Thursday, February 26, 2015

Circle of competence

Your circle of competence is the companies for which you can think like the owner, CEO or board. What does think like the CEO mean? It means you understand the:

·        Products & services –
o   what the product or service s
o   How is the product or service beneficial to the customer?
·        Customers
o   Why they buy
o   what are their alternatives
o   how does this product or service benefit the customer
o   what is the customer willing to pay for this
o   How does this company create value for its customers?
o   How loyal are the customers?
o   Can the customers be made more loyal over time? Is the company taking rapid actions to make the customer more loyal?
·        Suppliers & supplier economics
o   How much control do suppliers have over the business?
o   Can the business grow large enough to be able to control the suppliers?
o   Does the business have supplier alternatives?
o   How can the costs be controlled?
·        Pricing
o   How will an increase in price impact sales?
o   Can cost increases be passed on to the customers?
o   Can unreasonable price increases be done over time?
·        Competition
o   Is the competition smarter than this company?
o   How can the company beat the competition?
o   What are the advantages and disadvantages of the company over the competition? How will these evolve over time?
·        Change management
o   How rapidly is the customer, product, service, delivery
o   Can this product or service become obsolete?
o   Can the entire industry become obsolete?
o   Is the company a change leader, follower or will it succumb to change?
·        Industry
o   What is the market size?
o   What are the related products that can be forward or backward integrated?
o   Is this company the industry leader or does it have the capability to be the industry leader?
·        People
o   How well are they compensated?
o   Does the best talent work for this company? If not who does the best talent work for and why?
o   How will the people costs evolve?
o   Will the company be able to scale management like its people?
·        Scalability
o   How can the business be scaled going forward?
o   How rapidly can the assets be made to sweat?

As you can probably guess – no one is born with a circle of competence. As you go along your value investing journey your circle of competence will rapidly expand. Over time your sense of an industry or business will improve rapidly if you continue to look incisively at companies.

Before you finalize on an investment I would strongly recommend you study a few of the competitors with the same level of detail. That will give you a sense of the overall business model. You should especially study the top few companies in the industry and a few of the large laggards. That way you can understand what drives success and failure.

Increasing your circle of competence is very important as it keeps opening new avenues to you. If you find something that you don’t understand going at it with all gusto is good but only to a point. Sometimes some businesses are best left alone. If the complexity is something you don’t understand it does not necessarily mean you are not smart. It may mean that you don’t have the pieces of the puzzle together yet or it does not suit your style of thinking. All businesses need not suit everyone. Examples of industries that some investors have been known to leave alone due to complexity in the past are technology companies and pharmaceutical companies.

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