Weekly reflection
Last week I introduced twenty biases that influence investment decisions. Over the next couple weeks, I will discuss methods proposed by Charlie Munger and Warrant Buffett from Berkshire Hathaway to reduce or mitigate the impact of biases. The first of these is the combination of investment filters and the circle of competence.
Investment filters and the circle of competence share a common purpose: to work efficiently and reduce errors. NGP Capital applies these concepts by targeting “core investments” within our investment themes.
Berkshire Hathaway applies five filters:
1. Industry — Circle of Competence: Do I understand the business? Do I understand its demand, competitive, and investment return characteristics over the next ten years?
2. Company — Sustainable Competitive Advantage: Does the company have a competitive moat? What is the nature of its advantage? How durable? Capital intensity? How does that translate into profits & value?
3. Management: High integrity? Capable? Shareholder mindset?
4. Investment — Valuation & Terms: Is it priced to provide attractive return with adequate margin of safety, measured against other alternatives and supported by factual evidence?
5. Inversion: What could go wrong? How resistant to adversity? My motives and biases? What are the consequences if I am wrong?
Warren Buffett explains, “Elimination is the great conservator of energy.” Buffett advocates making fewer, better decisions. He has said that he only needs one good idea per year, and approaches each investment decision as though he could make only ten in a lifetime.
On the first filter, Buffett says, “You have to stick within your circle of competence. You have to know what you understand and what you don’t understand. It’s not terribly important how big the circle is. But it’s terribly important that you know where the perimeter is.” He advises further to stay humble and avoid distractions outside your circle of competence: “Only the strong swimmers drown.”
Why is the circle of competence so important? Because straying from your area of expertise subjects you to biases, overconfidence, persuasion from strong promoters, and other judgment errors.
Our investment themes help us develop and define our circle of competence. We have found that our investment performance improves when we stay within our strike zone and have at least two years of experience within our investment themes.
Buffett tells us, “It is not necessary to do extraordinary things to get extraordinary results.” Both Charlie Munger and Howard Marks say they look for one-foot hurdles to step over rather then seven-foot hurdles to leap over. It seems, then, to come back to staying humble: “We have adopted a strategy that requires us to be smart — and not too smart at that — only a very few times.”
In closing, the heady world of venture capital seems a world apart from the realms in which Buffett invests, and perhaps it is. But Berkshire Hathaway has produced returns over seven decades that would make us all proud in industries some have gladly overlooked. Consider this: in 1967, Berkshire Hathaway acquired National Fire & Marine for $8.6M. NFM now has a net worth of $111 billion, which exceeds that of any other insurer in the world and has been the cash-generating machine on which Buffett built his investment practice.
Consider this also: while venture considers itself patient capital, Berkshire works over timelines that outlive any fund lifecycle. Several of the CEOs that Berkshire has backed have continued to lead their firms for 30+ years after acquisition. Buffett first analyzed GEICO in 1951, but invested in the firm only in 1976 and acquired the business in 1995. Its long-time CEO, whom Buffett had known since 1961, retired in 2018.
Within this context, my motto — the first fifty years have been great, the next fifty will be even better — seems ever more plausible.
Make a difference and be the best you this week!
