What it means by investing within ones circle of competence? Value investing is not only about Stock Analysis. Value investing deals more with the business analysis.
Business analysis of companies can only be done if one understands how that underlying business operates.
It is a very important factor in value investing which asks and investor to invest only in those companies whose business they can understand clearly.
This is what is called as investing within once circle of competence.
So if you want to practice value investing to its core you should first analyze and ascertain what is your circle of competence.
So how to understand that what is one’s circle of competence?
On a broader perspective we can say that if a person is familiar with a product, its type of customers, and its operating climate, then we can say that this business is within the persons circle of competence.
How to build ones circle of competence?
Suppose you work for a company who deals in developing computer software’s. So for a person like you it will be interesting to invest in companies like TCS, Wipro, HCL Technologies etc as you have a better of how these businesses operates.
You can also develop your circle of competence with the products that you use in your everyday life.
Some products can be like your toothpaste, your shaving kit, your refrigerator, your television set, the furniture you use etc. These are some products with which you can actually relate to from your day to day life.
The best thing is that, you actually use this product and you know exactly how good or not so good they are.
Once circle of competence can also be developed by watching those companies which is operating within your city.
Suppose there is a person who is born and brought up in Bangalore. That person will surely heaven aptitude to understand more clearly how IT companies work and operate.
So what is essential is to keep a watch on the companies which are operating locally in and around where you live.
Questions investors must ask before investing
Here are few important questions that all investors must ask before buying value stocks.
These are those questions which will help you to understand that whether the company in consideration is within your circle of competence or not.
1st Question– What are the products and services of a company
2nd Question- Where are the products and services of the company get used?
3rd Question- All these products and services in high demand?
4th Question- How stable is the demand for these products and services?
5th Question- Are the products and services of the company unique in comparison to its competitors?
6th Question- How strong is the brand recognition of the company within its consumers?
7th Question- If the company will raise the selling price of its product and services, will their sales volume gets hampered?
8th Question- How big is the company now, compared to its competitors?
9th Question- How big is the customer base of this company. They depend on only few customers for sales, or they have a bigger network of customers?
10th Question- How does the company sell its products and services?
11th Question- Geographical where are the products and services of the company get sold?
12th Question- During any economic slowdown (local or global) how the sale of the company gets affected?
13th Question- How satisfied are the employees of this company?
14th Question- Is the company operate in a sector which is regulated by the government?
15th Question- Is it an established company, or it is a new start up?
The 15 questions that is being asked here are like qualitative checks about a company.
These questions not only highlights that, whether the company is within persons circle of competence or not, but it also highlights if the company is worth investing or not.
A person who is not able to answer all of the above 15 questions must understand that the company is not lying within his/her circle of competence.
There is no doubt that answering these questions is not easy. One will need information’s to fill up this form.
It may happen that off-hand the person may not have these information about the company. But what one can do is to look for the right answers……
To answer these 15 questions, it may take more than few of days to collect the data. Do not get distracted by the amount of time it takes to fetch the answers about the company.
This Hard-work will eventually pay you much more than you can imagine.
So now the point is, where one can look for the information’s about a company so that the above 15 questions get answered?
The best source of such information is is the latest annual report of the company.
It is also possible to get the information about the company from the Internet. There will be lot of news about a company published in the past. These news will help and investor to gain a deep insight about the company’s underlying business.
For sure this is not an easy task to do. And this is why value investing is not practiced by lot of people to its Core.
Gathering information about a company can be painful specially for those people who want to make quick money in stocks.
But value investing it is not about quick money. Practicing value investing builds wealth eventually in long term.
When it comes to value investing long term can be as long as 10-15 years.
There are big value investors who gather information about companies in typical ways. One approach is stated here:
* They talk to people who know the company.
* Talking to the customers of the company is also a key.
* They also talk to the employees of the company to get a feel of the inside-story.
* Talking to the suppliers of the company also gives a different perspective.
This way a huge insight about the company can be built which even newspapers cannot publish.
But it is true that only professional investors can take so much time and pain to gather information’s about a company like this.
For small investors like me and you, the best way to get the information about company is by reading their annual reports.
I also subscribe to news about the company using Google alert. I have found this method of information gathering extremely useful. It keeps me updated about any latest news/buzz about the company.
Circle of competence and brand image
Out of all the characteristic that defines a good company one of the strongest characteristic is brand loyalty.
Take example of Indian companies like Tata, Infosys, Amul, Britannia, Royal Enfield, LIC, Airtel, La Opala, Cafe Coffee Day, ITC, Lakme etc. These are such brands which people can vouch for.
Lets see some foreign brands which enjoys even bigger brand loyalty. Google, Amazon, Apple, Facebook, Samsung, Nike, Adidas, Ferrari, BMW, Mercedes, etc. These are such companies whose products people by by standing in large ques.
These are such companies which also exhibit huge earning per share (EPS) growth over long periods of time.
These companies not only pay good dividend but also ensure huge capital appreciation for its shareholders.
Why these companies display such excellent earning growth? It’s because they enjoy a competitive advantage.
To understand if a company has such a competitive advantage, one must learn to answer the above 15 qualitative questions about the company.
In addition to qualitative questions and investor must also known to answer quantitative questions about the company.
To get an answer about the quantitative questions, one will have to see company’s financial reports. What are the company’s financial reports?
Balance sheet, profit and loss account, and cash flow statements. These are three reports that helps investors to estimate the true value of a company.
But before getting into the details of the numbers it is essential for the investor to understand whether the company in consideration is within his/her circle of competence or not.
Before going into the quantitative checks it is essential to answer the above 15 questions.
Who is the Chairman, CEO, Board?
Apart from the above 15 qualitative checks, it is also important to introduce one more essential checkpoint.
An investor must know who is Managing the company. A good manager will eventually manage the company for the benefits of all stakeholders.
The positive impact of a good manager on the business of the company is huge. Atop manager like Ratan Tata can take a company from being a few million-dollar company to a hundred million dollar company in a matter of 15-20 years.
Imagine Microsoft being what it is today without Bill Gates. Try to guess Apple’s present being what it is today without Steve Jobs.
Top managers like Jeff Bezos, Warren Buffett has a huge influence on companies growth more than anything else.
Hence apart from the above 15 qualitative text it is also important for investors to know that, who are the top managers of the company.
Value investors like to invest only in those companies which is run by able and honest top managers.
It is also important to understand that even best of business gets destroyed if it is not run by good managers.
Once an investor has all the qualitative information about the company, only then he must moves ahead and and think about investing in the company.
But before investing, it is essential check the valuation of the company. This is the part of the quantitative check (financial analysis of the company).