Circle of Competence
Warren Buffet is considered as one of the most successful investors in the world. He is known as the father of investing. Many people around the world study his techniques, try to learn from him, and emulate his methods. One such method, and approach to select stocks which he uses and recommends is Circle of Competence.
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: 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 Buffet.
Your circle of competence with respect to investing defines your understanding about certain businesses. The businesses that you understand fall within the circle, and the ones you don’t understand fall outside it. Identify a company which is within your area of competence, whose business you understand, probably whose products you are using and you will be able to make a judgment on that company based on the product you're using.
A business will be ‘within’ your circle of competence if you fully understand the underlying economics of it:
- How does it work?
- What drives its growth?
- What makes it profitable?
- How does it stand against its competitors?
- How does it manage its raw material costs?
You need to have the answers to such questions.
As a newbie to investing you can start off with an exercise. Focus on your day to day activities. This way you can get into the habit of identifying the manufacturer of the product which you are using.
Example: When you get up early in the morning, what is the 1st thing you do? You brush your teeth. So the question is which toothpaste do you use? Say you use Colgate. So Colgate is listed on the stock exchange. So you have one stock to track for investing i.e. Colgate as it is in your circle of competence. You understand that every individual whether he/she lives in rural or urban India will brush their teeth. Know the price of Colgate toothpaste you buy. Know the prices of other company’s toothpaste too. Track the stock price of Colgate. So it becomes a natural process that once you start using a product your mind will start relating that product with the listed company associated with that product.
Now that you have decided to invest in a stock, how do you analyze whether it is a good investment or not? So, let us learn how to analyze a stock in the next section.