Investing Guidelines: Business Tenets 63A SIMPLE AND UNDERSTANDABLE BUSINESS
In Buffett’s view, investors’ f inancial success is correlated to the degree
in which they understand their investment. This understanding is a dis-
tinguishing trait that separates investors with a business orientation from
most hit-and-run investors, people who merely buy shares of stock. It is
critical to the buy-or-don’t-buy decision for this reason: In the f inal
analysis, after all their research, investors must feel convinced that the
business they are buying into will perform well over time. They must
have some conf idence in their estimate of its future earnings, and that has
a great deal to do with how well they understand its business fundamen-
tals. Predicting the future is always tricky; it becomes enormously more
diff icult in an arena you know nothing about.
Over the years, Buffett has owned a vast array of businesses: a gas
station; a farm implementation business; textile companies; a major re-
tailer; banks; insurance companies; advertising agencies; aluminum and
cement companies; newspapers; oil, mineral, and mining companies;
food, beverage, and tobacco companies; television and cable companies.
Some of these companies he controlled, and in others he was or is a mi-
nority shareholder. But in all cases, he was or is acutely aware of how
these businesses operate. He understands the revenues, expenses, cash
f low, labor relations, pricing f lexibility, and capital allocation needs of
every single one of Berkshire’s holdings.
Buffett is able to maintain a high level of knowledge about Berk-
shire’s businesses because he purposely limits his selections to companies
that are within his area of f inancial and intellectual understanding. He
calls it his “circle of competence.” His logic is compelling: If you own a
company (either fully or some of its shares) in an industry you do not un-
derstand, it is impossible to accurately interpret developments and there-
fore impossible to make wise decisions. “Invest within your circle of
competence,” he counsels. “It’s not how big the circle is that counts, it’s
how well you def ine the parameters.”^4
Critics have argued that Buffett’s self-imposed restrictions exclude
him from industries that offer the greatest investment potential, such as
technology. His response: Investment success is not a matter of how
much you know but how realistically you def ine what you don’t know.
“An investor needs to do very few things right as long as he or she avoids