Li Lu on Circle of Competency

So how do you really understand and get a great insight on a business?

Pick one business. Any business. And truly understand it.

The best metaphor to think is one of your distant relative passed away and you supposed to inherit 100% of the business they owned.

what are u going to do about?  That is the mentality to take when looking at any business.I strongly encourage you to start and understand 1 business, inside out. That is better than any training possible. It does not have to be a great business; it could be any business.

You need to be able to get a feel for how you would do as a 100% owner. If you can do that, you will have a tremendous leg up against the competition.

Most people don’t take that first concept correctly, and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading. You would really seek out knowledge on how it should be run, how it works.

If you start with that, you will eventually know how much that business is worth.

So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

The essence of investing is to predict the future. Understanding an industry and a company requires judgment of what the business fundamentals will be in 5 or 10 years. It’s not an easy thing to do.

When we invest a company, we have to at least understand in the next 10 years what the fundamentals of the business will look like? How would the business’s fundamentals be affected in a downturn? Otherwise, how can we estimate the downside of the investment? We have to make a good guess of the business’ cash flow for the next 15-20 years if we were to do a DCF calculation. But even if you were the founder of the business, do you really know what the cash flow will be for next year? You can’t say with absolute confidence that you can predict the future business development for the next 10 years. Very few people can do that. There are too many uncertainties. For most industries and companies, it’s impossible to see 10 years out. But there are some industries and companies that are predictable. If you spend enough time doing the research, gaining experiences in the industry, you will find out that you really can tell how the business will behave in the next 10 years during normal times, good times and bad times. It requires years of diligence, research and relentless learning. When you can make this judgment ( 10 years outlook), you are starting to build your circle of competency. Your circle will be extremely narrow starting out and it requires a very long time to build it.

That’s why value investing is a long journey and very few people can make it to the end. It requires a huge amount of commitment but you may still be much ignorant even if you spend much time for many years.

If you can’t tell the edge of your circle of competency and if you step outside of your circle, you will be destroyed by the market at some point.


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