Thursday, March 18, 2010

Staying within the Circle

"It is more important to say 'no' to an opportunity, than to say 'yes'." -Warren Buffett

It seems to me that many in the value investing community may be pushing the edges of their circles of competence. I think the run-up from the lows, lack of cheap-looking stocks among the more predictable businesses, and the pull of the Do-Something Aether have led many down the path to search and invest in areas that they would previously not consider; most notably technology, commodities, and many foreign markets (especially China).

Now, I'm all in favor of constantly expanding one's circle and learning about new businesses and new markets, but I think some of the mistakes being made are in mis-defining what it takes to really understand a business, industry, and market - and trying to simplify things that aren't that simple. Many investors getting into these areas have developed the right expertise, but I have a feeling that many others are getting into these areas for the wrong reasons. It's just more exciting for many investors to try new things - and justify one's actions - than to have, for example, 50-100% of his or her portfolio in cash waiting for more easily identifiable 1-foot hurdles to appear. About the concept of a circle of competence, Mr Buffett wrote: "The size of that circle is not very important; knowing its boundaries, however, is vital."

I think those boundaries are being tested by many, although I can't know for sure because I can't get inside other peoples' heads and really know what they know. And I don't have any issue with investors wanting to capitalize on something like the apparent China growth story. It just makes me a little nervous to see so many people put so much confidence in their - or management's - growth projections (and financial statements) for Chinese companies, even if they may be a little wary about sustainable high growth in the Chinese economy as a whole. I think similar concerns can be made about certain endeavors in commodity and technology-related businesses.

So my advice to readers - which you are perfectly within reason to ignore - is to take a step back and take an honest look to make sure you are staying within the boundaries of your circle. Think about what it takes for something to really fall within your circle and remember that there is a strong bias in all of us to want to invest in something in which we've put in a lot of time and work. Value investing is risk management - or risk aversion, as Seth Klarman might say - and the first risk that needs to be dealt with in any investment consideration is the risk that one may be straying outside the boundaries of his or her circle.