The Circle of Competence

Even veteran Fools occasionally need to be reminded of these two fundamental rules of investing: 1) Buy what you really understand, and 2) Don't buy what you marginally understand or what just floats your boat -- you will intermittently lose enough money to make this ultimately lead to below market returns. In this Motley Fool classic, former Fool Randy Befumo explains the importance of knowing and abiding by your circle of competence.

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By Randy Befumo
July 5, 2002

This piece originally ran on Oct. 10, 2000.

Valuation and quality form the length and width of the investment world. These two dimensions indicate, in the end, what the size of the investment return will be. Like everything else in life, our ability to use these tools successfully has finite limits. In fact, our ability to measure valuation or quality is actually fairly limited, despite the seeming precision that the numbers offer us. Although we always have the option of leaving an extra "margin of safety" in a purchase by being conservative in our assessments of the valuation and underlying quality to try to offset our human limitations, properly assessing another dimension of the investment process -- depth of knowledge -- is probably even more vital to avoiding mistakes.

Depth of knowledge is a straightforward concept, despite the fact that it is erratically employed. Simply put, it is a measure of how well you understand the company's economic model -- the way it interacts with customers, suppliers, distributors, and investors as part of its daily operations. The reason true depth of knowledge is erratically employed is because of the capacity most investors have for self-delusion. This is particularly true among investors who attempt to expand their idiosyncratic experience as a customer beyond its logical limits, allowing this impressionistic vantage point to color their perception of the company's overall economic model.

Understanding a business can be as complicated as the business itself, mitigated by our own personal knowledge and experience. The basic manufacturing model is probably the simplest business going. A company makes something, distributes it to the customer through set channels, and collects money from the customer in return. Another fairly simple model is the retailer, which receives manufactured goods from other companies and sells them directly to consumers. Or you can mix it up and have the hybrid manufacturer that not only makes products, but also markets and sells them. With the exception of natural resources, financial, and real estate companies, almost all companies involve some combination of the manufacturing or retailing format.

Digging down deeper than this simple understanding of how sales dollars are converted into cash is essential. Who are the company's customers? Who are the company's suppliers? What factors affect end-user demand for the company's products or services? What is management's strategy for growing the business and creating shareholder value (not always one and the same)? The maxim "Buy what you know" is insufficient -- it should really be "Buy what you understand."

Heraclitus probably said it best when he quipped, "Much learning teaches little understanding." Actual concrete understanding of what a business is is fairly rare. More often than not, it degenerates into a superficial sense of what the products are and how exciting they might be, or an idiosyncratic consumer familiarity with the product inflated into a purported understanding of the company's economic model.

Understanding goes beyond just reading the federal filings. Routine, boilerplate warnings about potential pricing irrationality in a market just don't have the same power as the concrete and real experience of seeing the price for hard disk drives dive in the spot market. Many times true understanding comes from months, or even years, of following a company before making your purchase. The first few times you look at a company's financial statements over the course of a year or two might be better conceived of as a "getting to know you" sort of engagement rather than a "hey, let's go out" kind of thing. While just twiddling around with preliminaries can be boring, many investors will tell you that their best investments were not necessarily their first investments, but the companies that they bought after years of watching them closely.

For me personally, this is true of my early 1996 purchase of America Online (NYSE: AOL) and my early 1997 purchase of Dell Computer (Nasdaq: DELL). In fact, many expressed surprise that I had not owned either company until then, given the amount I had written on both companies. The simple reality is that while I had an idea Dell might be cheap way back in the first quarter of 1996 after it had been pounded by 33%, it took months for me to really understand the mechanics of asset management and how Dell had used these to juice up its return on invested capital.

While you can argue that buying the stock on the first inclination that it might be cheap would have been better in that situation, I can think of a dozen other situations in which having patience and trying to learn more about a company through trade magazines, analyst reports, and a variety of other online and offline sources would have created a big enough picture to make buying as risk-free as possible, from an information standpoint.

The fact that there is no set number that measures your knowledge of a company is probably the main reason why many investors fail to consider this important variable before investing. While you can assess the relative strength of a stock by glancing at a copy of Investor's Business Daily, assessing your own knowledge level is a much more introspective, difficult, and sometimes brutally honest process. However psychologically painful this self-assessment might be, if you really think about it, probably 50% of your major investment boo-boos come down to knowledge risk, with the remainder evenly split between valuation (buying too high) or quality (buying a lousy company).

While knowledge is important, it should not be taken out of context with valuation and intrinsic business quality. The appearance of detailed knowledge about a company without a genuine understanding of how much cash the company will generate in the future can be as catastrophic an investment scenario as looking at valuation only and ignoring the company's underlying economic model.

It is depth of knowledge combined with low valuation and high quality that make for outstanding investments. Any deviation from these three dimensions involves taking on the distasteful risk of losing money. This is not the end, however. When you combine this fully functional, three-dimensional investment model with an appropriate philosophical framework and add the concept of time, you can engage in full-fledged security analysis.