How far are you willing to venture outside your “circle of competence”?

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You look at the number of businesses that failed in South Africa last year and wonder what the causes were.

There must be many reasons why 4,000 businesses failed in 2013. What did they do wrong? Why didn’t they make it?

I haven’t seen an analysis of those 4,000 businesses and the reasons for their failure. This total or aggregated number is reported under insolvencies. But anyone who’s been in business for a while will know some of the possible reasons. It could be the economy. Slow demand or crashing demand. Management inexperience. Cash flow management. Financial management. Skyrocketing costs. Wrong identification of markets and demand projection.

One reason for failure I don’t often see mentioned is where start-up and small business owners have ventured outside their “circle of competence”.

American investor Warren Buffett, in his annual letter for Berkshire Hathaway, says that when he and his partner Charlie Munger buy stocks they are careful and believe it’s vital to recognise the perimeter of their “circle of competence” and “stay well inside of it”. Even then, Buffett says, they make some mistakes with stocks and businesses.

When Buffett and Munger buy into a business they first decide whether they can estimate an earnings range for five years or more. If the answer is yes, they buy the stock (if it sells at a reasonable price). If they can’t estimate future earnings (which is often the case) they move on to other prospects. As he says, “Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.”

Now how does this relate to a new venture or small business?

When you come up with a new business idea or for a new product and service one of the crucial things you will need to do is to estimate market demand.

You need to match your product offering to the potential demand from a market or segment of the market (often a niche market). This is where things can go awry.

When making these estimates and projections do you know the market you are entering into?

If you, for example, know the automotive business well, have worked in it for many years, have built up a network, know what customers want, and know their problems, then you could say that you have a reasonable level of domain competence.

But if you want to start an estate agent business and you’ve never worked in the real estate market, then you are venturing outside of your “circle of competence”. You know nothing about the market. Little about the team of estate agents you need to manage and motivate. Nothing about how to forecast demand and sales.

I’m sure you’re asking yourself, well there must be many examples of small business owners who ventured into new fields and made a go of it. It happens all the time. Are these just the lucky ones? What did they know that others don’t?

Yes, there are ways to bridge the gap between where you are and outside the periphery of your “circle of competence” and the new market that you want to venture into.

Some investors would take a slice of the pie in a new venture or market and let competent and experienced managers run the business. If you’re a small business, you may be reliant on a partner who has domain expertise in the market and business that you want to go into.

The other way some astute would-be business owners go about obtaining domain expertise is to go work in a market or industry for a few months or maybe a year or longer to seep themselves in the business.

An example: you might want to start a restaurant or coffee shop. It could pay you to work weekends or for a few months in this such a business until you “learn the ropes” and know the problems and opportunities in that business.

We only need to look at one of the biggest company takeovers here in South Africa in recent times to understand “circle of competence” more clearly. Brian Joffe of Bidvest took over Adcock Pharmaceuticals and has become the chairman. He has a vision for the business but he will need to rely on competent managers who know the pharmaceutical industry well to execute his vision for growth.

Whatever idea you have for a product or service make sure that you consider your own “circle of competence”. Think about how you will bridge this gap, if possible. Remember Warren Buffet’s advice about not to invest unless you have a pretty good idea of your venture’s future earning power.

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