Learn how to create your own circle of competence
Well, Hi everyone, and welcome to another wise money tools video. I’m gonna kind of do a little bit more in depth discussion, kind of picking up from last week. And we’re gonna talk about what’s called the circle of competence. And don’t get, you know, too scared away from the title, it’s not that big of a deal. But when it comes to investing, it’s easy to notice that most people invest way beyond their understanding. It’s not that they can’t understand or are incapable of understanding. They simply haven’t put in the time or the effort or the interest maybe to understand.
So Warren Buffett calls this circle of competence that everyone needs to have. And it’s the idea that you only invest in what you understand. My guess is if you’re an investor in mutual funds, as an example, I bet you dollars to donuts that you have no idea what the top 10 holdings are in that mutual fund. Right? Then I’d go one step further, let’s suppose you do know what the top 10 holdings are. And my next wild guess would be that you don’t understand the business model or the cash flow of those companies. Now, what you and sadly millions of others have done is given up control, hope that your money is doing better than you could do yourself. One thing I love about Buffett is he wants to give you the confidence that what he does, it really isn’t that difficult, anyone can do it.
He also says that you would be better off having a punch card of sorts. Now a punch card, let’s just say it has 20 investments on this punch card that you make in your lifetime. And in other words, you really don’t need that many investments to build your wealth beyond what financial advisors and mutual funds can do for you. You may only need four or five at 22 do really well. The others could maybe fall short fall flat, you’ll still be much wealthier. The great thing about investing is you don’t have to know everything about everything, you can be focused on one sliver of the choices out there. You might like real estate, or businesses or stocks or even lending, it can all be good. The critical component is that you understand it. Let me give you a few steps to follow that might be helpful when you search and research investment opportunities. With a little tweaking, you can take the same steps and apply them to any investment opportunity.
However, since it’s easier to define the steps using the stock market, that’s what we’re going to assume is your investment of choice right now. We can again focus on real estate or whatever just as easily. So here are the 5 steps to incorporate your circle of competence. First, look around, take a mental snapshot of where you spend your money. This might be the first place to look for companies you like and maybe understand. I don’t know, maybe you shop at Walmart or buy clothes at Macy’s, you might like to shop online at Amazon, fly with Delta or united eat at McDonald’s or Chipotle. You might like Apple or Microsoft, you might ride Harley’s or love Ford’s or Chevy’s. Anyway, you get the idea. The first place to look is in the world that you live and breathe in? Where do you spend your money?
Now that you have a list of these few companies, let’s start to look at what they do. First off, are you capable of understanding the business it? In other words, is this too hard to grasp how they make money as an example, a new internet stock comes out, you like what it does, but you have no idea how the business runs or makes money. So what you do is you throw that into the to hard pile, and you’d move on. And don’t worry how big that too hard pile gets. In fact, you want a big to hard pile, because that means you’re going with companies that you really understand. For decades, Buffett stayed away from tech companies because he simply couldn’t understand them. In fact, his best buddy is Bill Gates, you know of Microsoft, but he never could buy Microsoft stock because he didn’t understand computers. Pretty simple concept. Once you find the few that meet your criteria, you’re starting to build your circle of competence.
Now it’s time to dive into the numbers. Now for this video, I’m just going to highlight them, we’re not gonna dive too deep, I’ll save the deep dive, if you will, for our investment course, when we can really get after it. What is so awesome about technology and the internet is we can pretty much Google and get an output almost instantly. But here’s what you want to know, kind of at a 20,000 foot level, you want to know the sales, the revenue, the income, whatever you want to call it. This is the amount of money that company brings in, then you want to know its expenses, how much does it cost the company to keep the doors open and produce their product and take it to the end customer.
Then you want to know the earnings? How much is left over after you subtract the expenses from the income. And you want to know their debt? How much debt does the company have. And if they took all their earnings to pay it off? How long would that take? Next, we want to know how much the earnings are going to grow each year, at least the last 10 years, we want to take a look at to get some sort of a trend. Then we want to look at what’s called the cash flow or the free cash flow. At its essence, this is what the company actually gets to keep and invest to grow or buy other companies. Cash Flow is where the rubber hits the road, so to speak, because it’s the true income of the company.What they do with this cash flow is important to are they wise in spending or investing the cash flow.
And finally we want to look at or know the liquidation value. So I’m awesome, also called the intrinsic value, or book value. This is what one share would be worth if they liquidated and sold, maybe the stocks sell it for $100 a share but its liquidation value is $50 a share. We kind of want to know this because that’s kind of our worst case scenario. If we can buy it at or lower than or close to liquidation value, then we’re in a pretty good situation of never losing money. This is pretty much the first few steps and the numbers had don’t get overly complicated right now, because we’re just kind of laying the groundwork. As a general rule, we like companies with consistent earnings of 10% growth every year for the last 10 years.
You want to kind of set your standards high at some point, but you kind of get the idea of where we’re starting. Now the fourth step is to learn what you can learn about the management. This is kind of the hardest part, integrity and honesty, you’re hard to come by these days. This is what we’re looking for in management. Often times, you can read through the annual reports and to the shareholders. Then these are typically written by the CEO. And that gives you a good feel. We want to see if management is straightforward on their mistakes. And don’t exaggerate their successes. As a comparison model, read Buffett’s letters to his shareholders. These are kind of the gold standard when it comes to how honest to report should read. And you can download every letter Buffett has ever written with just a quick search, it’d be really beneficial to read several of them years and years ago as well.
This will give you a sense if 5 years ago that the company said they were going to do this or that if they actually did it, or were they just blowing smoke. Again, if you ever feel uneasy or see something that just doesn’t quite add up, or maybe you feel like they’re hiding something, throw it in the too hard pile. When we feel good about the company we’re buying, we understand it, most likely use it, then in some way, we’re going to be comfortable once we see the numbers and the management, then the last step is to buy with a margin of safety. And we’ve talked about this on several videos. But in a nutshell, you want to wait for a price to have what’s called margin of safety. If I calculate that a company based on earnings and cash flow, and how it’s grown through the years, has a value of $50 a share, let’s say I want to buy this company with a margin of safety.
That means I’ll likely wait for an event or a market drop or recession that drives that price down to $25. About half of what its value is, that’s a good margin of safety price. Now, this doesn’t happen every day, and it requires patience to wait for that price to hit your margin of safety. If it doesn’t, you may never get to buy this company. And that’s just too bad. Okay? Now, these are the basic five steps that Buffett’s use since the 60s, and have proven to work through good and bad times. This is why he has those two rules. You’ve heard them before. Rule number one, don’t lose money, rule number two, refer to rule number one. In the end, it’s all about your circle of competence and buying with a margin of safety. You don’t have to speculate, turn your money over to advisors who don’t follow these principles.
Most advisors just give your money to mutual funds anyway, funds do not operate on the Buffett principles. It’s more like just buying a bunch of stuff speculating rather than investing. If they did the Buffett way, maybe they’d be sitting on the sidelines with a boatload of cash like Buffett is right now, about 100 and $5 billion. Most mutual funds are fully invested at least 90% of the time, or with at least 90% of their capital. So that’s it for this video. I know that was a lot to take in. If you have any questions, shoot them to questions at wise money tools.com, I’ll get them answered just as quick as I can. Again, this is going to be in our investment course we’re gonna go into more detail and it’s gonna be much more advantageous for you in that investment course.
But in the meantime, subscribe, stay with our videos, watch them all you can, we’re gonna have a lot more good stuff coming out. If you want to have a strategy session, click on the link below set up a time we can have a quick conversation about your situation. And that’s about it. Until next time, take care.