Charlie Munger's Investment Principles And Checklists [IN-DEPTH]

Charlie Munger’s Investment Principles And Checklists

[munger]

“You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.” – Charlie Munger

• Good checklists are precise, efficient, easy to use even under difficult conditions, do not try to spell out everything, and provide reminders of only the most critical and important steps; the power of checklists is limited
  • Bad checklists are vague, imprecise, too long, hard to use, impractical, and try to spell out every single step
• Do-confirm checklist: perform jobs/tasks from memory and experience, but then stop, run the checklist and confirm that everything was done correctly
• Read-do checklist: carry out tasks as they are checked off – more like a recipe

Process

Focus on original source documents, working from in to out

• SEC fillings
  • Read 10-Qs, 10-Ks, proxies and other filings in reverse chronological order
• Press releases and earnings calls/transcripts
• Other public information
  • Court documents, real estate records, etc.
• Industry publications
• Third-party analysts
  • Sell-side research only as a consensus-checking exercise
• Research the company’s competitors with the same process
• Research and speak to competitors, (former) employees, and people in the supply chain
• Estimate valuation before looking at market valuation
  • Valuation – What would a rational, long-term, private buyer would pay in cash today for the entire business?
    • Asset value
    • Earning power
      • if EP >NAV, then franchise value
    • Growth value
• Requirements
  • Large, well understood margin of safety
  • Reinvestment opportunities for capital in the business
  • Quality, ownership stake, and shareholder-orientation of management
  • Ability to bear pain, both the company’s and my own
• Munger’s “Four Filters”
  • Understand the business
  • Sustainable competitive advantages (aka, favorable long-term economics)
  • Able and trustworthy management
  • Price that affords a margin of safety (aka, a sensible purchase price)

Pause Points in the Process

Always think in terms of Process + Patience

How big is the margin of safety? How reliable is it? Why?

Pause #1

• Are the business and its securities able to be understood and valued?
  • Avoid loss by

Pause #2

• Go back through all financial disclosure looking for information and context missed the first time
  • Patterns/trends
    • Level and quality of disclosure
  • Specifics (see next section)

Pause #3 – final checks

• What can go wrong? Do a “pre-mortem”
• How can capital be permanently impaired by this investment?
• What are the probabilities? Are the odds heavily in my favor?
• What is the time horizon?
• How attractive is the opportunity? Namely, how attractive is compared to my best current investment?

Munger’s “two-track analysis”

• First, lay out and deeply understand the rational factors that govern the situation under consideration
• Second, focus attention on psychological missteps – either your own or those of other investors

“The Most Important Things”

• Margin of safety
• Balance sheet
  • Capital structure and liquidity
  • Asset value
• Cash flow
  • Realistic and reliable owner’s earnings (especially a few years from now)
  • Can cash be reinvested at attractive compound rates?
  • How has management allocated capital?

Initial ideas to consider in the process

• Separate the business from the balance sheet
  • How is the business capitalized? Is it sustainable? Is it relatively efficient/optimal?
  • What are the assets worth? Liquidation value and reproduction value
  • Are there any “hidden” assets or liabilities?
    • Excess cash, real estate, LIFO, etc.
    • Pension, legal liability, litigation, operational malfeasance, funding/liquidity puts, etc.
• Separate the business from the cash flows
  • What are the cash flows saying, regardless of the broader business stereotypes/assumptions?
  • How much cash can be taken out of the business every year? Owner’s earning (net income plus DA minus capex) normalized and over time
  • Earnings yield (EBIT/TEV) and ROIC (EBIT/(WC+fixed assets))
  • What are the capex requirements? With regard to inflation? Depreciation?
• What is the business’s competitive situation? How good is management?
  • What could kill the business? What disrupts the underlying fundamentals?
  • Competition/moat
  • Cost structure
  • What are incremental margins? How attractive is the compounding opportunity?
  • Is capital being allocated properly? Investing in the business vs. returning capital to shareholders
  • Are the company’s end markets stable/shrinking/growing? Susceptible to rapid (technological) change?
• Other considerations
  • Market perceptions
  • Quality of management and alignment of interests
  • Is this opportunity worth a punch on our punch card?
• Psychological factors
  • Think in terms of the “psychology of misjudgment” and common biases (see below)
• Where are we in the cycle?
  • Where are we in the economic cycle?
  • Where are we in the cycle for risk assets?
  • Where are we in the industry cycle applicable to this company?
• Portfolio composition
  • Target 15-25 individual (i.e., diversified or uncorrelated) investments
  • Size constraints
  • Portfolio liquidity
  • Ability to withstand pain

See full PDF below.

[klarman]