 times earnings or so. I don’t remember the exact figure. But, in the later 1990s, Village was routinely available at a single digit P/E ratio and a discount to book value. It operated very high volume supermarkets. The location I worked at seemed to be doing – based on what I saw during my shifts as a cashier – close to $1 million a week in sales. When I got my hands on the company’s 10-K, I saw that although not all locations were doing quite that volume – I was probably pretty close to correct in my guess about my location. Would I have bought and held Village stock if I hadn’t worked there?
No.
Of course, as a value investor, you’d think that a stock selling at a single digit P/E and a discount to book value would attract you. And it might. I believe you might have bought that stock off a screen. But, you wouldn’t have held it for 10 years. Holding for a while here was key. From the time I worked at Village till 10 years later (basically, 1999-2009) the stock returned about 23% a year. You’re probably not going to have the confidence to stick with a stock like that when it gets to a normal price multiple if you just found it on a screen. Familiarity with the stock – having worked there, having shopped there, having seen the locations and their parking lots, etc. – helps you decide to hold on to a stock. It grounds your thinking in the reality of the specific business you’re investing in and pulls your thoughts away from speculating about macroeconomics, the industry overall, etc. This was a supermarket chain using one banner (Shop-Rite) in one area (New Jersey). That’s what mattered. Larger concerns about the industry, the economy, etc. didn’t matter. You can see that in the timeline I just laid out. You could make 20% a year in this stock from 1999 to 2009. That wasn’t an especially good 10 years for the stock market, the economy, etc. If you knew what world events would be happening between 1999 and 2009 (NASDAQ crash, September 11th, a small recession, financial crisis, and then a big recession) you might not have bought the stock. Certainly, if I knew just how important the internet would become between 1999 and 2009 (and especially how important Amazon would be by the end of that period) I might have taken the threat of online groceries (something people were starting to talk about in 1999 whenever you brought up a stock like this) a lot more seriously. It’s now 18 years later, and competition from online grocery sales have still had no impact on the business results of companies like Village.
So, familiarity is important in three ways. One: it helps you analyze and understand the business. Two: it encourages you to bet big when you see have an “edge” in understanding this business you’re so familiar with. And three: it gives you the confidence to hold the stock for a long time.
Those are the 3 things you need to have to make a lot of money off a stock idea.
One, you need to be able to tell a good idea from a bad idea. Two, you need to bet big on your good idea. And three, you need to hold long enough to get the most from your big bet.
The payoff you get from an idea is really: Position Size * Time.
So, you want to do smart things like put 20% of your portfolio in Village Supermarket in 1999 and then hold it all the way till 2009. Even if you don’t have a big portfolio at all – say that VLGEA in 1999 was a $2,000 bet for you (you had a $10,000 portfolio) – such an idea could have ended up making you about $13,000 if you sized the position at 20% of your portfolio and held it for 10 years.
I think most investors allow themselves to focus on the wrong part of a story like this. They think “where can I find stocks trading at a single digit P/E and a price-to-book less than one?”. In other words, what should I screen for? Yes, screens would turn up a stock like Village. But, an idea you find off a screen is neither likely to get you to put 20% into it nor is it likely to get you to commit to a 10-year holding period. Good ideas from screens aren’t worth very much.
And I say this as someone who does screen. I use GuruFocus’s “All in One” screener and find it excellent. There’s a screen I run that right now will turn up Omnicom (OMC), Cheesecake Factory (CAKE, Financial), and AutoZone (AZO). Those are all stocks I’ve researched this year. For example, if you just screen for companies with 4 stars of predictability or more that are trading at a P/E of 15 or less – you’ll find a lot of the stocks that I personally have researched this year. GuruFocus gives you the tools to let you do that.
But, did I find Omnicom or Cheesecake or AutoZone on a GuruFocus screener? No. And if I had found those stocks on a screener and learned nothing more about the companies – those ideas wouldn’t be worth much to me. That’s because I wouldn’t be familiar enough with the companies.
How do you gain familiarity with companies? Let’s look at Cheesecake Factory. I know the company well. I’ve eaten at the restaurant. I’ve done a little research on two “A” malls where I’ve been to a particular Cheesecake Factory to get an idea of the quality of the location, whether they are driving traffic to the mall or drawing traffic from the mall, etc. I researched this stock with a partner, Quan Hoang (my newsletter co-writer), for a newsletter issue we planned. However, we shut down the newsletter before doing this issue. So, no issue was released. But, basically, all the research was done. We’d discussed together it in enough depth and had enough notes that I could have written a 10,000+ word report on it.
Part of what made it possible for me to write anything about Cheesecake Factory is that I had already researched and put out 10,000+ word reports on two other restaurants: The Restaurant Group (a U.K. owner of casual dine-in restaurant chains) and Ark Restaurants (a U.S. owner of non-chain – so, single location – large format restaurants). I had also researched Greggs (a U.K. fast food chain). The key thing we had to understand with Greggs is how much same store sales declines can be driven by lower traffic to food away from home places generally (in a bad economy) and how much same store sales declines can be driven by lower traffic to the shops in the vicinity of your locations. Greggs had posted poor results because: a) The U.K. economy wasn’t good and b) fewer people were visiting “high streets” (sort of equivalent to “main streets” here in the U.S.). So, I had a lot of familiarity researching the kinds of issues I’d have to think about with Cheesecake. Let’s list some of the strands in my “web of familiarity” that already connected Cheesecake (a stock I didn’t yet know well) to stocks like Greggs, The Restaurant Group, Ark Restaurants, and Village Supermarket.
Village Supermarket: The connection here is food deflation at supermarkets. In the last two years, food prices at U.S. supermarkets are down about 4% while menu prices are up about 2%. Cheesecake’s same store sales turned negative recently. The entire industry has negative same store sales in the U.S. Some analysts believe this is due to a societal shift away from eating out. I believe it’s completely due to falling prices for food at supermarkets happening at the same time you have rising menu prices. That’s a rare occurrence in the U.S. And the gap between supermarket deflation and restaurant inflation is the widest in my investing lifetime. If you were just looking at restaurant stocks and not looking at supermarket stocks, you’d never consider this possibility. So, my previous familiarity with the supermarket industry helped me analyze a restaurant.
Ark Restaurants: The difference between the store level economics of Cheesecake and its competitors is due to Cheesecake operating larger format locations than any other chain restaurant in the U.S. I had researched Ark Restaurants which operates very large format restaurants. Ark has significant corporate level G&A expense. It doesn’t own many restaurants. So, its economies of scale above the individual restaurant level are very bad. However, the economics of Ark’s individual locations are often not bad. And I knew this because I had some experience analyzing the economics of an especially large restaurant. If you were only familiar with restaurant chains that operate locations with something like 50% less square footage than a typical Cheesecake Factory location – you’d likely miss this point. Big restaurant locations can afford to do some things – like have extensive menus and make almost everything fresh at the location – that small square footage restaurant locations can’t do. It’s very hard to offer a wide selection of fresh made food outside of a big square footage restaurant.
The Restaurant Group: This is usually what people think about when I say “familiarity”. The Restaurant Group looks like a peer of Cheesecake. It’s good to have experience analyzing peers. I normally look at 1 stock and compare it to 5 peers at the same time to get a full view of the industry. There was a specific lesson in here which was analyzing what would happen if The Restaurant Group and its competitors were opening a lot of new locations. This is very different in the U.K. from the U.S. The one thing that really scared me about investing in The Restaurant Group was the pace of new store openings in the U.K. So, I wanted to know that it was unlikely Cheesecake would expand too rapidly in the U.S. and also that it was unlikely that competing restaurants would open near a Cheesecake (so in malls) at an especially fast pace in the years ahead.
Greggs: The connection here is foot traffic. In the U.K., everyone was afraid that Greggs would be made obsolete over time because: 1) It was unhealthy and society was more interested in healthy foods now and 2) It was on “high streets” and society would be shopping elsewhere now. The concerns at Cheesecake are almost exactly the same. Two of the most common complaints you hear about Cheesecake as a stock are: #1) It’s in malls – and U.S. malls are dying and #2) It is known for serving gigantic portion sizes and people don’t want this. The health thing is clearly not a valid concern. When analyzing Greggs, we knew it was nonsense and when analyzing Cheesecake I knew it was nonsense. Cheesecake has now posted calorie counts on its menus and hasn’t seen noticeable changes in behavior. There were already studies showing that people don’t eat less when they see high calorie counts next to menu items. The high street / mall traffic decline was the real and valid concern.
I do have a concern that Cheesecake may not be able to find enough good malls to put new locations in. Management has said they see the opportunity for about 300 Cheesecake Factory locations someday versus about 200 locations today. However, that means there have to be 100 suitable locations for a Cheesecake Factory that don’t yet have one. We’ll see how malls develop. The Cheesecake Factory locations I researched in person were in “A” malls along with other well-known (and often high end) restaurant chains, big movie theaters, and other entertainment options (bowling, arcades, etc.). I’d expect malls to move more in the direction of being filled with entertainment more and shopping less. But, I’m not sure there will ever be another 100 places here in the U.S. where you can put a Cheesecake Factory. This is something I’m unfamiliar with. I don’t know much about malls because I don’t much about retail.
So, learning about malls is a topic that might help me understand whether or not I should invest in Cheesecake. And then, sometime down the road, my knowledge of how U.S. malls work will be a thread in my “web of familiarity” that connects to some stock I haven’t yet researched.
What you learn each time you research a stock today accumulates and let’s you start from a point that is far beyond square one when you encounter a new stock. You can grow your circle of competence by moving along these threads that connect some business you already know to a business you don’t yet know.
Talk to Geoff about Your Web of Familiarity
Disclosures: None
