Apr 17, 2013|
4 simple steps to Value Investing: Step 1
We all know value investing as the art of buying stocks trading at a discount to its intrinsic value. But how does the entire process work? How should one go about choosing the right kind of stocks and then eventually calculate its intrinsic value. Fortunately for us, the entire process has been broken down in four simple steps by none other than one of the most famous practitioners of this art, Warren Buffett.
And what exactly are these steps? Well, let us discuss them one by a one in a series of four articles to be published over the next couple of weeks. Ok, so here comes the first of the four steps.
Circle of competence
What is your mental image of Warren Buffett? Or for that matter any great value investor? Do you imagine them as all-knowing number-crunching machines? Do you think of them as extraordinary supermen who have an in-depth understanding of everything in the world of business? If you did have these impressions about them, then you are grossly mistaken!
What is the secret to their investing success then, you may ask? The answer is, knowing your 'circle of competence', as Buffett likes to call it. Your 'circle of competence' would comprise all the businesses that you are familiar with and thoroughly understand.
Investing in what you understand
A value investor must focus solely on areas of business where he believes he has an edge over the average investor. Say you're a doctor. Being an insider to the healthcare industry, you would most likely have a pretty good first-hand understanding of the sector. You may have knowledge of various drugs by pharma companies. An analyst, on the other hand, would not have access to this valuable information. This puts you in a position of advantage. Of course, this does not mean you are already an expert on pharma stocks. But you are at a great starting position.
Similarly, many products and services that you use in your daily lives are often listed companies. As a regular consumer and visitor to the mall, you may have a good starting knowledge about product quality, pricing and competitors.
Some of Warren Buffett's major investments have been companies with whose products he has been familiar since his childhood. At the early age of 6 years, Buffett went door to door selling Coca-Cola cans and Wrigley's chewing gum. When he was in high school, he made money by delivering newspapers. As we know, these companies later became some of his major investments.
Staying away from what you don't understand
Investing in what you know is one thing. But there is another very important aspect which is often ignored. And this is where the likes of Buffett have a significant edge over others. Great investors have a very clear understanding of what they do not know.
Buffett is known to be quite disciplined as far as staying within the 'circle of competence' is concerned. He avoids businesses whose dynamics he does not understand well. When everyone on Wall Street was going gaga over internet and technology stocks in the late 1990s, he stood his ground and didn't invest a single penny in them. He openly admitted that he did not understand the sector. Simple...
This brings us to another very useful insight. Great familiarity may not always result in great understanding. Buffett has been a long-time friend of Bill Gates, the billionaire founder of Microsoft. He held the techie genius in very high regard and admired him for his management acumen. While he donated a significant part of his wealth to Bill & Melinda Gates Foundation, he never invested in Microsoft.
The reason has been simple. He did not know that industry very well. He could not clearly envision what the business would be like 5 to 10 years later. As such, he was willing to let go of a seemingly great investment opportunity. It is this discipline that has made him one of the world's richest investor.
To conclude, here is an interesting quote by Charlie Munger which summarises, in a nutshell, the whole essence about staying within your 'circle of competence': "Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly."
||Ankit Shah (Research Analyst) is the editor for Equitymaster Insider and Vivek Kaul's Inner Circle. A journalism graduate turned Research Analyst, Ankit joined Equitymaster when he was just 23 years old, right after getting his MBA from NMIMS, Mumbai. Having been an avid reader of Equitymaster's research through his college years, Ankit knew he would fit right in!
In his seven years with Equitymsater, Ankit rose quickly, leaving his mark on almost everything from: Travelling thousands of miles to find the next small cap stock, as part of the Hidden Treasure team... Designing Equitymaster's Secrets, an online value investing course based on the company's 20-year journey... Bringing global investing ideas to Indian readers through Vivek Kaul's Inner Circle... Right to launching his brand-new service, Equitymaster Insider.
Ankit is a firm believer in Charlie Munger's multidisciplinary approach on juggling between various disciplines...He is not just a research analyst, but also a voracious reader and an avid traveler...Born and brought up in Mumbai, he now prefers to keep away from the noisy megapolis as much as possible. In any given month, you could find him exploring the ancient ruins of South America, the beaches of South East Asia, or the organic cafes of Pondicherry.
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