Beyond the hype: Are you investing within your circle of competence?

Equity investing can be a remarkably rewarding journey, yet it always carries the inherent risk of market unpredictability. Time and again, it has been proven that market fluctuations-whether justified or not-are inevitable, and a market can remain depressed for years. Take the Bangladeshi market, for example; the broad index of the Dhaka Stock Exchange, DSEX, has been underperforming for years. The 5-year and year-to-date (YTD) returns of the DSEX as of October 20, 2024, are 4 per cent and - 17 per cent, respectively - clearly indicating how challenging it is for investors to optimise their funds in such a fragile and underdeveloped market. A simple yet powerful concept, the Circle of Competence, may help you beat the odds. Have you heard of it yet?

Equity investing is an art - where degree of perfection is determined by patient strokes of informed decisions. Hidden within the pages of history lies one simple secret - the greatest and most successful investors all had one trick up their sleeve: they only invested in businesses they properly understood, which allowed them to make informed and well-thought-out decisions.

To become a master artist in the field of equity investing, you must first understand what investing in equity, i.e. common stocks, genuinely means. A stock is not merely a written symbol or an electronic blip - it is an ownership interest in an actual business. For example, if you were to buy stocks of Grameenphone Limited today, it would indicate that you are taking an ownership interest in the business activities of Bangladesh's leading telecom company.

Now, assuming that you are an intelligent investor who plans to prudently invest his/her hard-earned money, you would only want to invest in businesses (i.e. buy stocks of businesses) that:

1. i) you think have a promising future ahead - and therefore, you want to own
2. ii) are trading at a cheaper price compared to what you expect its value to be

That makes it simple - to be a successful investor, all you need is to take ownership interests only in businesses that you believe are wonderful, and trading at a fair value. This is where it gets tricky - the odds of finding and understanding wonderful businesses, and monitoring their performance - are high.

'Circle of Competence' is a term coined by the legendary investor Warren E. Buffet, using which he conveyed the simple idea that an investor increases their chances of success by investing only in businesses they have deep understanding of, allowing them to make informed decisions. For example, a person who has worked in a pharmaceutical company all their life, or a person who has sound knowledge about the day-to-day business activities of a pharmaceutical company - may address a pharmaceutical business to be within their circle of competence. As these individuals have a deep understanding of how the particular business works, they can accurately identify a wonderful pharmaceutical company, invest in it, and monitor its performance over time. An investor who invests within their circle of competence won't get swayed by any unrealistic rumor, unjustified pessimism, or unsustainable optimism - as he has a clear idea about the business he invested in.

On the other hand, a person who invests in a business he doesn't understand, is likely to panic the moment he is exposed to the volatility of the market. This person simply ends up letting other people's mood swings govern his financial destiny. In the field of investing, it is of utmost importance to supply the emotional discipline - and it gets a whole lot easier to do so when one clearly understands what they are buying and for how much.

Adhering to this simple yet highly effective strategy allowed legendary investors like Benjamin Graham, Warren Buffet, Charlie Munger, Li Lu, Mohnish Pabrai achieve what most people cannot - success in the field of equity investing. During the early 1960s, Buffet, who was in his early 30s, showcased his ability to highly capitalise on market inefficiencies - thanks to his philosophy of investing within his circle of competence. In 1963, American Express Company (ticker: AMEX) had faced a major scandal (famously known as the Salad Oil Scandal) involving illegal credit card practices - which had caused its stock price to plummet. However, Buffet, thanks to his thorough understanding of the company, could figure out that the underlying business of AMEX was sound, and the market was overreacting to the negative news. He conducted his due diligence on the company - analysing its financial statements, management team, and competitive position. He concluded that AMEX had a strong competitive advantage in the credit card market and that it was well-positioned for long-term growth - which led him to make a substantial investment in it. AMEX's business continued to grow, and its stock price rebounded dramatically - just as Buffet had predicted. He did not give in to the market's level of irrationality, and later made significant gains thanks to his contrarian stance.

Ignoring the roar of the crowd is tougher than it seems - as it can easily override the judgment of even the brightest of minds. Back in the Spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the then-hottest stock of England. Sensing the market's over-optimism, Newton sold off the South Sea stocks he owned, pocketing a 100 per cent profit totaling £7000. But just months later, unable to ignore the wild enthusiasm of the market, he jumped back in at a much higher price - and lost £20,000 (over $5 million in today's money!).

Now you can fathom how powerful a simple investment philosophy like circle of competence can be, as it guides you to invest only in businesses that you understand - and when you confidently do, you can peacefully ignore the general investor's level of irrationality.

Let's consider the chart above for example - which portrays the dividend-adjusted price performance of Marico Bangladesh (Ticker: MARICO) over the past 10 years. Assume, 2 people - investor A and investor B, decide to buy stocks of MARICO on Oct 1, 2014. Investor A has a profound understanding of MARICO's business model, giving him a clear idea about its growth opportunities. Contrarily, investor B, doesn't have much idea about how MARICO runs its business or generates profits - making his investment in MARICO outside his circle of competence. Anytime within the next 2 years, investor B is more likely to sell off - as the market's pessimism would easily override his judgment. However, investor A, having a deeper understanding of the stocks' optimistic growth opportunities - would continue to hold the stock. Fast forward to 10 years, he enjoys a staggering 161 per cent return on his investment.

Investing within one's circle of competence can significantly reduce the chances of making poor investment decisions. When investors understand the underlying business, they are better equipped to assess its prospects, identify potential risks, and make informed judgments - as you can see in the case presented above. People like investor A, who invest within their circle of competence, usually feel confident in their investment decisions thanks to their understanding of the industry and the company they invest in. As they only make informed decisions, they don't let short-term market turmoil or general investor's level of irrationality shape their story of success in the long run.

A more common example of circle of competence can be found in the fields of Cricket. In a match of cricket, a batsman can choose to play a plethora of shots ranging from Cover Drive, Pull Shot, Straight Drive, Cut Shot, Switch Hit, Reverse Sweep etc. Now, some batsmen can pull off some of these shots remarkably better than others - taking their style of playing those shots into some form of art. For example, Chris Gayle and his slogs over mid-wicket. What happens in such cases is, the batsman in question has such a profound understanding of a particular type of shot that it can be considered within his circle of competence. He knows exactly which may be the perfect chance to hit that shot and utilises it, and refrains from unnecessarily taking risks at other times. Thanks to being within his circle of competence, he can make informed decisions timely to score crucial boundaries instead of making a poor and untimely decision leading to his dismissal.

By this point it shouldn't be any surprise to the readers that it is not only tough but also time-consuming for one single person to have a deep understanding of the day to day business activities of multiple businesses operating in different sectors - and even more hectic to regularly monitor their performance. This is where well-governed, research-oriented, and knowledge-driven asset management firms can come to your aid - as they have dedicated professionals covering different sectors. Such professionals, with persistent learning and careful monitoring, develop a sound understanding of the best businesses within their designated sectors - allowing them to make informed investment decisions with your money, so that you can rest assured.

The writer is an Investment Analyst, UCB Asset Management Limited

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