It is an essential part of investing like Warren Buffett to understand the company that you are investing in. Buffett explains, ?Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times.?
He also makes it clear that this circle does not have to be very large:
The most important thing in terms of your circle of competence is not how large the area is, but how well you?ve defined the perimeter. If you know where the edges are, you?re way better off than somebody that?s got one that?s five times as large but they get very fuzzy at the edges.
Elsewhere Buffett explains how he would go about setting up a circle of competence:
I would take one industry at a time and develop some expertise in half a dozen. I would not take the conventional wisdom now about any industries as meaning a damn thing. I would try to think it through.
If I were looking at an insurance company or a paper company, I would put myself in the frame of mind that I had just inherited the company, and it was the only asset my family was ever going to own.
What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find the strengths and weaknesses of this particular company versus other ones.
If you?ve done that, you may understand the business better than the management.
Buffett is suspicious of people who claim that they can value large numbers of stocks.
Anybody who tells you they can value, you know, all the stocks in Value Line, and on the board, must have a very inflated idea of their own ability because it?s not that easy. But if you spend your time focusing on some industries, you?ll learn a lot about valuation.
The types of companies Buffett?s circle of competence (and remember that he has been doing this full-time for almost fifty years: insurance companies, fast food companies, media companies, furniture stores and jewelers.
He stays away from computer and software companies. "Our principles are valid when applied to technology stocks, but we don't know how to do it... We just aren't the ones to do it. If we can't find things within our circle of competence, we won't expand our circle of competence. We'll wait." he said.
The clear lesson for us is to start with those areas where we have the most knowledge or the most interest. Go through the companies in those areas looking for those that appear to have a particular advantage or economic moat. Once we have developed an understanding of those areas, then we can more to other areas.