“Our favourite holding period is forever.” – Warren Buffett This is the wisdom that has flowed from one of the greatest investors of our times. The man is talking, but who is listening? The bigger question to be asked of those few listening is – ‘who is applying’? The richest man, second only to Bill Gates, has time and again proved that value buying always pays off in the long term. His mantra has been to invest in ‘businesses’ not ‘stocks’. The rationale – “If a business does well, the stock follows”. In this article, we delve a bit deeper into the principle of value buying and discuss the concept of ‘circle of competence’ as originally defined by Mr. Buffett.
For beginners, ‘value investing’ is about buying stocks that are selling ‘cheap’. In a sense, a value buyer is a bargain hunter. This, however, does not mean that one should buy any stock that is selling cheap. Value buying is about buying stocks of companies that are trading lower to their intrinsic value (this is what we mean by the term – ‘cheap’). Thus, it is not the price of the company’s stock that determine weather it is a value buy, but the potential value that the company has. As such, value investing is about being able to invest in companies with a conviction of the value being realised or unlocked over a period of time.
The most common method used to find the intrinsic value of a company is the discounted cash flow method, where projections are made of a company’s cash flows and a discount rate is applied to these to arrive at their present value. If the value arrived at is higher than what the share is presently trading at, it is a value buy else not. Many a times, to make comparative analysis between companies, the ‘price to earnings’ ratio (P/E) is used. An investor has a target P/E in mind and will buy a stock as long as it is trading below its target P/E. When share prices rise without a corresponding increase in earnings or when a company’s earnings are declining without any corresponding changes (or small change) in stock price, it will automatically lead to a rise in the company’s P/E, thus signaling the increased risk levels. This automatic mechanism, which is built into the P/E ratio, is what endears it to the investor community.
Value investing, although sound simple on paper, is not so simple to apply practically. This is on account of innumerable factors that affect the stock price movements. While on one hand we have news that apply to the broad market as a whole, on the other there are news that are sector or company specific. The markets are efficient enough to factor in the news flow into the stocks prices. As such, being in coherence with the ‘right’ kind of news is what is the basis for sound (and safe) value investing.
Circle of competence
For a value investor, the most crucial thing is his ability to pick up value stocks. However, this is easier said the done. While the use of different rates to discount cash flows affect the perception on whether a stock is a value buy or not, it is the assumptions with regards to future earnings that are more likely to have a greater impact on valuations. To be able to forecast earnings correctly, one should be able to build the information flowing into the company’s expected earnings forecasts.
In this light, it can be said that each individual will be in a position to understand a certain business better than others. This understanding will become his area of competence of which he will, over a period of time, be able to evolve a circle of competence. The concept, as is original defined by Warren Buffett, stands to mean: ‘an area where an investor can know significantly more than the average investor (called the circle of competence), and focus his efforts on that area’. By developing this, an investor should successfully be able to weave the information flow into his financial model to arrive at a stock’s intrinsic value. As is understood, the circle of competence is a process of evolution and cannot be developed overnight. Rather, it has to be built by gaining insight into the company’s area(s) of operations, finance, management and the scope of future events that are likely to affect it.
Thus in conclusion, you, as an investor, need to compare intrinsic value of the company as a whole to its current market capitalisation. Success will, however, depend on your skill of accurately determining the intrinsic value. It can also be said that to be a good value investor, one needs to harness the qualities of a contrarian investor, a patient investor, a rational investor, an analytical investor, and above all, a long-term investor.