I think the subject of circle of competence could have been covered in this blog, however it deserves special attention. And I am sure you will agree with it!
A lot of these concepts have been coined by different value investors. As a minuscule Indian investor I faced always challenge in customising a concept reflecting real life models.
Value investing always advocates one must buy a business what you understand. I always struggled to find out the answer to meaning of silly word "understand". First Hedgehog theory explained in Jim Collin’s highly successful book “Good to Great” inspired me. I drew three circles for passion, money and talent and started punching down one by one. As usual behavioral finance (availability, recency, confirmation etc. biases) swept me away and I landed up writing too many irrelevant activities. I practiced it for long year, still there was always doubt was this the best I can do? Does it really reflect passion, talent, and money?
Below is an abstract of questions I ask myself before analyzing a company based on opportunity sourced from anywhere. Not saying this would be final but I feel I am improving though at snail's pace.
In simple words if a business is outside your circle of competence don’t put money into that stock.
Scrip Name: Manali Petrochemicals, already I am holding few stocks based on financial analysis, management actions etc. Jai ho, you can see my incredible stupidity.
CONCLUSION STATEMENT: Avoid, I don’t understand head or tail of business. I will find it extremely difficult to document the analysis during all times.
CONFIDENT: FULLY UNDERSTAND: I understand the business very well.
AVOID: DON’T UNDERSTAND: I don’t understand the business at all.
TREAT: CAN UNDERSTAND: I can understand something but I think I need to put extra effort to move up to confident category.
Question 1: What is the business category of company? What is my first reaction?
BSE website says it is petrochemicals so as the name of company. I have a mixed reaction, all I know is chemical products from Petroleum. Not the best business I can understand, still I will move to next question to understand a bit further.
- Tips- the reaction can be anything, let it be natural. For example the moment I hear about Anil Ambani group I tuck my tail get into corner!
Question 2: Did I look at the “about us “ section on web site? Can I explain they’re what are written without referring to other sources including Google?
This is what I saw; MPL (Manali Petrochemicals) is a leader in production and marketing of Propylene Oxide and Propylene Glycols. I even don’t know what these animals are?
Fair, next line says these meet the demand of polyurethane industry in India. Another bouncer.
I am forced to use our GOOGLE baby. This is what is Google says:
Propylene oxide is an organic compound, a colorless liquid produced in large scale industrially mostly used for production of polyether polyols, which is used for making polyurethane plastics. It is a chiral epoxide although commonly used as racemic mixture.
This sounds insane to me, I needed a break. I stopped going further.
Question 3: Did I check the products and services sold by the company? Have I seen them or known before? Can I write down 2-3 lines about each product and services?
*Tips: this awareness comes from three sources- 1. Employment experience say you have worked for Media Company for some year, you will naturally understand a lot unless you were dozing off at work place 2. Daily acquaintance: right from medical bills, telephone, television, samosa, and grocery. You may not know in detail but it pump you definitely.
Question 4: Who is buying the products or services and what is the usage? How does the product and services generate money in business?
- Tips- same as question 3.
Question 5: What is required to make these products and services? Have I seen them or known before? Can I explain in 2-3 lines about requirement?
Tips* I should be reasonably breaking down the product or service at a broad level. Say Airtel- a chip, calls and bills. I know its not all, but good start for sure.
Question 6: Who (nature of) are the suppliers of the requirements as mentioned in question 5?
- Tips- who means nature of supplier. Say same Airtel, who can support billing i.e. either in house or outsourced IT Company.
Question 7: Do I think the business or company is ethical at first go?
- Tips- if I know dubious stories from beginning, it will take over my behavioral finance later. Better avoid.
Question 8: Can I mention one more competitors for the company (which are listed)?
- Tips- what you think competitor may not be actually competitor. Do a second level thinking, it may not be straightforward always. E.g. this petrochemical business ; comparing Reliance Industries with Manali would be recipe for disaster not because of size but nature. Reliance draws not more than 8-10% of business from Petchem. Try to find out one to one competitors if you can. The peer comparison given in most of websites is useless.
Question 9: Do I think I will get right resources to analyze the company further? What is the edge of circle?
- Tips- As a retail investor internet is my major strength, if the company you are analyzing does not have a website….you can imagine answering questions to quality, management and a host of others!
Question 10: What all I need to move from CAN to CONFIDENT category?
*Tips- I found this is the most crowded category. Every company I started with I feel not easy but I can do it. One needs to differentiate emotions from signals.
I have attached a opportunity sourcing exercise based on circle of competence, the BSE sectors used from BSE web site only.
- one tab shows how did I arrive at my circle of competence
- other tabs shows the BSE sector mapping to different category of circle of competence.COC Mapping.xls (62.5 KB)