The “Circle Of Competence Trap” – Retail, Energy And Metal Sectors

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iStock 03 14 14 book value

iStock 03 14 14 book value“I’m no genius. I’m smart in spots – but I stay around those spots.”
Tom Watson Sr., Founder of IBM

“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
– Warren Buffett (TradesPortfolio) 1996 Letter to Shareholders

In the world of value investing, one of the most important concepts is the concept of “Circle of Competence,” which came from and has been used over the years by Warren Buffett(TradesPortfolio) as a way to focus investors on only operating in areas they know the best. In one of my previous articles, I wrote that, by understanding the business, Buffett means understanding the business model, not necessarily the products or services provided by the business. You can drink Coca-Cola (KO) every day yet not have the faintest idea why it is such a great business. On the other hand, you may have no idea of Valeant’s pipeline of drugs, but you can understand the business model without understanding most of its drugs.

There are a lot of discussion points on this important topic of “Circle of Competence.” In this article, I want to discuss what I call the “Circle of Competence Trap,” and especially three sectors that investors are especially subject to this trap. These three sectors are retails, energy and metals. I intentionally exclude the technology sector because it is well known that value investors tend to shun this sector anyway.

Let’s talk about the retail sector first. When I first started investing, I naively thought retail was one of the most understandable business because it is so closely related to our daily lives be it general retailers or specialty retailers. They are everywhere in our lives. Because I could see and visit those retailers in person, I assumed that I could understand how they make money and observe the trend in the retail business. Boy, was I wrong. It didn’t take that many mistakes and observations for me to realize that retail is one of the toughest businesses out there and as value investors, we have to be very careful with this sector. Look at what happened to Borders, JC Penney (JCP), Aeropostale (ARO) and Tesco (TSCO). Borders and JC Penney were high-profile mistakes made by Bill Ackman (TradesPortfolio), who has a fabulous batting average and Tesco was a mistake made by great Warren Buffett (TradesPortfolio). Let’s not forget about Buffett’s early investment in this department store called Hochschild, Kohn and Co. The reality is, the business model of retailing is inherently tough. It is a challenging business because shopping habits and sales channels are constantly changing, making it difficult for businesses to build and maintain competitive advantages. Moreover, your competitors can copy your best practices in no time, making it even harder for everybody to compete in this business. Some retailers are also subject to rapid technology changes, which make their business models deteriorate very rapidly (RadioShack [RSH], Borders etc.). It is just very tough to assess the business model in the next 5-10 years in retail.

Energy and metals are another two sectors where many value investors claim false “Circle of Competence.” If you ask a typical analyst what the business model of an energy E&P company is, he or she will probably tell you that you make all these capital investments in machines and equipment so you can drill oil or gas wells, then you extract them out of the ground and sell them to somebody else, hopefully at a price that not only covers your extraction and development cost but also makes you nice little profit. Similarly, for metal miners, they invest in the mines, extract the metals and sell them to someone else. Of course there are many other sub-industries in this sector such as oilfield services, offshore drillers, steel mills, etc. But if you ask me what is the most important factor that affects almost all businesses in this sector, I would say it is the price of the commodity, be it the price of oil or gas or gold, the future price of which I would argue very few of us can forecast with a reasonable amount of confidence. I was looking at some onshore rig services companies recently and stumbled onto the 2001 and 2002 annual report of this one company. I was shocked to find out that, at one time during that period, oil was below $20 a barrel. That was merely 12-13 years ago and just recently, many people were freaking out because oil dipped below $80 a barrel. Incidentally, during the same period, gold was trading below $300 per ounce, which is about one-fourth of where it is today and one-sixth of what it was two years ago. If we were in the middle of 2002, instead of 2014, could any of us imagine the price of oil and gold would quadruple within the next 12 years? I doubt many of us could. And if we couldn’t, we should think twice if we think energy and metal businesses are within our “Circle of Competence.”

In the end, I want to clarify that I am not discouraging the readers. My intention is barely to remind us that these three sectors are very tough for us to come up with reasonable forecast on what is going to happen to the business in the next 5 to 10 years. Therefore, we should be more careful if we claim these businesses within our “Circle of Competence.” Although it might seem obvious that investors should stick to what they know, the temptation to step outside one’s circle of competence can be strong. By reminding ourselves of the perils in investing in retail, energy and metals, we are better guarded against the folly that may come from an incomplete understanding of the business model.