'Circle of Competence': What Buffett Really Meant

by: The Manual of Ideas

The following is excerpted from our July issue of Downside Protection Report:

Berkshire Hathaway (NYSE:BRK.A) chairman Warren Buffett once said that, “One of the things we try very hard to do at Berkshire, is to stay within what I call our circle of competence.” Buffett famously avoided Internet stocks during the bubble of the late 1990s. He also passed on Microsoft (NASDAQ:MSFT), a near-monopoly founded by an entrepreneur for whom Buffett has the utmost respect.

Buffett’s rationale for foregoing investments in industries such as software, hardware and biotech is that he doesn’t know how those firms will evolve over time. Ever the diplomat, Buffett leaves open the possibility that someone may know, but we get the feeling he is skeptical of such a possibility.

Buffett’s comment about staying within one’s “circle of competence” is usually interpreted as an admonishment to invest only in companies one truly understands. However, instead of referring to companies, Buffett likely meant situations. After all, Buffett has invested in derivatives, silver and other non-standard opportunities that presumably fit within his “circle of competence.”

It seems only logical that there could be companies that don’t normally fit into an investor’s circle of competence but that are involved in situations an investor can analyze with a high degree of confidence. The two companies featured this month might ordinarily lie outside of our circle of competence. However, each stock has certain attributes that make for an understandable, compelling investment situation.

In the case of Contango Oil & Gas (NYSEMKT:MCF), the high-margin, easily accessible, proved and developed reserves of natural gas can be seen as a huge tank of gas that can be monetized in a predictable way, subject to volatility in natural gas prices. Even at current depressed prices, the company’s value exceeds the market price. If we consider Contango’s capable and shareholder-friendly management, “free” options on future exploration, and a debt-free balance sheet, Contango becomes a compelling situation with low downside and material upside.

In the case of PDL BioPharma (NASDAQ:PDLI), the technology underlying PDL’s drug patents is virtually irrelevant. PDL is not pursuing new research and development; instead, the company is simply a conduit for passing on royalties received from third-party drug makers, net of expenses and taxes, to shareholders. Investors buying PDL shares today will likely see a return of their entire investment within five years, with any distributions beyond that point constituting upside.

Finally, we’re pleased that our thesis on Gravity Co. (NASDAQ:GRVY) has been playing out largely as presented in our April issue. As we pointed out, Mr. Market had not yet adjusted his appraisal of Gravity to reflect the recent inflection point. When Gravity reported strong Q1 earnings on July 8th, the shares rose 51% in one day. (Of course, investment newsletters often cherry-pick winners and ignore the losers — we invite you to review our complete investment scorecard.)

Disclosure: Long MCF, PDLI and GRVY. No positions in MSFT, BRK.A, BRK.B.