How to Build a Circle of Competency

I spent my last three articles focusing on the topic of circle of competency. It’s truly the most important concept in value investing because everything else has to build on the circle of competency. But it’s also vastly underappreciated by most investors because based on my observation, few investors really try to build a circle of competency. I didn’t try until two years ago because I didn’t know how to build one. I’m still in the process of building my circles of competency. Today’s article is a recollection of the steps required to build a circle of competency based on my experiences so far. I hope you will find them helpful.

1. Pick a business that you find interesting and preferably has good economics. I recommend reading all the Value Lines reports, both the regular Value Lines and the Small and Mid Cap Value Line reports. Go through each industry and each company page by page. Figure out which industries have good economics and which industries have horrible economics. Then find out which companies within the industries have the best margins and return on capitals. Which companies have the worst margins and return on capitals. In the end, pick a company and an industry based on your findings. You can also follow your heart. If you like beers, go with the beer industry. If you like banks, go with the banking industry. Whatever interests you the most.
2. Commit yourself for a few hours for at least 6 months. If time is a constrain, you may still want to commit at least 1-2 hours every day for at least 2 years.
3. Read all the annual reports for as many years as possible, transcripts, sell-side research reports, articles, industry periodicals, and anything you can find on the business. Some friends have asked me where they can find sell-side research reports. I know if you are a Charles Schwab client, you’ll get access to Morningstar and Credit Suisse reports and if you open up a Merrill Lynch account you’ll get access to Bank of America Merrill Lynch research reports.
4. Once you read everything about the business, try to define the ecosystem and find out all the players in the ecosystem and read everything about the players in the ecosystem. For instance, if you are interested in American Express (APX), you’ll probably find out that beside the competitors such as Discover Financial (DFS, Financial), Visa (V, Financial) and Mastercard (MA, Financial), you’ll also need to study the merchant acquirers such as First Data (FDC, Financial), issuing banks such as JP Morgan Chase (JPM, Financial), American Express’s card issuing partners such as US Bancorp (Payment Services segment), co-branding partners such as Delta Airlines (DAL, Financial) and Hilton (HLT, Financial). You probably also need to study other payment service providers such as Paypal (PYPL, Financial), Square (SQ, Financial).
5. Study the history of the business, especially the past failures. Go back a few decades and see how the business has progressed over the past few decades. When was the business in its prime? When did the business hit the bottom? Why others in the industry failed? Let’s use American Express (APX) as an example again. You need to study the history of the credit card business. How did it come about? Why American Express chose the closed-loop system? What are the pros and cons of the closed-loop system? What happened to American Express before the financial crisis? Ask many questions. You may not find the right answers to those questions but that’s ok.
6. This step is optional – some people are more comfortable with it and some are very uncomfortable with it. It depends on your personality type. But if you are the type of people who feel comfortable talking to others, go out and talk to anyone you can talk to. If you can’t access management team of the big corporation, find some smaller companies in the industry and try to reach out to the investor relation department. Ask them who the best players are in the industry and why? Who the worst players are and why? Then talk to other players in the ecosystem, ask them about the customers, the distributors, the suppliers. Who do they admire and why? You’ll find a lot of useful information.
7. Once you’ve done all the work, step back and re-read the annual reports, the transcripts and etc. See if you have any different views. By this point, you should already have generated some useful and different insights well deserved.
8. Keep up the compounding.

Conclusion

If you commit enough time and effort, you will build your circle of competency gradually. For many businesses, it takes at least 3-5 years. It’s a choice. You can choose to focus on one or two industries for a few years and build a circle of competency around them. As Warren Buffett (Trades, Portfolio) once said, “Everybody’s got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.”