“A man’s got to know his limitations.” — Harry Callahan in Magnum Force
Charlie Munger, vice chairman of Berkshire Hathaway, (the conglomerate controlled by Warren Buffett) and chairman of the Daily Journal Corporation, made some interesting comments at the Journal’s annual meeting a few weeks ago.
“The first rule in fishing has always been: fish where the fish are,” Munger told the meeting. “The second rule of fishing has always been: don’t forget rule No. 1.”
Munger was talking about Li Lu (a very successful Chinese investor) who he noted was fishing where the fishing was good (Charlie was referring to China).
“And the rest of us are like cod fisherman who are trying to catch cod where the fish have been fished out,” he said. “It doesn’t matter how much you work when there’s that much competition.”
Investors who bet on good management teams see the payoff when markets crumble
Why everybody loves a sale — except when it involves plunging stock prices
When markets tumble, investors need to remember the long game
Munger has a point. There may be a great deal more cod in the Chinese markets than in the U.S., a problem we and many other value investors have faced for some time.
But there is another Warren Buffett principle that I think has significant relevance here: staying within your circle of competence.
“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,” Buffett wrote in the Berkshire Hathaway Chairman’s Letter in 1999. “If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality.”
Which brings me back to Munger’s positive comments on investing in China. Yes, the fish are plentiful there, but how well does China fit into the circle of competence of most North American value investors?
In my case, I have several reasons to think that it most certainly does not.
First, there is the enormous problem of language. My understanding of the Chinese language is zero. I don’t speak a word of it. And if you are investing in a country where a completely different language you don’t understand is the language in which business is conducted, the disadvantage you face is immense — even insurmountable.
Having great translators go around with you to interpret things said and written by your potential partners invariably can leave huge gaps in exactly what is meant. Mis-interpretations can be deadly in investing, especially if the proper innuendo is not accurately transmitted.
Misunderstanding what a foreign speaker/writer really means can result in the wrong conclusion. In investing, this can lead to a potential loss of capital. For me, this puts us way outside of our circle of competence.
Second, cultural differences between West and East can result in lethal results. I don’t have a clue what Chinese culture is all about. And unless you understand how a people behave, how they conduct themselves with their own people much less inhabitants of other parts of the world that developed in completely different ways, separated geographically for centuries, you are going to miss a great deal. Again, not even close to my circle of competence.
Third, there are enormous differences in government and legal structures between China and North America. Democracy and the rule of law are the fundamental underpinnings of the United States and Canada. Not so in China. I have a problem investing in corporations headquartered in a country where such structures are completely different. I don’t think I have a chance. No competence here for me, I fear.
Please don’t think I have a negative view of China. What they have accomplished over the past 40-50 years has been nothing short of spectacular. And, no doubt, the country and its intelligent, hardworking population will advance a great deal in the future. They are and will be a world power. I just don’t know how it is done. And that spells risk.
There is, however, one way we have been able to participate in different countries where we would normally be in over our heads.
That is by “partnering” with companies who have done the heavy lifting in terms of knowing who they are in business with, wherever that might be.
Many years ago, we made a very successful investment in Japan through our ownership of American Family Life Assurance Company (renamed AFLAC Inc.) a company headquartered in Columbus, Georgia.
How this southern business family succeeded in Japan is a fascinating story. They got to know the country, the culture, the language. They also had Japanese management doing things the Japanese way.
This, I understood. It fell within my circle of competence. And it worked out very well for us. Today, we are invested in IMAX, a Canadian company expanding in China. Very simply, they know what they are doing with their Chinese partners. We rely on their expertise built over years to enter a foreign market with their products and services. Without that, we are potential prey. And, thus far, it is working well.
And that’s exactly what Munger has done. I doubt that Charlie is travelling around China, interviewing prospective Chinese public companies.
Instead, he has employed a brilliant Chinese investor who knows that country and does the heavy lifting for him.
For us, however, investing outside of the English-speaking world raises a whole host of challenges that makes our work much more complicated and, thus, dangerous.
Successful long-term investing is knowing your circle of competence and staying well within it.
• Larry Sarbit is the CEO and CIO at Winnipeg-based Sarbit Advisory Services. Sarbit is the sub-advisor on three funds for IA Clarington. For more information, please visit his blog at Sarbit.com