Charlie Munger: The Complete Investor – Charlieton Book ReviewsVW Staff
Charlie Munger: The Complete Investor – Book Review by Jesse Koltes, Editor of TheCharlieton.com
Charlie Munger: The Complete Investor by Tren Griffin
Welcome to The Charlieton’s first book review. The aim of this review is to deeply understand the ideas of the book, and to compare them with related and competing ideas as they exist elsewhere in the world. The recitation of historical facts, narratives, and other trivialities will be minimized, except insofar as they support an interesting idea.
I will number each major idea in the book as I come across them in order to create an easily referenceable catalog of ideas. My hope is that this numerical system will be of growing use of as the number of book reviews piles up in the future.
I encourage the readers of this review to support the author of the original work by purchasing the book.
Charlie Munger: The Complete Investor is a well-organized and thorough survey of both the Ben Graham value investing system, and Charlie Munger’s contributions to the investing world. Griffin expertly displays how Munger’s own ideas both emerged from, and later departed with the intellectual foundations laid by Graham.
Griffin also makes a valiant attempt at summarizing Charlie Munger’s notoriously artful and qualitative approach with rigor and detail. I believe this effort was successful, with my only quibble being that several points of explanation seemed duplicative or redundant. As a management consultant would say, the ideas within the constructed framework were not always “mutually exclusive and collectively exhaustive.” Still, this may be the price of trying to detail a system so thoroughly dependent on personal rationality, grit, and temperament. I doubt I could do better.
I hope to see more work from Tren Griffin that detail his own thoughts on contemporary value investing. His chapter on factor versus value was his best, despite it being one of the shortest. Now that the author has so successfully catalogued many of the great ideas of Charlie Munger, I hope to read future works by Griffin that are focused on more controversial subjects at the margins of modern value investing.
The purpose of the book is to teach the reader how to think more like Charlie Munger, the legendary thinker, investor, and vice chairman of Berkshire Hathaway.
Griffin first explores the Ben Graham value investing system (the foundation and intellectual progenitor of the Berkshire system). Second, Griffin explores Munger’s complementary system using three elements: “principles, the right stuff, and variables.”
Chapter 1: The Basics of the Graham Value Investing System
Griffin explore the basic ideas of Ben Graham’s value investing system, citing it as the intellectual underpinning of Charlie Munger’s own system of thinking.
Idea #1: Simplicity
- Investing is simple but not easy. Complexity militates against an effective understanding of what is going on. Keep things as simple as possible.
Idea #2: Circle of competence
- Knowing what you don’t know is as important as what you do know
- “Confucius said that real knowledge is knowing the extent of one’s ignorance. Aristotle and Socrates said the same thing.” – Munger, p. 11
Idea #3: Inversion
- Rather than trying to be smart, it's better to try to avoid being stupid.
- “It’s remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying, “It’s the strong swimmers who drown.”” – Munger, p. 13
Idea #4: Investing is a zero sum game
- It is an undeniable arithmetic fact that the average return of all active investors will equal the average return of all passive investors, less costs.
- “The idea that everyone can have wonderful results from stocks is inherently crazy, nobody expects everyone to succeed at poker.” – Munger, p. 15
Chapter 2: The Principles of the Graham Value Investing System
Griffin builds on the foundational work of chapter one by examining Graham’s principles of investing.
Idea #5: A share of stock is a partial ownership of a real business
- The value of the stock rests solely on an accurate total valuation of the business. Value investors are business analysts first, security analysts second. Following price momentum is a fool’s game.
- The monkey parable of speculation: A man and his assistant came to town and offered to pay $100 for every wild monkey. The townspeople captured many monkeys and were promptly paid $100. The man then raised the price to $200 and more monkeys were caught, and more people were paid. Finally, the man said he had to leave but would return later, and when he did, he would pay $500 per monkey. His assistant whispered to the townspeople that they could buy their monkeys back that day for $350, and earn $150 upon the man’s return. The townspeople promptly bought their monkeys back, but never saw the man again.
Idea #6: Buy with a margin of safety
- Graham cautioned investors to only buy at a significant discount to what something was worth (intrinsic value). By leaving a margin of safety for uncertainty, the investor protected himself from loss due to inaccurate forecasts, bad luck or other negative outcomes.
- “Confronted with the challenge to distill the secret of sound investment management into three words, we venture the following motto, MARGIN OF SAFTEY.” – Graham, The Intelligent Investor, p. 31*
- “The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Klarman, p 32.
- Editor’s note: This idea and idea #52 are among the most important and bedeviling concepts in value investing. Without a firm yardstick for the appropriate size of the margin of safety, who is to say it a safe enough margin at all? Graham’s net net strategy was firm and clear it is rules for setting the margin. Buffett, Munger’s and other modern value investors have been less rigid, which in my opinion, has immensely complicated the true essence of this all important credo.
Idea #7: Make “Mr. Market” Work for You
- Mr. Market is perhaps the most enduring metaphor popularized by Graham. Graham thought intelligent investors should view the public equity markets as though it were a moody business partner in a private venture. On some days, Mr. Market would be overcome by fear, and would offer to sell you his share of the business for pennies. On other days, he would be overcome by optimism, and would demand a rich multiple on the very same share. Intelligent investors would realize these were both variations around a central point, intrinsic value. Graham thought the intelligent investor should capitalize on the fear by buying, as well as on the booms, by selling.
- The Graham view is a direct and lasting challenge to the efficient markets hypothesis, which states that neither technical or fundamental analysis can result in better long term risk adjusted returns than the market average.
- “To Graham, it was a blessing to be in business with a manic depressive who gave you this series of options all the time.” – Munger, p. 28
Idea #8: Be rational
- “Rationality is not just something you do so that you can make more money;? it’s a binding principle. Rationality is a really good idea. You must avoid the nonsense that is conventional in one’s own time. It requires developing systems of that that improve your batting average over time.” – Munger, p. 40
Chapter 3: Worldly Wisdom
Griffin explain Munger’s philosophy of never sending self-education, colloquially referred to seeking to master elementary worldly wisdom.
Idea #9: Facts without theory are useless
- Facts alone don’t bring understanding—only by arranging them on a latticework of supporting and connective theory do facts bring meaning
- “The first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.” – Munger, p42
- Editor’s note: I consider this to be one Charlie’s most important ideas. The notion of the lattice work of theory is the metaphor that has led me to ask how and where new information “hangs” upon the latticework within my own mind.
Idea #10: Learn the big ideas from all the major areas of human knowledge
- “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.”—Munger, p. 42
Idea #11: Read widely, learn continuously
- Rather than filling their calendar with appointments, Buffett and Munger fill their calendars with free time in which to read books
- “You could hardly find a partnership in which two people settle on reading more hours of the day than in ours.” –Buffett, p.47
- Editor’s Note: This idea, like so many of Munger and Buffett’s, is known but not imitated. How many people in business read more than ten books a year? How many people in business can tell you the five best books about a given subject, not to mention the five worst books.
Idea #12: Avoid the common errors
- Most people over calculate, and overweight that which can be measured while dramatically underweighting the qualitative
- Use checklists to help avoid errors in repetitive tasks
- Embrace failure when it happens
- Think about errors not just of commission, but of omission
- “Forgetting your mistakes is a terrible error if your trying to improve your cognition. Reality doesn’t remind you. Why not celebrate stupidities in both categories?”—Munger, p. 52.
Chapter 4: The Psychology of Human Misjudgment
Munger states that the human brain is an immensely powerful yet imperfect tool for making rational decisions. Rules of thumb help people reach decisions quickly, but they can also bake in systematic errors. Griffin explores a non-exhaustive list of the the major psychological failures:
Idea #13: Reward and punishment super response tendency
- Psychologists call it reinforcement, economists call it incentives. Nassim Taleb suggests making reward / punish (“skin in the game”) the backbone of risk management. Munger concurs, and believe this tendency is both well understood, and still vastly underappreciated, even by him.
Idea #14: Liking / loving tendency
- We ignore the faults of those we like, and trust them more than we would otherwise. This point is a fundamental tool of persuasion professionals – read Influence by Robert Cialdini for the best explanation.
- Editor’s note: Charlie has said before that idea #13 is well known but still underappreciated. I would say that idea #14 is both unknown and underappreciated by just about everyone.
Idea #15: Disliking / hating tendency
- Inverse of Idea #2. The tendency to underweight the opinion of someone you dislike for irrational reasons.
Idea #16: Doubt-avoidance tendency
- The human mind avoids doubt because doubting everything consumed lots of energy. It’s easier to believe, and so we do. This idea was expertly exploited by Bernie Madoff.
Idea #17: Inconsistency-avoidance tendency
- Consistency is considered a virtue, even after the facts change. Close cousin of idea #4. This idea is the reason science is said to advance one funeral at a time.
Idea #18: Curiosity tendency
- The tendency to learn can lead people beyond their circles of competence, and into trouble.
Idea #19: Kantian fairness tendency
- People do irrational things (like make themselves worse off) in the interest of fairness.
Idea #20: Envy / jealousy tendency
- Relative performance leads people to do stupid things. Munger believes it’s a horrible sin, in part because it can’t even be enjoyed. It’s all bad.
Idea #21: Reciprocation tendency
- Humans have are extremely acculturated to reciprocate. “Free” lunches or favor often are rewarded. Salesman expertly exploit this tendency.
Idea #22: Influence-from-mere-association tendency
- Human like to associate good things with other good things even if the relationship is relevant. This explains celebrity endorsements.
Idea #23: Simple, pain-avoiding psychological denial
- Human prefer to imagine the good, and deny the bad.
Idea #24: Excessive self-regard tendency
- The classic example: the vast majority of people believe they are better than average drivers.
Idea #25: Over-optimism tendency
- Enthusiasm is always highest at the beginning.
- Editor’s note: an excellent way to fight this tendency is to write ‘pre-mortems’, predicting how a given venture will fail at the beginning, and then attempt to avoid that easily foreseen fate.
Idea #26: Deprival super-reaction tendency
- Loss aversion. Small decrements down hurt more than equal magnitude increases.
Idea #27: Social-proof tendency
- Human’s follow the behavior of the crowd first, often without applying critical thinking.
Idea #28: Contrast-misreaction tendency
- The tendency to compare something to its most immediate predecessor. The human man lacks an absolute scale. All comparisons are relevant to those around.
Idea #29: Stress-Influence Tendency
- Decision making under stress lowers rationality.
Idea #30: Availability-Misweighting Tendency
- Recent vivid memories dominate thinking. Behavior just after a stock market crash is different than 20 years after a stock crash.
Idea #31: Use-it-or-lose-It tendency
- Skills degrade with lack of practice (and we sometimes don’t recognize that).
Idea #32: Drug-Misinfluence Tendency
- Alcohol is a low upside, massive downside bet, and therefore one to be avoided.
Idea #33: Senescence-Misinfluence Tendency
- The mind, like a skill, degrade with age.
Idea #34: Authority-Misinfluence Tendency
- People follow authority, or the appearance of authority, blindly.
Idea #35: Twaddle Tendency
- The failure to separate idle chat from important truth. The hardest twaddle to avoid is the kind you tell yourself.
- Editor’s note: In meeting I often find myself thinking of the quote “Everything has been said, but not everyone has said it.” The more people talk, the more concerning it is that twaddle is running rampant. This is the idea behind our post quoting only Charlie’s concise comments at Berkshire 2016.
Idea #36: Reason-Respecting Tendency
- Reasons, even bad ones, make human more likely to agree with a given proposition.
Idea #37: Lollapalooza Tendency
- The tendency for other idea to come together in a negatively synergistic way.
Chapter 5: The Right Stuff
Griffin claims that like Buffett, Charlie Munger’s genius is more in his character than anything else, particularly in the areas of patience, discipline, and rationality. Chapter five details the unique behaviors Munger has identified as essential to being a successful investor. Note that all of these aspects are simple, but not easy.
Idea #38: Patient
- Munger ascribes to a philosophy of extreme patience. In poker terms, this strategy would be likened to folding the vast majority of the time, and then betting big when the odds are in your favor. The same is true of bridge, but with more frequently updated odds. This principle of patience coupled with fast action is central to the Munger system of investing.
- “Patience combined with opportunity is a great thing to have. My grandfather taught me that opportunity is infrequent and one has to be ready when it strikes. That’s what Berkshire is.” – Munger, p 91
- Editor’s note: I often remind myself that professional poker players often fold more than 70% of their hands.
Idea #39: Discipline
- Munger is adamant about being disciplined enough to say no to almost everything. That includes frivolous meetings, frivolous activity, and frivolous thought. Munger and Buffett devote enormous amounts of time to reading and being patient. “Do something-ism” is a siren that should be steered clear of.
- “We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business.” –Munger, p. 94
Idea #40: Calm but Courageous and Decisive
- Very similar in substance to the two aforementioned points. Bet big when the odds are in your favor, as Munger did in the depths of the financial crisis when he plowed his cash into bank stocks.
- “Too much competency and no gumption is no good. And if you don’t know your circle of competence, then too much gumption will get you killed. But the more you know the limits to you knowledge, the more valuable gumption is.” –Munger, p 97
Idea #41: Reasonable Intelligent But Not Misled By Their High IQs
- A big brain doesn’t equal a big result.
- “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments.” –Munger, p. 98
- Editor’s note: Charlie’s quote under Idea #12 is helpful. People with high IQs need to systematically remind themselves of how little they know, because it is so easy to fool yourself. I am especially fond of Wes Gray’s ability to do this (check out his great books and website at www.alphaarchitect.com). The same is true of Jason Zweig.
Idea #42: Honest
- Honestly is not only righteous, its incredible effective.
- “More often we’ve made extra money out of morality. Ben Franklin was right for us. He didn’t say honest was the best morals, he said it was the best policy.” –Munger, p. 100
Idea #43: Confident and Non-ideological
- Humility and knowledge go hand in hand.
- “I have a black belt in chutzpah. I was born with it.” –Munger, p. 101
- “The ethos of not fooling yourself is one the best you can possibly have. It’s powerful because it’s so rare.” –Munger, p. 101
Idea #44: Long-Term Oriented
- “Almost all good business engage in “pain today, gain tomorrow” activities.” –Munger, p. 102
Idea #45: Passionate
“Berkshire is full of people who have a peculiar passion for their own business. I would argue passion is more important than brain power.” – Munger, p. 104
Idea #46: Studious
- Perhaps Munger’s greatest contribution to the Graham system embraced by Buffett was the inclusion of Phil Fisher’s scuttlebutt notions.
- “Learning from other people mistakes is much more pleasant.” –Munger, p. 104
- “I have known no wise people…who didn’t read all the time—none zero.” – Munger, p. 104
- “I would go out and talk to customer, suppliers, and maybe employees in some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO “If you could only buy stock in one company that was not your own, which one would it be and why?” You piece those things together, you learn about the business after a while.”—Buffett, p106.
Idea #47: Collegial
- The central idea is that everyone needs an interlocutor to reach their full potential.
- “I hardly know anybody who’s done very well in life in terms of cognition that doesn’t have somebody trusted to talk to….You organize you own thoughts as you try and convince other people. It’s a very necessary part of operations. If you had some hermit sitting on a mountain, he wouldn’t do very well.” –Munger, p. 106
Idea #48: Sound Temperament
- A calm rational temperament is more important than brains. Controlling emotions is more important than a super high IQ.
- Griffin notes that many modern Graham value investors have begun using computers to automate the purchasing of stocks that are consistent with Graham’s principals. Griffin notes that while “machine learning is not used by Buffett or Munger, it is completely consistency with their principles.” – Griffin, p. 109
- Editor’s Note: While quantitative value approaches may be consistent with Graham’s principles, Munger has repeatedly stated that he doesn’t think value investing can be reduced to a formula. If it could be, the mathematicians would all be millionaires. Interestingly, Graham’s approach to net-nets is essentially a “quant” approach implemented before the age of computers.
Idea #49: Frugal
- Despite their fabulous wealth, Munger and Buffett eschew extravagance and embrace frugality. Berkshire’s headquarters is an excellent example, with only several dozen people on staff, despite the billions under management.
- Editor’s note: It is humbling to realize that even the vastest sums of money can be spent (see a variety of examples in sports and entertainment). This lends great truth to the econ 101 idea of “non-satiation.”
Idea #50: Risk Averse
Munger has clear, but contrarian views of risk.
- Risk and volatility are not the same thing.
- Real risk is the permanent loss of capital. Volatility is just a measure of Mr. Market’s mood.
- Prudent risk management is extra management. Always keep lots of cash around, and never go too far into debt.
- Risk comes from not knowing what you’re doing.
Chapter 6: The Seven Variables of the Graham Value Investing System
Griffin reviews seven concepts that Graham value investors implement with notable variety. While there are large differences, all of the listed approaches within this chapter are considered within Graham orthodoxy. Non-Grahamite “value” approaches are discussed in the post script note on factor investing.
Idea #51: Determining the Appropriate Intrinsic Value of a Business
- Buffett and Berkshire define the intrinsic value as “the discounted value of the cash that can be taken out of a business during its remaining life.” - Buffett P. 113
- Cash flows, time horizons and discount rates are hard to measure, so most value investors (including Buffett and Munger) think of intrinsic value as falling within a range. Not even too like minds will calculate the exact same intrinsic value. However, approximate accuracy is vastly preferable to incorrect precision.
- Munger doesn’t believe that all businesses can be easily valued with reliable in accuracy—in such case, he is content to take a pass.
- The tendency to attempt to value difficult business is part of the folly of overconfidence. Munger believes the ability to wait for your pitch is one of the easiest, and most overlooked ideas in all of investing.
- Despite all the talk of discounted cash flows, Munger has never actually seen Buffett do one, although he may approximate it in his head
- Buffett’s definition leads Berkshire to favor business with high returns on capital that can make high returns on invested capital.
Idea #52: Determining the Appropriate Margin of Safety
- Graham called the margin of safety the central tenet of his approach. Yet despite its wide celebration, the exact measure of the margin used by investors varies widely
- Some investors like to buy “75 cent dollars” while others (like Munger) seek massive dislocations before they invest
- The margin of safety notion has often been confused with Buffett’s and Phil Fisher’s arguments in favor of quality—they are not the same
- “The golden rule of investing: no asset (or strategy) is so good that should invest irrespective of the price paid.” –James Montier, p. 120
Idea #53: Determine the Scope of the Investor’s Circle of Competence
- Various investors define their circles of competence different
- There are likely both intelligent and justified differences in these circles based on expertise, life experience, and study, as well as stupid and unjustified differences wherein some investors are simply overconfident in their ability to understand things
- Knowing the true bounds on your competency saves time, decreases risk, and ultimately should increase performance
- “The true insights a person can get in life are still very limited, so correct decision making must necessarily be confined to your “circle of competence.” A “competence” that has no defined borders cannot be called a true competence.” – Li Lu, p. 123
Idea #54: Determining How Much of Each Security to Buy
- Investors within the Graham system differ on how much of each security they should buy: some favor an “adequate thought not excessive diversification” while other, such as Munger, advocate a strong concentration, provided you know what you are doing
- Munger favors a strong focus, because that is one of the best ways to beat the indexes—far too many “money managers” are in fact “closet indexers” who’s number of holdings necessarily mean they will track the index closely, for both better and worse
Idea #55: Determining When to Sell a Security
- Value investors differ on when to sell a security. Some sell when the security’s price reflects its intrinsic value. Some, like Buffett and Munger, prefer to hold a security forever if the quality is high, and the entry price is correct.
- “There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: you’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2, or 3 percentage points per annum compounded.” –Munger, p 129
- “To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with a one in two chance of winning, and that pays three to one. In other words, we’re looking for the mispriced gamble. That’s what investing is, and you have to know enough whether the gamble is mispriced.” –Munger, p. 129
Idea #56: Determining How Much to Bet when You Find a Mispriced Asset
- Munger says that when you find a mispriced asset that gives your chances of a success an edge you should back that edge strongly, because opportunities like that don’t come around very often.
- “The wise ones bet heavily when the world offers them the opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” –Munger, p. 130
- “Listen, business is easy. If you’ve got a low downside, and a big upside, you go do it. If you’ve got a big downside, and small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” – Sam Zell, p 131
Idea #57: Determining Whether the Quality of a Business Should be Considered
- “Ben Graham had blind spots. He had too low an appreciation of the fact that some businesses were worth paying big premiums for.” – Munger, p. 132
- No notion defines Charlie Munger’s contribution to value investing more so than quality. Graham, the father of value, famously ignored the returns the business in question could earn, perhaps because he was able to find so much easily discernible value on the balance sheet that he did not dare venture beyond. But as the world changed, the number of balance sheet bargains evaporated. Under the influence of Munger, and Phil Fisher, Buffett gradually mutated from a pure Grahamite eschewing quality, into a great appreciator of quality at the right price.
- “The investment game always involved considering both quality and price, and the trick is to get more in quality than you pay for in price. It’s just that simple.” – Munger, p 135.
Idea #58: Determining What Business to Own (in Whole or in Part)
- “The difference between a good business and a bad business is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.” –Munger, p 137
- “We buy barriers. Building them is tough….Our great brands aren’t anything we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it’s hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins.” –Munger, p 137
- Munger and Buffett prefer to own a part of a great business with a great barrier, rather than the entirely of a so-so business.
Chapter 7: The Right Stuff in a Business
Because one of the core tenets of the Graham system is that a stock is a partial ownership in business enterprise, Griffin devotes time exploring what Buffett and Munger consider to be the most important parts of their businesses.
Idea #59: Capital Allocation Skills
- Berkshire has an extremely decentralized management system, but an extremely centralized capital allocation function. This is because many CEOs are bad at capital allocation, having never had to learn the skill while they moved up the ranks.
- “Just as work expands to fill available time, corporate projects or acquisitions will material to soak up available funds. Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategy studies prepared by his troops” –Buffett, p. 141
- Because CEO’s are bad at a capital allocation, Buffett keeps that job isolated at Berkshire headquarters.
Idea #60: Compensation Systems that Create Alignment with Shareholders
- “It isn’t enough to buy the right business. You have to to have a compensation system that’s satisfactory to the people running them.” – Munger, p 142
- Compensation is hard to get right, and the incentives in setting up the scheme are terrible for the shareholders. Given these dynamic, setting executive compensation is the second activity that Berkshire concentrates solely at headquarters.
- “I’d rather throw a viper down my shirt front than hire a compensation consultant.” –Munger, p. 142
Idea #61: Moat-Widening Skills
- Munger would rather have a great business with poor managers, than a mediocre business with great managers. However, if given the choice, its best to have a great business and great managers.
Idea #62: Management Already in Place with Integrity
- Munger believes that integrity is a necessary component of a decentralized system.
- “Remember that reputation and integration are your most valuable assets—and that can be lost in a heartbeat.” –Munger, p 147
- When you mix raisins with turds, there are still turds” –Munger, p. 147
- “We don’t train executives, we find them. If a mountain stands up like Everest, you don’t have to be a genius to figure out that it’s a high mountain.” –Munger, p. 147
Idea #63: The Rare Exceptional Manager
- In extremely rare circumstances, Munger says it may even be wise to follow an exceptional manager into a mediocre business, such as Sam Walton into retail with Walmart.
- “Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t….Sam Walton was such a man.” –Munger, p. 148.
Postscript 1: Berkshire Math
Griffin summaries the mathematical process through which Buffett and Munger assess purchasing decisions.
Idea #64: The Berkshire mathematical process
- Buffett and Munger estimate the likely and future “owners earnings”
- Owners Earnings = Reported Earnings + depreciation and amortization +/- non cash cash charges – maintenance capex +/- changes in working capital
- Apply a reasonable and conservative growth rate to future earnings
- Discount future owner’s earnings back by the 30 year treasury rate
- Editor’s note: Munger seemed to walk back the idea that he uses just one rate at the 2016 Daily Journal meeting. It is also not clear to me that either Munger of Buffett actually calculate intrinsic value using an actual formula at all. My own assumption is that they approximate it based on years of experience, but this would be an excellent question for a future Berkshire or Daily Journal shareholder.
Postscript 2: Moats
Munger has not ever fully offered a full explanation of what a moat is, or how it comes about, however five primary elements can be gleaned from his writings
Idea #65: Supply side economies of scale and scope
- “Some [supply-side advantages] comes from simple geometry. If you’re building a great circular tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. There are all kinds of things like that where the simple geometry—the simple reality—give you an advantage of scale.” –Munger, p. 157
- Examples: Wal-Mart, Burlington Northern, Proctor and Gamble
Idea #66: Demand-side economies of scale (network affects)
- Network effects results when a service becomes valuable the more people use it
- Examples: American Express, Facebook, Amazon
Idea #67: Brand
- Buffett and Munger said they did not understand brand until they bought See’s
- “What See’s Candies sells is not just food, but rather an experience.” – Griffin, p. 160
- “[Coke spend] 100 years getting people to believe that trademark had all these intangible values too. And people associated it with a flavor…Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would’ve been the biggest fiasco in modern times. Perfect insanity.” – Munger, p. 161
- Examples: BMW, Coke, Nike
Idea #68: Regulation
- Businesses that compete in highly regulated industries can learn those regulations so well that it keeps all likely competitors out
- Example: Moody’s (regulators require that all bonds be rated by a very number of firms, including Moody’s)
Idea #69: Patents and Intellectual Property
- Firms with patents and trademarks can earn effective monopolies
- Examples: Lubrizol (petroleum additives with over 1,600 patents)
Idea #70: Cumulative Moats
- Berkshire has created a moat by a unique network effect of highly unusual management decisions. Those factors are: tax efficiency, low overhead, being the private buyer of first resort, permanent capital, outperformance in down markets, the benefit of float, high quality shareholders,
- “Moats that emerge from a complex adaptive system like an economy are hard to spot. This is because a moat is something that is greater than the sum of its parts, emerging from something else that is greater than the sum of its parts. In contrast, a moat being destroyed is easier to spot because this is a process of something transforming into nothing.” –Griffin, p. 178
- Editor’s note: I highly recommend the excellent (yet poorly titled) The Little Book That Build’s Wealth, by Pat Dorsey. The book should have been called, The Little Book of Moats. If memory serves, Dorsey used Precision Castparts as an example of a formidable moat years before it was purchased in whole by Berkshire.
Postscript 3: Value Investing and Factor Investing
Griffin compares and contrasts the value investing system of Graham with the factor investing research of Eugene Fama and Ken French. Griffin concludes both systems are very different, and a statistically cheap Fama-French stock may not resemble Graham value stocks
Idea #71: Fama/French is top down, Graham value is bottom up
- Fama/French are models used to explain which stocks that over perform the averages without abandoning the concept of market efficiency
- “Here is a simple way to think about this difference using an analogy. Suppose you want to put together a basketball team…the Fama / French approach would be to recruit 100 of the tallest males in town. This team would do better than average because there is a correlation between height and ability. In the same way there is going to be a statistical correlation between an undervalued company and a company with a low book-to-market.” – Griffin, p. 182
- “The bridge between book value and earnings/cash flow can be found in a company’s return on equity. That is: Earnings yield = return on equity x book to market.” – Griffin, p. 182
- “When all is said and done, the factor investing approach is essentially a tweak (perhaps an enhancement) on index investing…. If more investors actually read Ben Graham’s The Intelligent Investor and other books on Graham value investing, they would realize that the approaches are fundamentally different.” – Griffin, p. 182.
- Editor’s note: One of the only sections I wish was quite a bit longer. My own opinion is that factor investing has an enormous overlap with Grahamite approaches now called “Deep Value.” I also believe that factor investing, and perhaps even index investing, have positively contributed to the value investing body of knowledge in ways that Griffin fails to appreciate. I would again point you towards the work of Wes Gray, as well as Joel Greenblatt, both of whom have published works I intend to summarize in the future.
Charlie Munger: The Complete Investor by Tren Griffin