Berkshire Ruminations

Tuesday, August 15, 2006

Simple, understandable buinesses and the circle of competence

Mr. Buffett advises investing in simple and understandable businesses. But in my experience, the concept of a business being “simple and understandable” is, ironically, one of the most misunderstood. Perhaps it is the simplicity of this advice that causes the confusion, because far too many people fail to take the time to consider what exactly this means.

I have heard students make assertions like “Sprint provides phone services that we all use and therefore is simple and understandable.” The problem is that these individuals are confusing familiarity with simplicity. Just because you know what the product or service is and how the customer uses it does not mean you can confidently project how the business will fare in the future. That is, you cannot make an accurate assessment of the company’s economic outlook. Projecting this is the essence of business simplicity and understandableness, in my opinion.

Mr. Buffett describes a simple and understandable business in his 1996 letter to shareholders as one that is “unlikely to experience major change” and that you can be “virtually certain to possess enormous competitive strength then or twenty years from now.”

A company like Sprint just doesn’t meet those criteria. Although I use a Sprint phone myself, I have no idea what the company’s economic prospects look like. I know that they have a large network, but have no idea why it is so large or if it will remain large given the various competitive pressures. And beyond the letters GSM and CDMA, I have no idea the strength of the company’s technological advantage. Without an understanding of these, I can have no confidence in my assessment the economic prospects of the company.

Mr. Buffett has also explained that a simple and understandable business is one within your “circle of competence.” It isn’t how big that circle is, though, it is how well you have defined its perimeter.

In the late 1990s, of course, Berkshire was criticized and even mocked for failing to invest in technology firms. From the 1999 letter to shareholders: “If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.”

I have also heard students suggest that a company like Movie Gallery is simple and understandable. At least for me, even a company like this (keep in mind it is also very familiar) is not at all simple and understandable. First I might try to determine how likely is it that this company can maintain its current operations without major change. But then, I will have to decide how confident I am that I even know how likely this is. With a company like this, there are simply too many potential threats (video-on-demand, internet rental companies, internet video etc) for me to say that I understand the business’ economics.

To sum up, a simple and understandable business is one that is within your circle of competence. It will be in your circle of competence if you fully understand the underlying economics of it. Before you let someone convince you that a well-known company is simple and understandable, I think you should review Mr. Buffett’s guidance. To invest in something you do not understand can have disastrous consequences.


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