- By Grahamites
Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it.
Above is one of my favorite quotes from Charlie Munger (Trades, Portfolio). It's also one of those quotes which I know is so true but in practice find very puzzling. Particularly in this case, there are some vague concepts involved: competency, circle and edge. Each one of them can't be precisely defined.
During his Value Investing class session last week, Chang Jing from Himalaya Capital offered great insights on how to find your "edge of competency."
Most importantly, a circle of competency is a type of competency. Then, the competency has a circle around it. Once you step out of the circle, it's no longer a competency. But in order for you to even know the edge of the circle of competency, you have to build a competency circle first.
The four most important factors in establishing circle of competency are: intellectual curiosity, critical thinking, open-mindedness and focus. Needless to say, it's a daunting challenge to build a circle of competency in the first place. I've written numerous articles on the topic of building a circle of competency before so for the sake of discussion I won't go in depth on this topic.
Let's assume that an investor has taken the efforts and built a circle of competency in an area. The next important question then becomes how to define the edge of the competency. According to Chang Jing, there are three ways to find the edge of circle of competency. The core idea is intellectual honesty, whichever way you take.
First of all, you can self-test the edge of your circle of competency. This requires a very high degree of intellectual honesty because you will be debating yourself and try to falsify your own statement. You have to honestly assess whether you truly understand something or not. A good practice is to actively seek disconfirming evidences. Try your best to disprove yourself. For instance, let's say you are researching a bank and concluded that one sign of the bank's competitive advantages is that it has a higher than average return on assets. The next thing you should do is to ask, "what evidence can I collect to prove myself wrong?"
For instance, the bank may have been investing in higher risk assets to boost its returns. It may have lowered its risk standards for loan originations. Neither might be true, but they are the potential disconfirming evidences you should look for.
Personally, I think this way of finding out the edge of circle of competency is the most convenient and timely one. But it also requires an extremely high degree of intellectual honesty.
Explaining to others
Secondly, you can explain your statements to others. Ideally you should speak to people who you know will have different levels of understanding of a business. For instance, let's say you've done some research on Coca Cola (NYSE:KO). You can discuss what you know about the company with your friends who might know little about the business. You can also discuss it with your value investor buddies who have some knowledge about the company. But in order for you to test your circle of competency, you should actively seek opportunities to speak to the company's distributors, managers and its senor executives. If nothing they say can surprise you, then you might have truly built a circle of competency. I think this method, if applied correctly, is very powerful, but it may not be suitable to investors who are less inclined to speak to others, or who are not in a position to get through to the management of a company they are interested in.
Last but not least, you can always compare your projections to subsequent events. If there's a large deviation, if something surprises you, it means that you haven't defined the edge of your circle of competency yet.
In my previous job as an analyst, I've always kept track of my projections and compared them to the actual results. Needless to say, I was humbled many times. When the actual results differed materially from the projections, obviously I had to conduct variance analysis and figure out why there was such a big gap between the projections and the reality.
I've written about my humbling experiences with Colfax (NYSE:CFX) and DeVita (NYSE:DVA) in the past. In both cases I was shocked multiple times when the actual fundamentals of the business fell sharply below my expectations. Looking back, that's a sure sign that I'd stepped out of my circle of competency.
I like this way of self-validation. However, the drawback of this method is its long feedback period. It may take at least a few quarters, or even a few years to have enough samples to judge whether you truly understand a company or not.
As Chang Jing shrewdly pointed out, the most important aspect of finding the edge of your circle of competency is intellectual honesty. Without intellectual honesty, you won't be able to build your circle of competency, let alone define its edge. But what is intellectual honesty? How to practice intellectual honesty? It's an area I'm still struggling in. Hopefully, in the future, I'll gain a better understanding.
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This article first appeared on GuruFocus.