Warren Buffett on Circle of Competence

Buffett argued that owning a whole business and owning a piece of one through the stock market are economically the same act, and that Berkshire's mix of wholly-owned subsidiaries and marketable securities was a single portfolio chosen by the same standard. He wrote that the only differences were tax and control, and that the mistake many investors make is to treat 'investing' and 'acquiring' as different disciplines.

On the unity of investing in whole businesses and in marketable securities.

Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America? * * * * * * * * * * * * When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions. It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

Buffett publicly acknowledged that he had made an error in buying a large position in ConocoPhillips near the top of the oil price, and that the position had been reduced at a loss. He used the admission to make the broader point that mistakes of timing on commodity-sensitive businesses are a recurring hazard, and that the discipline of staying within the circle of competence applies to industries whose economics depend on a commodity price one cannot forecast.

On the ConocoPhillips error.

Buffett wrote that Berkshire would continue to invest only in businesses it understood, even if that meant underperforming a market inflating speculative valuations in businesses it did not understand. He argued that the test was not whether Berkshire had participated in whatever was rising fastest, but whether the businesses it owned continued to meet the standard of durable competitive advantage and reasonable price. He framed the bubble as a test of temperament rather than intellect.

On refusing to chase the dot-com boom.

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.

Buffett wrote that he and Charlie Munger had never made an investment decision based on a forecast of the economy or of interest rates, and that such forecasts would not have helped them if they had tried. He argued that the work of investing is to judge the long-term economics of individual businesses, and that macro forecasting is a distraction that produces activity without judgment.

On the irrelevance of macro forecasting to business-quality investing.

Buffett argued that broad diversification is a strategy for the investor who does not understand businesses, and that the informed investor is better served by concentration. He wrote that if an investor genuinely understands a small number of companies, the risk-reward of owning those companies in size is superior to diluting conviction across many names whose economics are less clear.

On concentration as the corollary of genuine understanding.

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." * * * * * * * * * * * * Our other major portfolio change last year was large additions to our holdings of RJR Nabisco bonds, securities that we first bought in late 1989. At yearend 1990 we had $440 million invested in these securities, an amount that approximated market value. (As I write this, however, their market value has risen by more than $150 million.) Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly.

Buffett published his first detailed account of his own mistakes. He distinguished errors of commission — buying a business that turned out badly — from errors of omission, the opportunities he saw and failed to act on. He argued that omission errors are invisible in the financial statements but are often the largest in dollar terms, and that the remedy is to act decisively when conviction is genuine.

On mistakes of omission vs commission.

Buffett wrote that an investor's goal is not to calculate a business's intrinsic value to many decimal places but to have enough conviction that the value is well above the price. He emphasized that a rough but correct estimate is more useful than a precise but wrong one, and that the chief error is not arithmetic imprecision but buying businesses one does not understand.

On the precision-vs-correctness point in intrinsic value.

Buffett argued that diversification, beyond a point, is a concession that the investor does not understand the businesses. He wrote that anyone who understands a handful of industries can do well by concentrating in them, and that broad diversification is primarily a defense against the consequences of ignorance — necessary for the uninformed, but a drag on the returns of those who genuinely know what they own.

The 'diversification is protection against ignorance' framing.

Buffett emphasized that the investors he cited were not making the same investments; they owned different businesses, in different industries, with different concentrations. What they shared was a disposition: the willingness to act only when price offered a genuine margin of safety relative to value, and the temperament to do nothing when no such opportunity existed. He argued that temperament, rather than intellect, was the differentiating factor the hypothesis could not model.

On temperament as the true common factor.