Tuesday, 23 August 2011 - 20:00

 

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Circle of Competence

As investors, it is important that we invest within our circle of competence. Purely purchasing an asset, be it a share, bond, property, commodity, etc, based on a hunch or trend is a sure way to destroy capital over time. There is no doubt that this type of purchase (note that this would not be regarded as an investment) can, and will, at times produce spectacular returns, but if repeated can, and will, also lead to spectacular losses. We therefore often refer to these purchases as speculating.

Building an investment circle of competence requires a significant number of man hours of diligent research and analysis. Someone entering the industry and starting a small operation will no doubt have a smaller circle of competence than a company with a 50 year track record and 100 investment professionals. A small circle of competence does not preclude an investor for great performance, but does limit the areas in which the investor can invest with confidence. Over time an investor will be able to expand their areas of expertise, with successful investors being the ones that don’t attempt to invest outside of their circle or grow their circle too quickly.

Warren Buffett is famous for saying that Berkshire Hathaway constantly focuses on staying within its circle of competence. He is generally regarded as the most successful investor of all time, but famously passed up on investing in TMT (Technology, Media, and Telecommunications) companies. In the late 1990’s he was widely criticised as not being in touch with the ‘new world’, but was adamant that he’d continue to focus on investing in what he knew. Orbis, Allan Gray’s sister company investing globally, also avoided TMT shares in the 1990’s.

Warren Buffett, through Berkshire Hathaway, and Orbis were happy to ‘stick to their knitting’ and carry on investing within their circle of competence. They both have outstanding long term track records but went through extremely tough relative periods at the end of the 1990’s. There were, no doubt, some managers who were able to profit handsomely during the TMT boom and bubble but Buffett and Orbis were brave enough to admit that they didn’t understand the valuation of TMT companies and that they were therefore not going to invest into them, a move that was vindicated in the early part of the 21st Century. Interestingly, Orbis currently has a large holding in technology shares. They have clearly worked hard on developing the right skills to be confident in their ability to value technology companies.

The fear of ‘missing out’ is often the main reason that investors stray from their circle of competence. Seeing others profiting from strategies that you are not entirely familiar with can be frustrating, but changing your strategy to an unknown one with is a certain way to generate disappointing returns.

At Seed we are constantly working on slowly expanding our circle of competence. The expertise developed over years of asset class valuation and manager research has stood us in good stead in managing our multi-managed portfolios. The evolution of our skills has resulted in the development of the products and services that we offer to our clients. Understanding our process inside and out is key to sticking the course when things get tough.

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Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Tue, 23 Aug 2011

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