Discover Your Investor Circle of Competence

Summary:

• Discover your circle of competence in the sectors and industries that house the common shares of targeted companies.
• History dictates that the retail portfolios of investors following the crowd often lose momentum at market extremes. Sidestep the herd.
• The Wall Street consensus is often senseless. So avoid the temptation to interpret it as a definitive buy or sell signal and, instead, as a suggestion to move in a different direction.
• Buying and selling common stocks based on predicting a future event is no different from investing based on hope. Stick to objective facts and ignore subjective forecasts.
• Paraphrasing baseball legend Yogi Berra, investing is 90 percent half common sense. The other half—discussed in future QVI newsletter posts—is patience and discipline.

Financial media often quote Warren Buffett and Charlie Munger of Berkshire Hathaway (NYSE: BRK.B) for a shared commitment to investing within their circle of competence by buying what is known and understood. In other words, first, read for discovery and then apply cognitive thought when allocating hard-earned dollars to an investment portfolio.

Paraphrasing American baseball legend Yogi Berra, investing is ’90 percent half’ common sense. ‘The other half’ is patience and discipline. As much as the institutional way of stock-picking attempts to convince us otherwise, it is far from rocket science.

Keep investing super simple, and the beneficiaries of our portfolios will thank us. And when the Wall Street fee machine insists that its complex investing paradigms are best, remember that keeping it uncomplicated with a pinch of common sense is the primary tenet of successful, do-it-yourself portfolio management.

Discovering Our Circle of Competence

Be committed to a thoughtful approach to quality-based value investing. The mantra includes understanding and accepting the limitations of our circle of competence as we avoid the crowd’s bias toward expensive or low-quality investments.

For example, institutional investors tend to favor financials more than other sectors. It is because each exists as a full-time member of the financial services industry, and the sector presents as an investment comfort zone—or circle of competence—by default. As a result, whether professional or independent, investors develop a sphere of expertise that defines their successes in specific market niches.

My circle of competence—developed from over twenty years of retail-level investing—is restricted to six sectors: communications services, consumer discretionary, consumer staples, health care, industrials, and technology.

• Communications services spun off from the consumer discretionary and the former telecommunications sectors and now includes the original holding in our family portfolio: The Walt Disney Company (NYSE: DIS).
• Consumer discretionary companies consist of easy-to-understand products and services, although at higher risk because cyclical stocks dominate the sector.
• Consumer staples also covers easy-to-understand products or services but are at a lower risk as noncyclical businesses.
• Health care is to twenty-first century America what the automobile industry was to the twentieth century: the centerpiece of the domestic economy.
• Industrials are manufacturing things an everyday investor can understand for the most part.
• Technology companies are sometimes challenging when comprehending the products and services of the companies; however, the value propositions are often compelling.

By default, I bypass the other five sectors. Here is why I avoid each:

• Financials are often too leveraged and overinvested by Wall Street.
• Real Estate is predominated by REITS (real estate investment trusts). However, a significant portion of our family’s net worth is home equity; therefore, 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 indebted, although a wise choice for retirees seeking income diversification.

Staying within our circle 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?

Avoid the Crowd

History dictates that the retail portfolios of investors who follow the crowd—whether the favorite momentum stocks of fellow retail investors or the Wall Street flavor of the month—will often lose momentum at market extremes. The 2020 COVID-19 pandemic and the 2022 inflation, crypto, and unprofitable tech stocks-induced bear market were vivid examples of this stock market phenomenon.

Some time ago, I concluded that market-cap-weighting our family portfolio was akin to following the investor crowd. For example, higher market capitalizations—shares outstanding times the stock price—indicate that the market has perhaps overbought the stock.

After self-reflection, I changed the structure of the Quality Value Investing Real-Time Portfolios to equal weight; thus, each holding represents an identical percentage of the total portfolio instead of a weighted share arrangement based on market capitalization or speculative allocation. Hence, the overall performance since inception lowered slightly after rebalancing from market-weight to equal-weight. Nonetheless, the individual performance and weighing against the benchmark, based on the date of inclusion in the portfolio, remained constant.

My intent for tracking the cumulative portfolio performance has always centered on presenting individual holdings and overall portfolio outcomes in a straightforward format to test the QVI investing strategies. The equal-weight methodology continues this tradition for the benefit of subscribers.

The proven way to make long-term money in the stock market is staying invested for the unpredictable, albeit welcomed price jumps, thereby cultivating a less vulnerable portfolio to sudden and unexpected price drops such as those triggered by pandemics and bear markets. But, unlike many in the crowd, we must have the courage to stay invested through each market cycle to achieve alpha consistently.

My Journey as a Common Stock Investor

I evolved into a bottom-up, quality-focused value investor from trial and error after failing at top-down macro research earlier in my self-managed retail investing career. At some level, I have tried many genres defining the stock market: momentum growth, trend following, technical analysis, sector investing, fund strategies, and similar macroeconomic 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-driven 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 value bent, do-it-yourself 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 institutional or accredited investors’ thirst for fast money, and charging excessive fees to bankroll 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 was declared dead by the market pundits and the crowd that followed them as I achieved alpha for 14 consecutive years and counting. Go figure, right? The difference is that I uncovered my circle of competence, studied with devoted rigor, and, most importantly, stuck to my sphere of competence through thick and thin.

Since inception in 2009—as the Great Recession became the second worst economic downtown in American history—the holdings of the QVI Portfolios enjoyed a cumulative average total return that had outperformed the S&P 500 as of the writing of this post on June 13, 2023. Note that the holdings’ stock prices adjust for splits and dividends on an equal cap-weighted basis. So, although the price is what I paid for ownership slices of these excellent companies, value, over time, is what I got.

These alpha-achieving outcomes took over a decade of diligent—albeit enjoyable—work, although the outperformance is not guaranteed to continue. Nonetheless, building wealth from a self-managed investment portfolio’s performance over an extended holding period is infrequent compared to professional managers collecting millions in portfolio advisory fees each quarter, regardless of investment performance.

John Bogle Meets Warren Buffett

On the one hand, I came to respect the low-cost, lesser-risk foundation of 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 active investing, albeit with minimal capital.

Despite compromising some of the lesser risks of passive investing, do-it-yourself investors who enjoy researching and owning quality businesses through slices of common stocks purchased at value prices still delight in active investing but at a lower cost.

Acknowledging that I was leaving too much money on the table in the form of 1 to 2 percent annual investment advisory fees, 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 lower costs and lesser risk advocated by Bogle.

In other words, add a pinch of common sense and stay within my circle of competence.

The Wall Street Consensus is Often Senseless

Thoughtful individual investors on Main Street avoid interpreting the Wall Street consensus as a definitive buy or sell signal and, instead, as a suggestion to move in a different direction. For example, during celebrated quarterly earnings seasons, after a company comes up short on analyst consensus estimates of earnings or revenue, they ask who missed: the senior management of the enterprise or the Wall Street analysts?

Raw emotional investing produces losses more often than gains. However, emotional intelligence, or EQ, is more crucial to investing success than intelligence quotient, or IQ. Thus, Main Street investors who stay within their circle of competence have the temperament to outperform the high IQ Ivy Leaguers of Wall Street. Nevertheless, we’re looking at super investors when combining high IQs with elevated EQs. Bogle, Buffett, and Munger come to mind again, as do Benjamin Graham, Seth Klarman, Peter Lynch, and Howard Marks, among other high-profile value investors.

Many investors—for better, although more often for worse—trade on geopolitical news and other macroeconomic events, inspiring passionate feelings more than emotional intellect. On the contrary, long-only, buy-and-hold-quality investors on Main Street practice discipline to endure the peaks and valleys of the volatile journey of stock market investing in the short-term trading vacuum called Wall Street.

Using common sense, thoughtful investors know that quarterly earnings, news, and other short-term events, if nothing else, create buying opportunities for the common stocks of already determined quality enterprises. In contrast, countless investors—professional and retail—sell at a loss on the report or event by placing emotional feelings before emotional intelligence.

Take a Rearview and Side View Focus

Although the life lessons of hindsight also apply to investing, foresight or predicting the direction of the market and stock prices with consistency is implausible. As such, my research and ensuing theses of targeted common stocks tend to be rearview and side-view focused. The investment philosophy implies that the rearview mirror represents the past, and the sideview mirror indicates the present, each being clear. Unfortunately, however, the windshield projecting the future is foggy.

And yes, I take some heat from market pundits focused incessantly on the windshield of predictive analysis. However, I achieve alpha more often when limiting my investment research to the current wealth of the business and the present value of the stock, as I stay within my circle of competence.

As shown throughout Quality Value Investing, I put minimal weight on the forward consensus. It’s all speculative to me, thus, the foggy windshield metaphor. Most active investors—professional or individual—underperform the market over time. Each buys or sells based on speculation of what will happen via price targets, earnings estimates, sales volume, potential mergers & acquisitions, or market corrections. Despite conveying confidence, does any forecaster know what will happen to a market, company, or stock price at any specific time?

I don’t and refuse to pretend at my readers’ expense or the account balance in my family’s portfolio. For example, if a targeted stock is down 3 percent the day after initiating a position, impatient stock traders second-guess the decision against waiting one more day to buy. Patient investors who purchased the same stock at $50 are waiting for a ten-bagger $500 a share years later. In contrast, the market-timing traders buy at $48 the next day and sell at $53—or worse, $43—after the next earnings release.

There is No Hope When Investing

Investing based on predicting future events is no different from investing based on hope. Predictive investment analysis is nothing more than hopefulness disguised as intelligent forecasting. Again, I weather occasional heat—pun intended—from readers and editors of my research for focusing more on the current quality makeup of the company and the present valuation of the stock price and less on the forward predictions of where the products, customers, and markets are heading.

It is best to leave those crystal ball attempts at investing to the limitations of our circle of competence, including the EQ elements of common sense and instinct. The investment thesis is often directly before us, negating the need to take a risky trip down some murky road of predictive analysis.

I am in this game to buy and hold the common stocks of quality enterprises and then write about the experience—win or lose—instead of providing entertainment fodder for the whims of readers. So leave the Magic 8-Ball part of the investment thesis to Wall Street analysts and senior management. Because they often make more money from fees, bonuses, and stock options than from compounded annual growth in capital gains and dividends as we do on Main Street.

By limiting stock purchases to excellent businesses selling at affordable share prices, the future takes care of itself. Invest based on objective facts, ducking the ever-present subjective forecasts. That has worked for me since I reinvented my approach to investing 14 years ago, including during the pandemic and a bear market.

As I am neither a stock guru nor a market wunderkind, I am confident the approach works just as well for motivated subscribers who discover their circle of competence and practice do-it-yourself investing within self-imposed limitations.

In time, thoughtful retail investors learn the Yogism of the financial markets where investing is 90 percent half common sense. The other half—discussed in archived and future QVI posts—is patience and discipline.

Thank you for reading this edition of the Quality Value Investing weekly newsletter, a reader-supported publication. Please consider subscribing if you want to receive new weekly posts and support my work. It’s free on LinkedIn.

If you found value in this post, please hit Like or add a Comment below, as it is helpful to LinkedIn’s algorithm that is monitoring the newsletter.

Also, this post is public, so feel free to Share it with your network.

About the Author

David J. Waldron is the founder and contributing editor of Quality Value Investing, and author of the international-selling book Build Wealth with Common Stocks.

David’s mission is to inspire the achievement of his readers’ financial goals and dreams.

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.

Disclosure: I/we have beneficial long positions in the common shares of BRK.B and DIS through direct stock ownership in our family portfolio. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Substack paid subscriptions). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David J. Waldron’s Quality Value Investing newsletter posts, course modules, research reports, and model portfolios are for informational purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs nor intended for portfolio construction beyond his family portfolio, which is presented solely for educational purposes. David is an individual investor and author, not an investment adviser. Readers should always engage in their own research or due diligence and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or specialized attorney before making any investment, income tax, or estate planning decisions.

Disclaimer: Although Quality Value Investing (QVI) takes a skeptical view of Wall Street—a euphemism for professional or institutional investing anywhere in the world—it neither implies nor expresses specific issues with or negative references to any actual organizations or individuals existing or working in the financial services industry. Any perceived reference or offense to actual firms or real persons is coincidental and unintentional. In its general lament of the Wall Street way, QVI abstains from unproven conspiracy theories and presents a narrative nonfiction platform of commentary, critique, education, and parody. In this world, facts are exempt from any alternative paradigm; thus, the subjective thoughts shared throughout this post are QVI’s opinions and, therefore, independent from fact.

Copyright 2023 by David J. Waldron. All rights reserved.