Understand Your Circle of Competence

 

If Warren Buffett cannot understand a company’s business, then it lies beyond his circle of competence, and he usually won’t attempt to value it. He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology. During the technology stock mania of 1999, Berkshire’s return badly trailed the market’s return, and a number of observers commented that Buffett was hopelessly behind the times for avoiding technology stocks. When the tech bubble burst, however, he and other value managers who had stuck to their discipline were vindicated.


Although it might seem obvious that investors should stick to what they know, the temptation to step outside one’s circle of competence can be strong. Since we're located in Nashville, Tennessee, we often feel pressure to show an expertise in healthcare stocks, but an investigation of the movements in healthcare stocks might give you pause. Healthcare companies are affected by many things that are outside the companies’ control, and that are difficult to predict with certainty. Political battles over healthcare policy have caused considerable volatility in the sector in recent years, and Medicare reimbursements can be changed with little warning, having severe consequences to the stock prices in the sector.


Some industries are dominated by the same companies for many years because of the high entrance barriers that must be overcome to gain a foothold in the arena. Long-standing histories of cash-flow, earnings and performance provide degrees of predictability. On the other hand, for example, the leaders in technology can seemingly change overnight by a new idea conceived by a young brainiac in a dorm room, making investing in the technology sector difficult and less predictable.


We believe that what counts in industries most is not so much what we know, but how realistically we can define what we don’t know.  We prefer to invest in industries where we believe we are most competent, and to avoid those areas that are less predictable.


“Never invest in a business you can’t understand.” -- Warren Buffett

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Dave Crouch and not necessarily of Raymond James. Raymond James is not affiliated with and does not endorse the opinions or services of Warren Buffett or Charlie Munger. This is not a solicitation to buy or sell Berkshire Hathaway stock or any other security. Investing involves risk, and you may incur a profit or loss regardless of strategy selected. Past performance may not be indicative of future results.