Charlie Munger: The Complete Investor (Columbia Business School Publishing)
Tren Griffin
Introduction
Part of the benefit of creating a checklist is the process of writing down your ideas. I have always loved the point Buffett made about the importance of making the effort to actually put your ideas in writing. In Buffett’s view, if you cannot write it down, you have not thought it through.
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Munger likes to say that a successful investor never stops being a “learning machine.” This need to learn and relearn means that an investor must read and think constantly. Munger has said he does not know a single successful investor who does not read voraciously. His own children describe him as a “book with legs sticking out.” Reading and learning will require some real work.
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1. The Basics of the Graham Value Investing System
Because investing is a probabilistic activity, decisions made in ways that are fundamentally sound may sometimes produce bad results. Sometimes a person will produce an unfavorable result even when his or her process is well constructed and executed. However, in the long run, it is always wise to focus on following the right process over any specific, intermediate outcome. Munger believes that when creating a successful investing process, complexity is not the investor’s friend.
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“Turn complicated problems into simple ones. Break down a problem into its components, but look at the problem holistically.”1 Keeping things as simple as possible, but no more so, is a constant theme in Munger’s public statements. In a joint letter to shareholders, Munger and Buffett once wrote: “Simplicity has a way of improving performance through enabling us to better understand what we are doing.”2
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“Knowing what you don’t know is more useful than being brilliant.”
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There are two sides to every trade. The best way to think about it is that every time you buy a stock, someone is selling… So you always have to ask the question, “Why am I on the right side of this trade?”—BRUCE GREENWALD, BETTERMENT INTERVIEW, 2013
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The idea that everyone can have wonderful results from stocks is inherently crazy. Nobody expects everyone to succeed at poker.—CHARLIE MUNGER, DAILY JOURNAL MEETING, 2013 If [investing] weren’t a little difficult, everybody would be rich.—CHARLIE MUNGER, DAMN RIGHT, 2000 For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.—CHARLIE MUNGER, WESCO ANNUAL MEETING, 2008
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Some investors knowingly do a small amount of active investing for fun, much as they might gamble in Las Vegas. This can be logical as long as people remember that gambling is, well, gambling. Knowing the difference between gambling and investing is important. Investing is an action that defers consumption in the present in the hope that you will be able to consume more in the future. An investor has an expectation of a positive real rate of return, even though it is possible that this will not happen (especially in the short term). In other words, an investment is a net present value–positive activity (the likelihood of the net present value of the potential benefits minus the likelihood net present value of the potential losses is positive). Gambling is a form of present-moment consumption, and the net present long-term value of the activity is negative. Many people who think they are investing are actually gambling. Some people try to outperform the market by saying essentially, “I can be smart about picking other people who will outperform the market via active investing.” Munger believes that if something related to active investing is worth doing, then it is worth doing yourself.
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2. The Principles of the Graham Value Investing System
First Principle: Treat a Share of Stock as a Proportional Ownership of a Business THIS FIRST PRINCIPLE of the Graham value investing system is the foundation on which any valuation must begin. Put simply: if you do not understand the actual business of the company, you cannot understand the value of assets related to that business, like a share of stock or a bond. Graham value investors approach any valuation as if they were actually buying a business in a private transaction. In buying a business, Munger believes the place to start is at the bottom, with business fundamentals, and work up.
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If valuing the business requires understanding how cash flows will change in the future based on factors like rapid technological change, Munger puts that business in the too hard pile and moves on to value other companies. Munger makes it quite clear that he does not have a way to value all companies, which is fine with him because he feels no need to do so. There are more than enough businesses that Munger can value using his valuation method to make him happy as an investor.
Notes:
Munger doesn't bother about understanding tech, stick to what you know and predict
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you must value the business in order to value the stock. Graham value investors price assets based on their value to a private investor now (based on data from the present and past) rather than making predictions about markets in the future.
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Munger is a firm believer in the Ben Graham view that “an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”3
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“I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections but we care very much about, and look very deeply, at track records. If a company has a lousy track record but a very bright future, we will miss the opportunity.”6
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Private Market Value (PMV) is the value an informed industrialist would pay to purchase assets with similar characteristics. We measure PMV by scrutinizing on- and off-balance-sheet assets and liabilities and free cash flow. As a reference check, we examine valuations and transactions in the public domain.
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Intrinsic value is the present value of future cash flows. Margin of safety reflects the difference between the intrinsic value and the current market price. The purpose of a margin of safety is quite simple according to Graham: “The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.”9 Seth Klarman described the Graham value investing system simply: buy at a bargain defined by a margin of safety and wait. However, as the Tom Petty and the Heartbreakers lyric says, “The waiting is the hardest part.”
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Behind the margin of safety principle is the simple idea that having a cushion in terms of excess value can protect you against making an error. If you buy at a discount, you have a margin of safety, which will help protect you from making mistakes. This will improve your odds of success. Everyone makes mistakes, so having insurance against those mistakes is wise.
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I think it’s roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible.
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3. Worldly Wisdom
You must know the big ideas in the big disciplines, and use them routinely—all of them, not just a few. Most people are trained in one model—economics, for example—and try to solve all problems in one way. You know the old saying: to the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.
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In the language of Wharton Professor Philip Tetlock, Munger is a “fox” (who knows a little about a lot) rather than a “hedgehog” (who knows a lot about very little).2 Among the foxes one may encounter in life, Munger is truly special. He knows a lot about a lot, and he knows a little about nearly everything. Bill Gates made this point when he said, “Charlie Munger is truly the broadest thinker I have ever encountered.”3 Buffett added that Munger has “the best 30-second mind in the world. He goes from A to Z in one move.
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I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up, and boy, does that help, particularly when you have a long run ahead of you.… So if civilization can progress only with an advanced method of invention, you can progress only when you learn the method of learning. Nothing has served me better in my long life than continuous learning.
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4. The Psychology of Human Misjudgment
The iron rule of nature is that you get what you reward for. If you want ants to come, put sugar on the floor.—CHARLIE MUNGER, WESCO ANNUAL MEETING, 2001 Reward and punishment superresponse tendency relates to what psychologists call reinforcement and what economists call incentives.
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Munger believes that people tend to ignore or deny the faults of people they love and also tend to distort facts to facilitate that love. He believes we are more influenced by people we like, and perhaps more importantly by people who genuinely like us. There are obviously positive aspects to this tendency for society, but they rarely have a place in making investment decisions. You may like or even love your friend or relative, but that does not mean that you should trust him or her with your money.
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The disliking/hating tendency is the inverse of the previous tendency. Munger believes that life is too short to do business with people you don’t like. He also refuses to invest in certain companies that sell goods and services that he does not like for ethical reasons. As an example, Munger and Buffett avoid investing in casinos.
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Researchers believe that the doubt-avoidance tendency exists because a brain’s processing load can be substantially reduced if a person rejects doubt.
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People are reluctant to change even when they have been given new information that conflicts with what they already believe. Inconsistency-avoidance tendency is another often-useful heuristic because starting each day with a fresh mind about everything requires too much processing power.
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The desire to resist any change in a given conclusion or belief is particularly strong if a person has invested a lot of effort in reaching that conclusion or belief and/or if the change will result in something that is unpleasant.
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Absence of the inconsistency-avoidance tendency among some people operates to benefit society. For example, company founders who are not wedded to old ideas can sometimes create innovative new businesses more easily. As another example, an executive may cling to an idea he or she has publicly advocated, even after facts come to light proving the idea false.
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Mark Twain’s statement comes to mind on this tendency: “All you need in this life is ignorance and confidence; then success is sure.”7 Some entrepreneurs often don’t know enough to think that something can’t be done, so once in a while they actually do something that is completely unexpected. As the old saying goes, even a blind squirrel finds a nut once in a while.
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Curiosity can provide both fun and wisdom, and occasionally trouble.—CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
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I was born innately curious. If that doesn’t work for you, figure out your own damn system.—CHARLIE MUNGER, WESCO ANNUAL MEETING, 2010
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Curiosity can also cause an investor to engage in too many activities or a business owner to offer too many products and services, but end up failing by offering none. Startup founders can end up repeatedly “pivoting” their business (i.e., changing business models or business categories) into oblivion if they overload on curiosity. At the same time, curiosity can lead to important breakthroughs for a business. Striking the right balance on something like curiosity requires judgment.
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The automatic tendency of humans to reciprocate favors and disfavors has long been noticed as extreme.—CHARLIE MUNGER, HARVARD UNIVERSITY, 1995
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Professor Robert Cialdini has pointed out that, “People will help if they owe you for something you did in the past to advance their goals. That’s the rule of reciprocity.”8 The reverse is also true if you have done something that negatively affects a person. The urge to reciprocate favors and disfavors is so strong that even someone smiling at you is hard not to reciprocate.
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Humans are programmed to be pattern seekers. They look for patterns to obtain what they believe is guidance about how to make decisions.
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This tendency is similar to the liking tendency, except only association is required. Liking tendency is more about being blind to the faults of people we like. With association theory, the compliance professional is trying to get you to do something like buy a financial service because it is endorsed or used by a famous actor. Because compliance professionals know this human weakness, advertisers spend huge amounts of money to associate their products and services with favorable images.
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One should recognize reality even when one doesn’t like it.—CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2000
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People hate to hear bad news or anything inconsistent with their existing opinions and conclusions. For this reason, if something is potentially painful, the human brain often goes to work trying to deny reality.
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One of our biases is that we can ignore the lessons of experience. A group of people compiling a report will estimate they can do it in a year, even though every other similar report has taken comparable groups five years.
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The deprival super-reaction tendency is more commonly called loss aversion, and it can cause investors to irrationally avoid risk when they face potential for gain, but irrationally seek risk when there is a potential for loss. In other words, people tend to be too conservative in seeking gains and too aggressive in seeking to avoid losses. The most important point to remember about this tendency is that it causes investors to do things like sell stocks too early and hold on to them for too long.
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Humans have a natural tendency to follow a herd of other humans. In other words, because humans do not have unlimited time and complete information, they tend to copy the behavior of other humans. Cialdini put it this way: “One means we use to determine what is correct is to find out what other people think is correct. We view a behavior as more correct… to the degree we see others performing it.”15 Social-proof tendency is one major cause of financial bubbles.
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Munger points to real estate brokers who may first show clients unattractive properties at inflated prices in order to increase the probability that clients will buy a subsequently viewed property at an inflated price as an example of this tendency. In other words, if your real estate broker starts the tour with a dog of a deal, they are very likely trying to train you to buy what is coming next. No one should buy an investment merely because it’s better than the lousy one you just saw or owned.
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Some level of stress can actually increase a person’s performance. However, people under too much stress tend to make really lousy decisions.
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Munger’s own life is support for the view that if you have the right genetics and consciously work hard to remain physically and mentally active, you can stay sharp as you age. Luck certainly plays an important part in outcomes related to aging, but there is no excuse for not working to do the best you can with the luck you have. Staying active is essential to mental and physical health. As just one example, nothing is more fun for people like Munger than learning—and nothing helps learning more than reading. When it comes to health, do not be passive. As an example of Munger not accepting deteriorating health passively, when he was confronted with a diagnosis that he might lose all of his sight, he began studying Braille.
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It is far better to wear out from work than rust out from inactivity.
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People tend to follow people who they believe are authorities, especially when they face risk, uncertainty, or ignorance. Professor Cialdini described the authority tendency this way: “When people are uncertain… they don’t look inside themselves for answers—all they see is ambiguity and their own lack of confidence.
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5. The Right Stuff
In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time—none, zero. You’d be amazed at how much Warren reads, at how much I read.
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Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.—CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
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6. The Seven Variables in the Graham Value Investing System
Intrinsic value can be defined simply: It’s the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it’s additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.—WARREN BUFFETT, BERKSHIRE HATHAWAY OWNER’S MANUAL,
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If Munger determines that the valuation of the business is too hard, he simply says, “I pass.” This is such a powerful and underutilized idea.
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When Munger and Buffett value a business, they use what they call owner’s earnings as the starting point. Owner’s earnings can be defined as: Net income + Depreciation + Depletion + Amortization– Capital expenditure– Additional working capital. Berkshire uses the owner’s earnings figure in this process to take into account capital expenditures that will be necessary to maintain the business’s return on equity. A more complete explanation of an owner’s earnings calculation is provided in the section of this book called Berkshire Math.
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Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.
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We’d rather deal with what we understand. Why should we want to play a competitive game in a field where we have no advantages—maybe a disadvantage—instead of playing in a field where we have a clear advantage? Each of you will have to figure out where your talent lies. And you’ll have to use your advantages. But if you try to succeed in what you’re worst at, you’re going to have a very lousy career. I can almost guarantee it. To do otherwise, you’d have to buy a winning lottery ticket or get very lucky somewhere else.—CHARLIE MUNGER, STANFORD UNIVERSITY LAW SCHOOL, 1998
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Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly.
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7. The Right Stuff in a Business
a financial asset, like a share of stock, is not a piece of paper; rather, it is a proportional share in an underlying business. You cannot be a successful Graham value investor if you do not understand the underlying business.
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Proper allocation of capital is an investor’s number one job.—CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
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The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.… CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it’s more likely to accentuate the capital-allocation problem than to solve it. In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)—WARREN BUFFETT, 1987 BERKSHIRE ANNUAL LETTER, 1988
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In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s big and whether it’s material. You can do a lot to mitigate bad behavior, but you simply can’t prevent it altogether.—CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2012 Of course, fear of micromanagement is not a reason to abdicate all management responsibilities. A board of directors letting a parade of managers run down a business is not justified by a fear of micromanagement. Delegation to the extent practiced by Berkshire Hathaway only works if you follow this rule as described by Munger: Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. But if you’re going to provide minimal oversight, you have to buy carefully. It’s a different model from GE’s. GE’s works—it’s just very different from ours.—CHARLIE MUNGER, NOTES FROM THE BERKSHIRE HATHAWAY ANNUAL
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The only duty of a corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it’s too tough. But duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you.
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Munger wants managers of the business who have an ownership mentality toward the business, not just the attitude of manager. Carnegie was always proud that he took very little salary. Rocke-feller and Vanderbilt were the same. It was a common culture in a different era. All of these people thought of themselves as the founder. I was delighted to get rid of the pressure of getting fees based on performance. If you’re highly conscientious and you hate to disappoint, you will feel the pressure to live up to your incentive fee.
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Remember that reputation and integrity are your most valuable assets—and can be lost in a heartbeat.—CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
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Moats
Everyone is influenced by what others do and approve. Another advantage of scale comes from psychology. The psychologists use the term “social proof.” We are all influenced—subconsciously and to some extent consciously—by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better.
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