The Investing Philosophy of Warren Buffett: Part 6

This is my sixth post in a series about Warren Buffett’s investing philosophy. If you haven’t read the first five parts yet, you might want to do so now. I am going to build on the concepts that I talked about previously.
Part 1
Part 2
Part 3
Part 4
Part 5

Stick to your circle of competence.

Your chances of investment success will be greatly increased if you focus your energies on analyzing companies within your “circle of competence” or area of expertise. Your circle of competence could be related to your career, your hobbies, your interests, your background, or whatever has given you insights into the particular industry you are looking at. Once you have found an area where you think you could develop some expertise, sharpen your focus by analyzing the industry more deeply. Is the market growing or shrinking? Do the market conditions change quickly or slowly? How predictable is the industry? Are there a few large competitors or many smaller competitors? Is the industry heavily unionized? Is it capital-intensive, labor-intensive, or both? Are there specialized accounting rules for the industry? How heavily is the industry regulated? What are the key metrics for the industry?

If you are really interested in improving your investment results, you need to become an expert in the area you are investing in. In yesterday’s post, I suggested that you should approach a stock purchase as if you were acquiring a private company. If you were buying a private company, you would do it very carefully and deliberately. Buying a publicly traded stock should be no different. Let’s say that you were considering buying Microsoft stock. Would you be able to have an intelligent conversation with Steve Ballmer – Microsoft’s CEO – about the product markets that Microsoft competes in? Or would you lack the confidence that you know what you are talking about? If you would lack confidence, then you need to do more homework, shift your focus to another area, or give up stock picking entirely and invest in index funds instead.

Incidentally, it’s not important to have a huge circle of competence. It’s more important to know what areas are solidly in your circle of competence, as Buffett talked about.

“Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
1996 Letter to Berkshire Hathaway shareholders

“The most important thing in terms of your circle of competence is not how large the area of it is, but how well you’ve defined the perimeter. If you know where the edges are, you’re way better off than somebody that’s got one that’s five times as large but they get very fuzzy about the edges.”
“Warren Buffett Talks Business,” The University of North Carolina, Center for Public Television, Chapel Hill, 1995

Let’s say that you have decided that you have some insights into the software industry and that you would like to increase your knowledge in this area. Where should you start? A good place to start is by reading as many 10-K’s (annual reports filed with the SEC) as you can stand. You might want to begin by reading an industry leader’s 10-K from start to finish. Then continue onto a competitor’s 10-K and read that from start to finish. Then read another competitor’s 10-K. And another. Keep going. If you still aren’t even familiar with the basic layout and structure of the 10-K, then you know you haven’t come close to reading enough 10-K’s. Once you are familiar with a particular company and industry, you will no longer have to read the entire 10-K. You will learn how to scan the 10-K for changes and important items.

In the software industry, Microsoft is clearly an industry leader. You can find Microsoft’s 10-K on the Yahoo! Finance website by entering Microsoft’s ticker symbol (MSFT) and then by clicking on the SEC Filings link. Or you can search the Edgar database on the SEC website. One cool feature about the Yahoo! Finance website is that you can quickly find some of the major competitors by clicking on the Competitors link.

What if you don’t want to do so much reading? In my opinion, you would be better off investing in index funds. Intelligent investing isn’t glamorous, and it isn’t always particularly exciting, although it can be interesting and challenging. It helps to have a burning curiosity to continuously learn more. If you don’t have the desire to really make a strong effort at picking your own investments, then don’t do it. Beating the market consistently is very difficult, which is why most investors (even most professionals) are unable to do it. There is no shame in investing in index funds. In fact, you just might find that you can Beat the Pros by Being a “Know-Nothing Investor”.

To be continued…

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