The margin of safety and circle of competence are two vital investment principles, although they both have very different meanings.
The margin of safety principle is associated with value investing while having a circle of competence is essential for any investor. These two principles go hand-in-hand because, without a circle of competence, you cannot calculate a margin of safety (speaking from a value perspective) and having a margin of safety helps cushion any of your decisions against possible gaps in your circle of competence.
However, neither of these concepts are fluid. The circle of competence is unique, and while some investors may say that the margin of safety should be a non-negotiable 50% discount to intrinsic value, it can also be argued a margin of safety itself is flexible depending on your circle of competence. If you know about a lot about an industry and where it is heading, you can afford to invest with a smaller margin of safety and tighter margin for error.
Experience and skill
Following on from my last article on the circle of competence and how you can build your own, I wanted to use this article to explore how the circle of competence idea can be used in the value investing style. What I mean by this is that value investing require some specialist skills, and so does growth and momentum investing. There is a specialist circle of competence for each investment style and only by continually updating your skills relative to the specific method can you claim to have an up-to-date skill set.
You can relate this back to the godfather of value investing, Benjamin Graham. Graham specialized in balance sheet analysis; he did not focus on one industry in particular. He just wanted reasonable value. His circle of competence was not a specific industry but the balance sheet. The same can be said for other notable value investors throughout history. The early part of Warren Buffett (Trades, Portfolio)'s career, Irving Kahn, Walter Schloss and Peter Cundill to name a few.
I could also argue that Seth Klarman (Trades, Portfolio) follows a similar approach, although his process of analyzing a company is much more rigorous. Still, if you look at his portfolio today, it is difficult to argue that the highly respected value investor prefers any one industry over another. His specialist circle of competence is value investing wherever it can be found.
Put simply, I believe that having just a circle of competence in the style of value investing alone could be enough for focused value investors. However, when it comes to blending value and growth, I believe it is essential to know what you are talking about.
Growth and experience
In my view, growth investing is a lot more specialist than value investing. You need to know everything you can about the company you are considering, including its competitors and what could go right or wrong.
Growth investing is not just about the balance sheet, in fact, today, with tech companies taking over the world, the balance sheet has become somewhat irrelevant as intangible assets such as intellectual property and customer relationships become more important than ever.
With growth investing, calculating probabilities of specific outcomes is an essential part of the process and when you blend value and growth the same is true. To be able to estimate these probabilities accurately, you need to understand the industry and the risks and rewards for different scenarios.
All in all, building a circle of competence is as much about knowing your investment style as it is anything else. If you are looking for pure value, you need to focus on finding genuine value, which means considering growth stocks, where the value is intangible is not sensible. Meanwhile, growth stocks require a higher level of skill and more defined circle of competence. It's best to focus on what you know and understand.
Disclosure: The author owns no share mentioned.
