January 19, 2006

Increasing circle of competence

Found this Q&A buffett had with University of Kansas Business School Students. As usual the Q&A was a learning experience for me. In particular I found the following reply interesting

Q: What sources of investment ideas are available today?
WEB: First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don’t understand and can’t reasonable predict. An example is chewing gum versus software. You also have to recognize what you can and can not know. Put everything you can’t understand or that is difficult to predict in one pile. That is the too hard pile. Once you know the other pile, then its important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis (emphasis mine). We’re getting ready to make a $5 billion investment and this was the process I used.
I used to handicap horse racing. The odds had to add to 100%. Sometimes there would be what in horse racing is referred to as an “overlay”. We’re looking for overlays in the stock market. It’s like a treasure hunt.
You can increase your sources of investment ideas by widening your circle of competence. I’ve widened my circle over the years. I only needed to understand insurance in 1951. There were enough opportunities in that sector alone.

The above answer had me thinking. I have been making an effort in trying to learn about various industries and deepen and wide my circle of competence. The process I am following is

- pick up an industry and identify the major players in the industry
- If available, read a sector analysis report from any major brokerage firm: These reports give me good starting point and allow me to develop an initial understanding of the industry
- Use the initial understanding to build my ‘industry analysis’ worksheet
- Come up with additional questions (in terms of the competitive dynamics of the industry)
- Read the AR for the major companies (initially for the current year and then for the previous)
- Update the ‘industry analysis’
- Do valuation analysis for some of the companies which may be cheap

At the end of the above process I may find some companies worth investing. A lot of times I draw a blank. But I guess it is fine because as long as I keep doing this and improving my circle of competence, opportunities will come up.

2 comments:

pey said...

what is the best way to obtain ARs in India - apart from owning shares.

All the motivation to do a detailed study from the ground up gets killed due to lack to information in the public domain.

Do you have any suggestions?

Rohit said...

i use 2-3 sources for to get an AR
- website of the company
- SEBI's EDIFAR database
- ICICI direct.com website has AR (condensed version) for over 5000 companies

but if i am not able to get the AR, then i drop the analysis.