What does the capability circle include? - Top Cryptocurrency Exchange Platform

Today I would like to briefly discuss what exactly the capability circle is. I have two interpretations: a broad sense and a narrow sense.

In the broad sense, the capability circle refers to outward abilities, such as your understanding of companies, investment targets, and industries. It also includes another layer of meaning—your self-awareness, such as what you can do as an investor. For example, you should know your internal capability circle, understand your “strength,” what you can do, and what you cannot do. For instance, you cannot predict the market, and you should not focus too much on macroeconomics. You should do simple things and avoid researching beyond your knowledge and ability scope. Defining your capability circle also falls within the broad sense.

The narrow sense of the capability circle refers specifically to our understanding of external investment targets (companies). Today, we mainly discuss the narrow sense. Within this scope, analysis of the company is key, with two levels: one is industry analysis, which is more important than analyzing individual companies because the industry is the soil for the company. A company is like a flower; if the soil is poor, it’s hard for the flower to thrive. Even if the flower’s genetics are excellent, like a superior breed, planting it in a desert will kill it—good genes are useless in poor conditions.

This is also why many excellent management teams find it difficult to make their companies outstanding if they are in a bad industry. Therefore, industry analysis is the most important part of the narrow capability circle, accounting for over 70% of investment research, depending on the industry.

What does industry analysis include? It covers the economic characteristics of industry products and services, as well as the specificity of these products. For example, in agriculture, the economic features are quite similar—apples produced by Zhang’s farm and those by Li’s farm are quite similar; wheat varieties differ slightly but are generally not high-priced.

Product economic characteristics can vary greatly. For example, selling liquor—there’s a big difference between selling sorghum liquor and Moutai. This is an important aspect of industry characteristics, stemming from the inherent economic traits of the products or services.

Another aspect of the capability circle is the analysis of supply and demand features. For instance, the control of the supply chain by suppliers is crucial. The competitive landscape within the industry—whether it’s oligopoly or fragmented competition—relates to industry concentration and future pricing power. Entry barriers are also significant: lower barriers mean more intense competition; higher barriers mean more monopoly power, which often leads to super profits, profits, and sustainability.

An important aspect of the capability circle is also assessing the industry’s lifecycle stage: is it in the beginning, growth, maturity, or decline? Even in decline, is it cyclical or structural? For example, industries like heavy metals, coal mining, and energy are cyclical, but some are structural, such as environmental protection. If coal is no longer used in the future, coal mining becomes a structural decline. Industries like offline retail and traditional newspapers, impacted by the internet, also face structural issues. Therefore, lifecycle analysis is very important.

Industry analysis can be roughly divided into four types: the economic characteristics of the products/services themselves, the features of the supply-demand chain, the competitive landscape within the industry, and the industry’s lifecycle stage. Additionally, within industry analysis, the capability circle also includes factors related to the company. When analyzing a company’s competitiveness, one needs to examine its business model, moat, etc. Besides cost advantages, brand advantages, and patents, attention should also be paid to network effects and management’s competitiveness, including corporate culture and incentive mechanisms.

Furthermore, product analysis is also crucial, including pricing power, costs, scale, and sustainability. At the corporate level, the analysis generally involves: hard factors like competitiveness analysis and product analysis, and soft factors like management analysis, corporate culture, and stock market incentive mechanisms.

Industry and company analyses are mainly qualitative, based on analysis reports, industry research, stock market books, annual reports, etc. For company analysis, annual reports and stock market books are important references. For industry analysis, comparisons within the same industry, industry reports, and brokerage reports are useful. Over time, these will help you develop a systematic understanding and framework.

There are two main levels: industry analysis and company analysis, which are interconnected—companies are influenced by their industries, such as their growth potential. Qualitative analysis is the core of the capability circle, while quantitative analysis is just a tool. For example, financial statements and annual reports are quantitative tools, which I will discuss in detail later, including the functions of financial statements and key items.

The benefit of quantitative analysis is that it provides data, allowing you to measure risks through financial indicators like debt ratio and repayment ability, which impact the company’s risk profile. I’ve mentioned before that risk is the top concern in investing, followed by asset quality. Asset quality and profitability levels can be obtained from the income statement, including turnover rates and asset utilization efficiency. These are important because they help you understand whether the company’s operations are improving or declining, and by how much—only data can reveal this.

Therefore, financial analysis is a very important part, but it is mainly a tool to support qualitative analysis. Although very important, it is a lower-level, foundational aspect. Each indicator can be compared with industry peers to assess the company’s competitive advantage and whether it has formed a moat. Whether it’s growth rate, profit margin, or turnover rate, these can be analyzed. You can also compare the current year with the previous year—for example, how has the gross profit margin changed? These insights reveal the company’s operational changes.

All these factors influence valuation. Therefore, qualitative and quantitative analyses complement each other. For example, if someone says a company is very profitable, you can find supporting data in the financial statements. Remember, opinions and facts are different: opinions are subjective qualitative judgments, but you can support them with factual data from financial statements. The main function of financial statements is here.

Additionally, these two analyses need to be mutually confirmed. For example, if the gross profit margin is high in the financial report, you need to find the reasons behind it. Why is the gross margin so high? Is it due to pricing power? Does it result from brand effects? Cost advantages? Or other resource advantages? These factors can be identified in your qualitative summary and research, by analyzing the data behind the reasons.

Thus, these two factors corroborate each other—conclusions should be supported by data. After seeing the data, you should keep breaking it down until you find the true underlying reason. Whether that reason is sustainable will form the basis of your valuation.

The analysis aims to reach a conclusion, which serves as the basis for our investment decision (compound interest scenario). For example, the final result is verified through qualitative and quantitative analysis: what is its profitability (specifically cash profitability)? The compound interest model refers to how the “snow layer” will change each year.

Another aspect is sustainability—within the industry, the company should not be constantly changing. Rapid technological updates can increase costs and lead to poor profits (as predicted). Demand should not fluctuate too frequently—today customers like this, tomorrow they like another. Such rapid changes are beneficial for customers but nightmares for companies.

Growth potential refers to how large the industry space is. How is the industry’s concentration or dispersion? Is there remaining room for development? Can the “big pie” continue to expand (i.e., its growth potential)? Profitability, sustainability, and growth are all key metrics for valuation.

In the compound interest formula, the most important factor is the annual return rate—like a snowball. Is the snow layer thick enough (profitability)? Will it get thicker (growth rate)? Is the slope long enough (sustainability)? These factors determine the company’s valuation. The valuation of a company is reflected by these three indicators: profitability, sustainability, and growth.

Today, I’ve roughly discussed the meaning of the capability circle. The narrow sense involves qualitative analysis based on industry and company research, supported by quantitative financial analysis, with mutual verification. This leads to an assessment of the company’s (investment target) profitability, sustainability, and growth potential. These three evaluations ultimately determine the company’s valuation level, which involves the margin of safety, timing of purchase, and whether it’s worth buying—fundamental considerations.

Later, we will discuss the other side of the broad capability circle—investor’s capability circle, which requires another session for detailed explanation.

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