In the early 1980’s Sir James Dyson’s new bagless vacuum cleaner was rejected by manufacturers and distributors in his native UK.
They saw Dyson’s invention as a threat to the lucrative domestic market in disposable cleaner bags at approximately £100 million per year. Dyson, not one to sit still, set up his own manufacturing company.
Today, his net worth is estimated to be £1.45 billion.
It appears that the principle of cyclonic separation (bagless vacuum cleaning) won through in the end. Dyson had an idea and simply ran with it, successfully suing Hoover for patent infringement to the tune of $5 million in the process. He has sold millions of bagless cleaners, developed more innovative products and gained recognition as one of the UK’s most respected inventors and entrepreneurs.
What does this have to do with value investing and a circle of competence?
The results of my analysis into the 74 potentially undervalued junior miners has led me to one conclusion: I have been operating outside of my circle of competence in direct violation of my investment plan which
could will increase risk if I invest in a niche with which I am unfamiliar.
Dyson never gave up on his original idea because he had a deep conviction that cyclonic separation would work out.
But are there undervalued opportunities in junior miners? Yes there are; out of the 74 I short-listed, there were a few that I’ve added to the Shares and Stock Markets discretionary model portfolio – more on this next week.
So why would I add these companies if they are outside my circle of competence?
The simple answer is that in my view, they are ‘demonstrable bargains’, a phrase coined by Benjamin Graham to describe the phenomenon of when a potential investment is an outright and obvious bargain and has a large margin of safety after careful and thorough research and analysis. At least that is my interpretation of it. Like Sir James Dyson, I have a deep conviction – not that these companies will work out as successful investments – but that they meet deep-value orientated criteria and exhibit a large enough margin of safety to warrant an investment.
I’m unable to know for sure if these considerations mitigate the increased risk of operating outside my circle of competence. All I can tell you is that I’ve followed value investing criteria throughout my analysis with a focus on the characteristics of the mining sector.
As a quick reminder about the additional considerations for the mining sector, they are:
- The geopolitical area in which the company has it’s operations
- The value of resources in the ground
- How good/bad management are
- Singular or multiple mining projects
- Tangible book value
- How much cash the company has
***At this point I must state that those new to value investing should totally disregard the way I have violated a pillar of value investing philosophy. In plain English: STAY WITHIN YOUR CIRCLE OF COMPETENCE.***
What Is A Circle Of Competence?
Warren Buffet first coined the phrase circle of competence. For example it is well documented that Buffett did not invest in internet and technology stocks during the late 1990’s because he freely admitted that he did not understand their businesses.
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 – Charlie Munger
Examples of a circle of competence include but are not limited to:
- Focussing on stocks listed on your home exchange
- Directing your research with a sector with which you are extremely familiar (do you work in insurance, banking telecoms?)
- Selecting only nano, small, mid or large cap stocks (some experienced value investors focus on one or a mixture of different markets caps)
Buffett said this about his own circle of competence:
We are best at evaluating businesses where we can come to a judgement that they will look a lot like they do now in five years. The businesses will change, but the fundamentals won’t. Iscar will be better – maybe a lot bigger – in five years, but the fundamentals will be the same. [In contrast,] look at how much telecom has changed – Warren Buffett, BRK Annual Meeting, 2006.
To me that means boring, stable, fairly predictable businesses. Businesses that are so simple to understand that you can explain its operations, how it makes money and its intrinsic value to a child.
I have also heard a circle of competence described as having an ‘edge’ over other stock market participants, but the simplicity of Buffett’s description appeals to me.
The most important aspect of your circle of competence is that it will be unique to you. No one will tell you what your circle of competence is, its just something you will have to figure out for yourself. The process of doing so is part of building an investment plan and value orientated style that is unique to your personality, life experiences and time constraints.
In the meantime, here’s a tip you can use right away which will help you to start to define, research and increase your own circle of competence in 10 minutes by following these 2 steps:
- Assume that your circle of competence is small, no matter how smart you may think you are – whether you have an MBA or not your knowledge is finite. As you gain experience either with virtual accounts or putting your hard earned money at risk, your circle of competence will develop over time.
- Start a blog about your experiences in the stock market – don’t forget that free blogs from wordpress.com can be set to ‘private’ if you do not want share your mistakes with the world. You would lose out on getting free (and sometimes valuable) advice from financial bloggers if you do.
Follow through with these steps, come back here and post a link to your new blog in the comments section.
For now, I’m the proud owner of some pretty beaten-up junior miners. Time will tell if like Sir James Dyson my conviction will pay off.
All the best
If you enjoyed this, you might also enjoy these posts on intrinsic valuation: