In my previous article, I wrote about the three ways to define the edge of circle of competency that Chang Jing from Himalaya Capital defined in his value investing class.
However, to define the edge of a circle of competency, we have to build a circle of competency first. How can we tell whether we have built a circle of competency? Chang has offered some general guidelines for this as well.
The ability to judge
The first criterion of assessing the existence of a circle of competency is an investor's ability to make judgment calls. Chang didn't go into details in terms of what judgment calls have to be made. My understanding, based on the lecture, is that there are a few things about a business that an investor should judge.
Firstly, is the business model superior or inferior compared to an average business? In other words, you have to make the judgment of whether the business is an above average business. Secondly, does the business have a moat? If so, how wide is the moat? How deep is the moat? And how sustainable is the moat? Thirdly, can you differentiate the company from its competitors from multiple dimensions such as products and services and management team quality?
For instance, if you are researching Boeing (BA, Financial), through some basic research you should be able to tell Boeing's business model. Does it have an above average profit margin? Does it earn a high return on invested capital? How is Boeing different from major competitors like Airbus (XPAR:AIR, Financial)?
The first criterion, in my opinion, can also be viewed as the first level of competency. It's mostly about making some general assessments of the business prospects.
The ability to generate insights
The second criterion of assessing a circle of competency is the ability to generate insights. An insight is a deep and accurate understanding of a business. It's about understanding the nature of a business. Chang said during the lecture that one sign that you have generated some insight about a business is that you can tell whether the business is going through some changes, while others cannot.
During last year's class sessions, Chang gave an example of the channel changes that have been taking place gradually at Kweichow Maotai (SHSE:600519, Financial), which might be underestimated by other investors. Another example is Li Lu's investment in Timberland Co. (which is now part of VF Corp. (VFC)). During Li's field research, he discovered that while Timberland was previously mostly known for its products' waterproof feature, at the time of his investment, within Timberland's core consumer group, the brand had become a fad. Everybody wanted a pair of Timberland shoes and Timberland jeans. The consumers' perception about the brand has changed.
This is the second level of competency. It's especially relevant when the business is going through some changes. I view it similar to what Howard Marks (Trades, Portfolio) calls "second-level thinking."
The ability to predict
The third criterion of assessing a circle of competency is the ability to accurately predict the future prospects of a business, especially the long term prospects. By long term I think Chang means at least ten years.
In most cases, it's much easier to make short term predictions. For one thing, it's almost a standard practice now for management teams of public traded companies to give quarterly and yearly guidance. Management teams will try everything to meet the guidance or beat the guidance. These days, with the help of expert networks, professional investors' ability to make three year predictions for some businesses is greatly enhanced. But few experts and company insiders can genuinely make ten year predictions about a business. This is truly the highest standard of competency.
Conclusion
Based on my understanding of the lecture, it seems that there are three levels of competency, each which corresponds to different levels of understanding. A value investor's understanding about a business inevitably has to start from the bottom level and move all the way up from there. But because it's exponentially harder to move up one level, very few take the high road. For those who take the high road, it will be less crowded.
Read more here:
- Edge of Competency
- Notes From Peking University's Fall 2020 Value Investing Course - Q&A 1
- Notes From Peking University's Fall 2020 Value Investing Course - Lecture 1
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
