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Grahamites
Grahamites
Articles (343) 

Understanding Circle of Competence and Knowing the Edge of Your Competency

January 02, 2015 | About:

“You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital”.

- Warren Buffett (Trades, Portfolio)

“It's not a competency if you don't know the edge of it. You are a disaster if you don’t know the edge of your competency.”

- Charlie Munger (Trades, Portfolio)

“I’m no genius. I’m smart in spots and I stay around those spots.”

-Tom Watson

Einstein said there are five ascending levels of intelligence: smart, intelligent, brilliant, genius and simple. The idea of circle of competence seems to be a rather simple one, which every person with an average intelligence level should be able to grasp. However, in life and in investing, it is very often the level of simplicity that separates the great from the average. Circle of competence, in its simplest form, offers such an opportunity for us to ponder.

Every value investor should have heard of the idea of circle of competence during different stages in the investing journey. It is not a new idea. What has not been discussed enough, from my observation, are two critical second level questions that are more important than the notion itself. In 2014 (yes, we are in the year of 2015 now), I wrote an article about the difference between knowing the name of something and knowing something. At the beginning of the article, I quoted Richard Feynman:

"The next Monday, when the fathers were all back at work, we kids were playing in a field. One kid says to me, “See that bird? What kind of bird is that?” I said, “I haven’t the slightest idea what kind of a bird it is.” He says, “It’s a brown-throated thrush. Your father doesn’t teach you anything!” But it was the opposite. He had already taught me: “See that bird?” he says. “It’s a Spencer’s warbler.” (I knew he didn’t know the real name.) “Well, in Italian, it’s a Chutto Lapittida. In Portuguese, it’s a Bom da Peida. In Chinese, it’s a Chung-long-tah, and in Japanese, it’s a Katano Tekeda. You can know the name of that bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird. You’ll only know about humans in different places, and what they call the bird. So let’s look at the bird and see what it’s doing—that’s what counts.” (I learned very early the difference between knowing the name of something and knowing something.)"

In the end of the article, I quoted Feynman again:

“We had the Encyclopedia Britannica at home and even when I was a small boy my father used to sit me on his lap and read to me from the Encyclopedia Britannica, and we would read, say, about dinosaurs and maybe it would be talking about the brontosaurus or something, or tyrannosaurus rex, and it would say something like, ‘This thing is twenty-five feet high and the head is six feet across,’ you see, and so he’d stop and say, 'let’s see what that means. That would mean that if he stood in our front yard he would be high enough to put his head through the window but not quite because the head is a little bit too wide and it would break the window as it came by.’ Everything we’d read would be translated as best as we could into some reality and so I learned to do that  everything that I read I try to figure out what it really means, what it’s really saying by translating.”

Please forgive me for bringing up those two brilliant quotes again. My intention was not to digress from the discussion of our topic the circle of competence, but to remind the readers that we need to keep in mind that too often, all we really know is just the name of something.

Let us get back to the aforementioned two questions:

  1. What is circle of competence?
  2. How do you know the edge of your competence?

In answering the first question, I can’t help but circle back to Mr. Buffett’s wise words: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage." In other words, if you can reasonably assess the qualitative factors of the business in the past, presently, and in the future, you may claim the business within your circle of competence.

Doesn’t sound too hard, right?

Hold on to that thought for a second and think about this question – there could be numerous qualitative factors such as competition, technological change, management quality, business model; how many of these factors do I need to be able to assess in order to say this business is within my circle of competence? For instance, you may be able to tell that Coca-Cola (NYSE:KO)sells carbonated and non- carbonated non-alcoholic drinks;that its biggest competitor is Pepsi Co.(NASDAQ:PEP); that it perhaps is not subject to rapid technological change;that it has a distribution network that reaches more than 200 countries; and that it has an “ok” management team led by Muhtar Kent. Does that mean Coca Cola is within your circle of competence?

The answer is a firm “No.” Why? Because you haven’t touched on the most important few factors that will make the business succeed or fail in the long run. Here we may want to revisit the horse-handicapping technique that Alice Schroder said that Mr. Buffett uses – you have to be able tell the most important factors that can make your horse win or lose, otherwise your odds are not going to look good. If you read my previous articles on Coca-Cola, you would find out the following application of the handicapping technique from the Oracle himself:

“In my view, the two important elements in Coke are its unit case sales and its shares outstanding. There have been transactions where people have purchased rights to various drinks – in fact, Coca-Cola’s purchased some of them – around the world. And when you see what’s being paid per unit of business – for a million cases or 100 million cases – and you think to yourself that Coke may add 1-1.5 billion cases a year, that’s a dramatic gain in value. And that’s what counts in terms of the Coca-Cola Company.

"Coke’s earnings are very easy to figure out. Just figure out what they earn per case from operations. And you’ll see that over the years, their earnings per case go up, their cases go up and their shares go down.

"If you think it’ll sell a multiple of its present volume 15-20 years from now and there’ll be a lot fewer shares outstanding, you’ve gone about as far as you need to go – because if shares outstanding go down and unit case sales advance at a good clip. You are going to make money over time in Coca-Cola. “

We know the most important factors in understanding the business, there is one other step – can we assess how these factors will play out in the next 5-10 years?

The answer is yes. And I’ve explained “why” in Part III of my Coca-Cola article.

Now I think I can claim that Coca-Cola is within my circle of competence because:

  1. I understand the business model.
  2. I understand the most important factors that will make the business succeed or fail in the long run, and
  3. I can come up with reasonably good assessment of how these factors will play out in the next 5-10 years.

Great. What about the second question, namely, how do you know your edge of competency?

Invert, always invert.

Having answered the first question, now you just need to negate the answers. I know a business is out of the boundary of my circle of competency if:

  1. I don’t understand the business model, or
  2. I cannot assess the most important factors that will make the business succeed or fail in the long run, or
  3. Even if I understand the business model and the most important factors, I cannot confidently assess how these factors will play out in the next 5-10 years. Said differently, the range of outcomes is so wide and you don’t know which one is likely to dominate the odds.

I could easily give the readers many many examples of how I’ve used the above exercise to rule a company out of my edge of competency but it is much better for you go through this exercise on your own. You can share your experiences in the comment section of the article or write it out as a separate article. It may make you think twice about the stocks you own, or intend to buy.

Let me end with another simple idea:

“Take a simple idea and take it seriously.”

-Charlie Munger (Trades, Portfolio)

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.8/5 (11 votes)

Voters:

Comments

Thomas Macpherson
Thomas Macpherson premium member - 5 years ago

Wonderful article (as usual) Really enjoyed it. Thanks for posting.

Matt Tommasiello
Matt Tommasiello - 5 years ago    Report SPAM

Thanks for the article, it has kept me thinking since I read it yesterday.

I'd argue, however, the two factors you list (unit sales and shares outstanding) are more of important metrics to observe rather than the underlying factors causing the business to succeed over the next 5-10 years.

You've researched Coke, and I haven't, so take this for what it's worth. I'd be more interested in knowing what factors contribute to Coke being able to increase unit sales in future.

Being able to know and explain the underlying cuases seems a better test of knowing whether a business falls within your circle of competence (chauffeur knowledge vs. Planck knowledge type thing)

Look forward to your response and keep the articles coming.

Grahamites
Grahamites - 5 years ago    Report SPAM

Tmacpherson- Thanks for your nice words. I'm glad you enjoyed the article:)

Grahamites
Grahamites - 5 years ago    Report SPAM
Matt- Thanks for your comments.

I may have not expressed my view clearly in the article.The two factors I listed (actually it's Warren Buffett (Trades, Portfolio) who listed it out for us) are more of important metrics. And you have to understand the business model to know which metrics you need to keep track of. This is only the first step, I absolutely agree that being able to know and explain the underlying causes or whys is a better circle of competency test. In terms of Coca Cola, I've written about what I think are the underlying factors that will most likely lead to unit case volume growth in the long run. You can read it here.

batbeer2
Batbeer2 premium member - 5 years ago

@ Grahamites

Thanks for another nice article.

@ Matt Tommasiello

>> You've researched Coke, and I haven't, so take this for what it's worth. I'd be more interested in knowing what factors contribute to Coke being able to increase unit sales in future.

I can think of two factors that would help Coca-Cola sustain its profitability and one that would drive growth.

1) Advertising effectiveness. Coca-Cola can buy the rights to the olymipcs and anyone watching the olympics could probably go out and buy their product in a matter of minutes. Not so for say... Red Bull. Most people watching the Olympics could not buy that product if they wanted to. This means Red Bull would be wasting dollars if they bid as much as Coca Cola for the same advertising space.

2) Distribution. Every bar or restaurant has to have Coca-Cola or else 10% of the customers would simply walk on by to the next bar. This means Coca-Cola can and does send their product to the most remote places on our planet by the truckload. Just imagine you wanted to have plain water that was known to be safe available in every corner of our planet. How would you go about setting up that infrastructure? Have you ever noticed that plain water in your supermarket is not very much cheaper than Coca-Cola? More than 50% of the cost of the product is probably transport and Coca-Cola has huge economics of scale going for it.

As for growth... if you assume consumers in mainland China in 20 years are going to behave much like consumers in Hong Kong (or Taiwan or Japan or the USA) behave today, it is easy to see how Coca-Cola can triple its unit sales in 20 years.

Chalie Munger wrote about Coca-Cola here.

Just some thoughts.

goo
Goo - 5 years ago    Report SPAM

Excellent article. I have a question : Where did you get the Buffett quote on Coke ? The comment that starts with “In my view, the two important elements in Coke are .... "

Grahamites
Grahamites - 5 years ago    Report SPAM

Goo- Thanks for the nice words. The Buffett quote came from the December 1998 issue of Outstanding Investor Digest.

Grahamites
Grahamites - 5 years ago    Report SPAM

Batbeer - Thanks for the nice words and thanks for helping addressing Matt's question:)

snowballbuilder
Snowballbuilder - 5 years ago    Report SPAM

My umble opinion is that coke is becoming a company in wich is better to be a top manager that a shareholder.

As for Munger , coke that was one of the core permanent holding in Wesco , in not an holding in djco .

Just some thoughts

Snowballbuilder

Grahamites
Grahamites - 5 years ago    Report SPAM

Snowbuilder - Thanks for sharing your thoughts. I'm very interested in the factors that you considered when you formed your opinion.

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