Essays of Warren Buffett Chapter 3: Competence & Management

"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

The Investment Context

Buffett emphasizes two critical, personal elements of investing: knowing your own limitations, and trusting the people running the business.

The Circle of Competence is the idea that you should only invest in businesses you deeply understand. If you cannot understand the product, the competition, or how the cash is generated, you have no business buying the stock. Secondly, because you are buying a piece of a business, you are partnering with the management team. Buffett insists on partnering only with managers who display extreme integrity and act like owners.

The Wall Street Translation

Wall Street analysts are forced to have an opinion on everything. The independent investor has the luxury of saying "I don't know" and simply walking away.

1. The Tech Trap: Buffett famously avoided the Dot-Com bubble because he admitted he did not understand how those tech companies were going to make money in the long run. Wall Street mocked him as an out-of-touch dinosaur. When the bubble burst, Buffett was vindicated.
2. The "Institutional Imperative": Buffett warns against managers who suffer from the "institutional imperative"—the tendency to mindlessly imitate the behavior of their peers, no matter how foolish. If a CEO buys a terrible company just because their rival bought one, they are destroying shareholder value to stroke their own ego.
3. Candor in Reporting: A great management team is radically honest. When they make a mistake, they admit it in the annual report. A bad management team hides failures behind complex accounting and corporate jargon.

Actionable Trading Rules

1. Draw Your Circle: Write down the 3 or 4 industries you actually understand (based on your job, your hobbies, or your deep research). Confine 100% of your investments to those industries. Ignore everything else, no matter how hot the sector is.
2. Read the CEO's Letter: Before buying a stock, read the last three annual letters from the CEO. Are they taking responsibility for bad quarters, or are they blaming the weather and the macroeconomy? Avoid management teams that refuse to admit mistakes.
3. Watch Capital Allocation: Pay close attention to what management does with the profits. Do they reinvest it at high rates of return? Do they buy back their own stock when it's cheap? Or do they waste it on overpriced, ego-driven acquisitions?