Circle of Competence - Investing within your expertise

Welcome back to The Barakah Investor - a weekly newsletter on patient, halal investing taught the right way.

Last week, we discussed Mr. Market and the importance of maintaining an even temperament during market volatility. We established that wild price swings are inevitable and often present opportunities for the disciplined investor. This week, we will discuss how to identify and act on those opportunities – or, more accurately, how to avoid acting on opportunities you do not understand.

The Small Circle: Where You Actually Make Money

The concept is straightforward: you invest only in businesses you genuinely understand. Not just what they sell, but how they make money, who their customers are, what their competitive advantages look like, and what could disrupt them. Warren Buffett popularized the term "Circle of Competence." It is not about how big your circle is, but how well you define its boundaries and how rigorously you stick within them. Most investors, frankly, have no idea what their boundaries are, or they pretend they do. This leads to speculative investments based on headlines or hot tips, rather than reasoned analysis. You will find that most of your profitable investments come from within this small, well-understood area.

Why this matters more for halal investors

Halal investing adds another layer of scrutiny. Your understanding of a business must extend to its Sharia compliance. This means not just checking a screening report, but comprehending the underlying revenue streams and financial structure. For instance, a tech company might appear clean on a basic screening, but if a significant portion of its revenue comes from interest-bearing lending to customers, or from advertising on prohibited content, your superficial understanding will fail you. This deeper dive often requires a more intimate knowledge of the industry and the company's operations. You cannot simply outsource your Sharia due diligence to an algorithm. You need to understand the business well enough to identify potential red flags yourself. This automatically shrinks your justifiable investment universe, making a defined circle of competence even more critical.

Practical Framework: Defining Your Circle

1. Identify Your Knowledge Base

   Start with what you already know. What industries do you work in? What products or services do you use daily? What topics do you naturally gravitate towards reading about? If you spend your evenings researching semiconductor fabrication, perhaps TSM is worth a closer look. If you build software, perhaps MSFT or AAPL's services division might fall within your grasp. Do not force it. Your personal and professional experience is a legitimate starting point.

2. Understand the Business Model

   For any company you consider, can you articulate, in simple terms, how it makes money? Not just "they sell phones," but "they design premium smartphones and profit from high margins on hardware sales, plus recurring revenue from their App Store, Apple Music, and iCloud services, leveraging a loyal customer base and strong brand equity." If you cannot explain it to a teenager, you do not understand it well enough. This includes understanding the competitive landscape, the regulatory environment, and the key drivers of profitability.

3. Assess Competitive Advantage (Moat)

   Why will this company continue to make money in ten years? Is it brand, network effects, switching costs, cost advantages, or proprietary technology? If a business has no discernible moat, its long-term profitability is tenuous, regardless of how well you understand its current operations. A business without a moat is a business constantly fighting for survival, which translates to unpredictable returns.

4. Evaluate Management and Governance

   Who is running the show? What is their track record? Are they competent and ethical? Do they allocate capital wisely? For halal investors, this extends to Sharia governance. Is there a Sharia board? What is their reputation? Good management operating within a defined ethical framework is paramount. Bad management can destroy even the best businesses, and even good management can make poor capital allocation decisions.

Worked Example: Apple (AAPL)

Let's consider Apple (AAPL). Many people own Apple products, so there's a natural inclination to believe they "understand" the company. But do they truly? My circle includes consumer electronics and software services, so AAPL falls within my broader area of interest. However, I need to go deeper.

• Business Model: I know AAPL sells iPhones, Macs, iPads, and wearables. More importantly, I understand their services division (App Store, Apple Music, iCloud) is a high-margin, recurring revenue stream. In Q1 2024, Services revenue was $23.1 billion, up 11% year-over-year, representing a significant and growing portion of their total revenue. I understand the ecosystem lock-in.
• Competitive Advantage: Their brand is unparalleled. Switching costs are high due to the integrated ecosystem and user familiarity. Their retail presence and supply chain are world-class. They also have significant R&D capabilities, allowing them to innovate consistently. This forms a strong moat.
• Management: Tim Cook has proven to be an effective operator, expanding services and managing the supply chain efficiently. Their capital allocation, primarily through buybacks and dividends, has been consistent.
• Halal Screening: Revenue from interest-bearing activities or prohibited content advertising is minimal. Their core business activities are permissible. Their financials usually pass the basic debt and liquidity screens comfortably.

If I can explain all of this, and understand how a new product like Vision Pro fits into their long-term strategy (or doesn't), then AAPL is within my circle. If I only know they sell iPhones and look at the stock price, it is not. Knowing AAPL traded at $170 in early 2024, then dropped to $165, then rebounded to $175, is useless without understanding the underlying business. The price is just Mr. Market's latest opinion; my conviction comes from my understanding of the company's fundamentals and its place within my circle.

This week's action

1. Take stock of your current portfolio. For each holding, write down in one paragraph how the business makes money and what its competitive advantage is.
2. If you struggle to write that paragraph for any holding, it is likely outside your true circle of competence. Consider reducing or liquidating that position.
3. Identify 1-2 industries or companies that genuinely interest you and for which you have some inherent knowledge or passion. Begin to research them deeply, focusing on their business model and moat.
4. Review your Sharia screening process. Are you just relying on a report, or do you understand the underlying business well enough to identify potential compliance issues yourself?

Next week, we will discuss "Margin of Safety - Investing for the Worst Case." We will explore how to build a buffer into your investments to protect against unforeseen events and imperfect analysis, a critical concept for long-term wealth preservation.

Rizal M
Founder, Barakah Profits

The Barakah Investor is educational only and not financial advice. Always do your own research and consult a qualified professional where needed.