What Warren Buffett Really Means: Apple Inc. (AAPL), Moody’s Corporation (MCO)

A lot of investors think that when Warren Buffett says to invest within one’s own circle of competence, he means invest in companies whose operations you understand. This misguided notion causes people to think “I understand Apple Inc. (NASDAQ:AAPL)’s products, so it’s within my circle of competence and I can invest in it.”

These investors believe that Buffett just doesn’t understand how software works or what mobile apps are — that he’s just too old to understand these concepts.

I don’t know the extent of Buffett’s understanding of software. He is good friends with Bill Gates, so I presume he has a working knowledge of at least the basics — though my feeling is he knows how it works as well as you or I. But Buffett’s understanding of how software works is practically irrelevant to whether or not it is within his circle of competence.

A circle of competence is not defined by someone’s understanding of a company’s products — though such an understanding is usually necessary. Instead, it’s defined by an individual’s ability to determine the earnings level of a company five or 10 years into the future.

This definition of a circle of competence is problematic for investors who wish to invest in high-flying tech companies, so they choose to ignore it. Apple Inc. (NASDAQ:AAPL) is earning lots of money even after competition has started to eat into margins. This has sucked in smart money and dumb money alike — AAPL was owned by more hedge funds than any other U.S. stock for much of 2012. However, how many of those investors can say “I know what Apple will earn in 10 years” or even “I know what products Apple will be making in 10 years” or “I know what the competitive environment will look like in 10 years”?

If you can’t answer those three questions, then Apple Inc. (NASDAQ:AAPL) isn’t within your circle of competence. You don’t understand Apple Inc. (NASDAQ:AAPL) any better than Buffett does, you’re just less selective than Buffett. Or you’re less honest with yourself than Buffett is with himself.

I’d venture to say that Apple Inc. (NASDAQ:AAPL) is not within any investor’s circle of competence. Therefore, the stock should only be purchased by short-term traders and speculators. It should not be bought by investors trying to maximize return per unit of risk — at least not at its current stock price.