Chapter 10: Discover Our Circles of Competence
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 10 of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real-time.
Chapter 10 expands on investing within a circle of competence by buying what is known and understood.
Chapter 10
Discover Our Circles of Competence
Staying within our circle(s) of competence is a sage method to help protect our invested capital.
Rational, disciplined, and patient investors discover their circles of competence in the sectors and industries that house the common shares of their targeted companies.
Financial media often quote Warren Buffett and the late Charlie Munger of Berkshire Hathaway ($BRK.B) for a shared commitment to investing within their circle of competence by buying what is known and understood. First, read for discovery, and then apply cognitive thought when allocating hard-earned dollars to an investment portfolio.
Uncovering Our Investor Circles of Competence
Be committed to a thoughtful approach to quality-driven value investing.
The mantra includes understanding and accepting the limitations of our circles of competence as we avoid the crowd’s bias toward low-quality, expensive investments in businesses, industries, or sectors with hard-to-understand value propositions.
For example, professional portfolio managers tend to favor financials more than other sectors. They participate as full-time members of the financial services industry, and the sector presents itself as an investment comfort zone—or unique circle of competence—by default. As a result, they develop narrow spheres of expertise that define their success in specific market niches.
My circles of competence—developed from over twenty years of retail-level investing—are restricted to six sectors: communications services, consumer discretionary, consumer staples, health care, industrials, and information technology.
The communications services sector spun off from the consumer discretionary and the former telecommunications sectors and now includes an original holding in our family portfolio: The Walt Disney Company DIS 0.00%↑.
Consumer discretionary sector companies consist of predominantly easy-to-understand products and services, although at higher risk because cyclical stocks dominate the space.
The consumer staples sector also covers easy-to-understand products or services, but, as noncyclical businesses, at a presumed lower risk.
The health care sector is to twenty-first century America what the automobile industry was to the twentieth century—the centerpiece of the domestic economy.
Industrials sector companies manufacture things an everyday investor can understand for the most part.
It is sometimes challenging to comprehend the products and services of information technology sector companies. However, the value propositions are often compelling.
By choice, I bypass the other five sectors. Here is why I avoid each:
Financials are often too leveraged and overinvested by Wall Street. The exception is our family portfolio holding in Berkshire Hathaway, which is more of a multi-sector investment than a purely financial one.
Real estate investment trusts (REITs) predominate in the real estate sector. Since a significant allocation of our family’s net worth is home equity, I would only include quality REITs in my portfolio if I were a renter or retiree.
Energy stocks tend to go up and down with energy prices more than the performance of the representative companies.
Materials are volatile, commodity-based stocks. See Energy above.
Utilities are overregulated and often too leveraged, although perhaps a wise choice for retirees seeking income diversification.
In addition, I focus research on major-exchange large, mid, and small cap stocks while avoiding microcaps and over-the-counter (OTC) issues as speculative.
Staying within our circle(s) of competence is a sage method to help protect our invested capital. Always ask, what sectors or industries are within our sphere of confidence? On the contrary, which should we avoid or leave to professional money managers with histories of generating alpha in their areas of expertise?
My Journey as a Common Stock Investor
I evolved into a bottom-up, quality-driven value investor from trial and error after failing at top-down macroeconomic growth earlier in my self-managed retail portfolio investing career.
At some level, I have tried many genres defining the stock market—momentum growth, trend following, technical analysis, whole sector investing, fund strategies, and similar speculative macro approaches to portfolio construction.
This high-cost investment education taught me a hard lesson in retail investing, as I paid tuition through trading losses. But luckily for me, the trial-and-error experiences kept bringing me back to the concept of quality at value.
Longer-view value investing has an enduring legacy, including the inevitable ups and downs, similar to every other stock market experience and our lives in general, for that matter. Moreover, when executed with a quality-driven bent, retail-level investing leaves us less vulnerable to the traps that sometimes compromise professional money managers.
Such practices include forced quarterly portfolio activities to protect job security, caving to their institutional or accredited investor clients’ thirst for fast money, and charging excessive fees to bankroll luxurious office suites and overly generous bonuses.
I am humbled and proud that the investment principle of common sense has continued to work well for our family beyond the post-Great Recession thousand-legged bull market that commenced as I ventured into quality-driven value investing for the first time.
As it went, value investing, in all its forms, was declared dead by market pundits and the fast-money growth and forward high-yield dividend crowd that followed them. I relented and went on to achieve alpha from compounding capital and dividends with wide safety margins for 15 consecutive years and counting. Go figure, right?
The difference is that I was fortunate to study with devoted rigor, uncover my circles of competence, and, most importantly, courageously stick to my learning sphere and personal conviction to a renewed investing approach through thick and thin.
Since inception in 2009—as the Great Recession became the second worst economic downturn in American history—the holdings of the QVI Real-Time Stock Picks enjoyed a cumulative total return that had collectively outperformed the S&P 500 since 2009 average per holding as of the writing of this chapter. Note that each holding’s cost basis adjusts for splits and dividends on an equal-weighted allocation basis.
So, although the price is what we pay for ownership slices of these collectively excellent companies, value, over time, is what we get.
Such alpha-achieving outcomes took over two decades of diligent—albeit enjoyable—work, although the outperformance is not guaranteed to continue. Nonetheless, retail investors building wealth from self-managed investment portfolios over an extended holding period is infrequent compared to professional managers collecting millions in portfolio advisory fees each quarter, regardless of investment performance.
The question begs, whose yacht, sports car, or waterfront weekend retreat are we paying for, ours or our financial advisors?
John Bogle Meets Warren Buffett
On the one hand, I came to respect the low-cost, lesser-risk foundation of passive index investing promoted passionately for decades by the late Vanguard Group founder John “Jack” Bogle.
On the other hand, I aspired to the gratification and potential rewards of Warren Buffett-style stock-based quality value investing, albeit with minimal capital.
Despite compromising some of the lesser risks of passive investing, quality-driven investors who enjoy researching and owning slices of excellent businesses purchased at value prices still delight in active investing but at lower costs and lesser risks than the speculative trading of faceless stocks.
Before transitioning to value-driven investing in the shares of quality businesses, I was leaving too much money on the table in the form of 1 to 2 percent annual investment advisory fees.
As my growth investing efforts came to a crashing end, the collective wisdom of Buffett and Bogle grabbed my attention. I discovered how to invest with the discipline and patience of Buffett and at the low cost and less risk advocacy of Bogle, albeit in individual stocks, instead of his preference for mutual funds.
In other words, I applied rational thought and a pinch of common sense and stayed within my acquired circles of competence.
Book Chapter is copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Author
David J. Waldron is the contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Substack Finance, Seeking Alpha, MSN Money, TalkMarkets, ValueWalk, Yahoo Finance, QAV—Australia’s #1 Value Investing Podcast, Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.
Resources
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