Category Archives: Charlie Munger

Buffett & Munger’s Four Investing Filters

A few takeaways:

  1. (Filter #1) The most important thing is to understand the business.
  2. (Filter #2) Look for a business with an enduring competitive advantage.
  3. (Filter #3) Invest with able and trustworthy managers.
  4. Filter out most prospective investments through inversion, i.e. businesses you don’t understand, businesses with lousy economics, etc.
  5. (Filter #4) Pay a price that makes sense and affords a margin of safety.

Berkshire Hathaway 2012 Shareholder Meeting Notes (part 3) – GregSpeicher.com

Buffett stated that Berkshire is not even close to running afoul of the Investment Act of 1940.

Google and Apple are great businesses. They will be difficult to dislodge. Buffett does not get to the level of conviction he needs to buy them. He thinks IBM is less likely to stumble.

Buffett would not have selected Apple ten years ago. What makes him think he can now predict what it will do over the next ten years. (My comment: this is a useful filter to counter hindsight and overconfidence bias.)

Buffett likes the very positive long-term economics of BNSF.

Munger: Getting good and bad breaks is in the nature of things.

REITs and MLP’s would not be attractive to Berkshire because it must pay corporate tax.

The $20 billion of cash that Buffett holds is not a magic number. They think about risk all the time and build in a margin of safety. They are not interested in explaining why the lost the business.

They think about what could go wrong, and they put in place a huge margin of safety. 99 out of 100 years will be punished as a result of this conservative approach. 1 in 100 will be the payoff.

Buffett keeps photocopies from the pages of newspapers that chronicled financial collapses, as a reminder. He mentioned the financial collapse surrounding Pacific Northern.

Regarding Combs and Weschler, Buffett is always more concerned with how a record was achieved. He has seen hundreds of great records – very few from people he would hire.

Combs and Weschler make $1 million per year plus a bonus for each point of outperformance of the S&P 500. 80% of the bonus is based on their individual performance and 20% on the other’s performance, so as to foster cooperation. This is the same comp package that Lou Simpson has. It is based on a rolling average of three year performance.

Buffett recently increased each of their allocation of investment capital to $2.75 billion.

They have a much bigger universe of potential investments than Buffett because of their size. They will do a great job running more money.

Combs has already racked up a large gain.

The majority of people would starve with this comp structure. Combs and Weschler could make more with a different job but with a less desirable life style.

When looking at an investment, Buffett looks at every aspect of how the world may develop over the next five to ten years. They look at all aspects of both the business and the industry. They are looking for a high level of certainty.

Managers at Berkshire have an advantage because they do not need to think about investors, lawyers, etc.

It is very hard to imagine Berkshire getting a bad result.

Getting real GDP growth of 2 1/2% over one’s lifetime if remarkable. Given the U.S.’s mature economy and the increased level of global competition, Buffett and Munger think real GDP growth of 1% is all you can expect. Add to that 2-3% of inflation – which will be lumpy. This gives an expected return on equities of 6%: 1% real growth + 2-3% for inflation + 2% dividends.

Buffett thinks superpacs are wrong. There is enough push towards a plutocracy already. You need to make a stand. He will not spend money to mislead people.

Investing in Berkshire is not for those with a short-term outlook. You should actually feel better today than a year ago because the margin of safety has grown.

They don’t pay a dividend because they think they can get more than a $1 of present value by retaining it within the company. Dividends will come out in due course but, hopefully, that day is a long time in the future.

MidAmerican may be able to put $100 billion to work over the next ten years.

Munger: Buffett has continued to learn.

They could do better with $1 million of capital because there would be many more places to look.

How do you minimize mistakes? Think about things that would not allow you to play tomorrow. Buffett does not worry about mistakes because the next mistake may be different.

He has learned more about people over the years. He will recognize the extraordinary ones perhaps more easily going forward.

They have tried  to learn a lot from the mistakes of others.

Buffett loves to read about financial markets. There is plenty of folly in this area.

They don’t build barriers to entry; they by them. You could not knock off Coke with $20 billion.

GEICO should be valued both on the basis of its float and its underwriting profit. They will grow as far as the eye can see because of their cost advantages.

Ajit must be smart on each deal. He cannot look it up in a book.

If you do 100 deals, you will learn if you are doing things right.

Earnings power is affected by current Fed policy.

Munger: the U.S. would be better off not using its natural gas now. Munger prefers to suffer now so better things will be in the future.

 

Charlie Munger on Google’s moat – it’s huge … probably widest he’s ever seen

Buffett has famously said that one useful way to think about a business’s moat – its durable competitive advantage – is to imagine that you had unlimited resources to attack it.  If you still could not topple it, you would have found a business with a solid moat.

In Google’s case, this isn’t a hypothetical.  Microsoft has spent billions of dollars in a determined effort to put a dent in Google’s moat.  So far, all they have to show for it is heavy losses and only modest market share.  It is believed that a large part of Bing’s market share has come at the expense of search engines other than Google. Microsoft was recently embarrassed when Google discovered that it was copying Google’s search results.

Charlie Munger had this to say about Google’s moat. “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”

Why?

It’s useful to think about Google’s moat the way you would think about the moat of a dominant city newspaper in the pre-Internet era.

NEWSPAPERS – THE READER’S PERSPECTIVE

For readers, the newspaper was the only game in town for keeping up with local news and an essential tool for buying a car, getting a job, learning about retail sales events, and an almost limitless number of niche activities.  Reading the paper was also quintessentially habit forming: pleasurable, repeated daily and low cost.

If you use the Internet, Google is a basic essential tool.  Its value lies in letting you navigate the Internet in a rational fashion, whether you’re looking to buy a new camera or need to know the capital of Uzbekistan.  This value grows as more information is placed on line – something that is happening at a dizzying pace – and as Google’s search algorithm improves.  Google is maniacally focused on improving its search engine and it benefits from having by far the largest number of searches to analyze and learn from.

It tells you something about a company when the company’s name becomes a verb that is synonymous with the underlying function it performs. Could you “xerox” that for me?  Google has this kind of mind share.

If you’re Bing, you can’t attack by lowering the price to customers. Google is free. At one point, Bing even tried paying people to search. There is no easy lever to disrupt the habit of going to Google each day to navigate the web.

NEWSPAPERS – THE ADVERTISER’S PERSPECTIVE

If you were an advertiser – auto dealer, employer, department store, furniture store, pretty much any local business – you needed to advertise in the newspaper because you had to be in front of your customers and that was the only cost effective way to do it.  The newspaper set the rate and you paid it.  Period.

Google is a must-have outlet for advertisers given its 65% share of U.S. search.  Its share is much higher in many international markets.  Advertisers not only pay for advertising but also work hard to optimize their sites so they show up at the top of searches on important key words.  A recent tweak in Google’s search algorithm showed the lengths that companies will go to rise in the search rankings.  A company can see it’s sales materially reduced if it falls in the rankings.

Google’s advertising is superior to that of traditional media because it is targeted and the results can be quantified.  More value means happier advertisers.  That rates are set by auction helps mitigate accusations of monopolistic price gauging which were frequently heard in the “old days” from newspaper advertisers.

A dominant daily newspaper’s growth was constrained by the development of the local economy.  Google is not constrained by local geography and is riding two huge secular waves: the transfer of advertising dollars to the Internet and the ever increasing adoption and usage of the Internet.

Regulatory risks swirl around Google but the threat to its core search business seems remote. Because Google’s business is based on technology, there is a some risk of disruption from creative destruction.  However, Google is determined to stay ahead in search and it has plenty of cash to purchase start-ups with a better idea.

Recent price: 524.20

Cash per share: 113.00

Cash adjusted price: 411.20

2012 consensus EPS estimate: 39.91

2012 cash adjusted earnings yield: 9.7%

 

Finding your Charlie Munger may boost your bottom line

In his book The Checklist Manifesto, Atul Gawande writes about how checklists are used in complex construction projects. One type of checklist that is used is a Gantt chart that lays out in infinite detail every step of a project.

Builders have found that this type of checklist alone is not enough. In the real world, there are inevitable clashes where one subsystem – a steel beam, for example – clashes with another subsystem – the placement of an HVAC duct. In such cases, experience has taught builders that the best way to manage these types of issues is to have all those affected come together and work out a solution. The inherent complexity involved requires human interaction and input from experts in various disciplines. This gives birth to a second checklist which is used to track and make sure that those conversations actually take place and the issues resolved.

In learning about this use of checklists to ensure dialog among experts, I could not help thinking about Warren Buffett and Charlie Munger. Here is Buffett – one of the best investors of all time – and over his career he has found great value in picking up the phone and discussing his investment theses with Charlie. Of course, Buffett is more than capable of making his own investment decisions, but he knows that Charlie may point something out to him that he missed.

I think all investors could benefit from having a Charlie Munger to speak with. Here is a list of what to look for:

Intelligence (although genius is not required)

Wisdom

Patience

Business acumen (actual experience a plus)

Understanding of value investing

Healthy skepticism

Broadly read

Not a “yes man” or “people pleaser”

Not prone to spouting Chauffeur knowledge

Planck knowledge vs Chauffeur knowledge

“After winning the Nobel Prize, Planck toured around giving a speech. The chauffeur memorized the speech and asked if he could give it for him, pretending to be Planck, in Munich and Planck would pretend to be the chauffeur. Planck let him do it and after the speech someone asked a tough question. The real chauffeur said that he couldn’t believe someone in such an advanced city like Munich would ask such an elementary question and as such, he was going to ask his chauffeur (Planck) to reply].

In this world we have two kinds of knowledge. One is Planck knowledge,the people who really know. They’ve paid the dues, they have the aptitude. And then we’ve got chauffeur knowledge. They have learned the talk. They may have a big head of hair, they may have fine temper in the voice, they’ll make a hell of an impression. But in the end, all they have is chauffeur knowledge

Source: Charlie Munger – USC School of Law Commencement – May 13, 2007

The internet is filled with opinions and superficial analyses that are an inch deep and a mile wide. A steady diet of this can lead to a lot of chauffeur knowledge. Couple this with over-confidence bias and you have the recipe for lousy returns at best and permanent loss of capital at worst.

Don’t succumb to this tendency. Spend the majority of your time reading source documents and forming your own opinions, and stay within your circle of competence – even if it is quite small. Rose Blumpkin got very rich focusing on one tightly defined retail niche. There are no short cuts to Plank knowledge, but that is where the money is.

Gold Hiding in Plain Sight

“Finance properly taught should be taught from cases where the investment decisions are easy,” said Munger. “And the one that I always cite is the early history of National Cash Reigster Company. It was created by a very intelligent man who bought all the patents, had the best sales force, and the best production plants. He was very intelligent man and a fanatic, all of whose passions were dedicated to the cash register business. And of course, the invention of the cash register was a godsend to retailing. You might even say that cash registers were the pharmaceuticals industry of a former age. If you read an annual report when Patterson was the CEO of National Cash Register, an idiot could tell that here was talented fanatic – very favorably located. Therefore, the investment decision was easy.” [emphasis added] – Damn Right, Janet Lowe, p. 234.

If you had read NCR’s early annual reports, it would have been obvious. That is what you should be looking for – situations that are obvious. You may only be able to find one or two a year, but that is enough to make you rich. Of course, you need to also make a meaningful investment when you find one.

The point is that the fact that NCR was a no-brainer jumped off the pages of its annual report. John Patterson was laying it all out for anyone willing to read it. This underscores the importance of spending a lot of time reading annual reports. That’s what Buffett does. The greatest investor of our time is intensely focused and jealous of his time, yet he spends most of his day reading annual reports.

Buffett is intensely critical of annual reports that are written by the PR department and have little to say of real meaning. The bad news is that there are a lot of annual reports written in this fashion. The good news is that when you find one that actually says something – where the CEO is laying out the case for why the business is a great opportunity – you may really be on to something.

There is no way to screen for these types of annual reports. You have to go out and find them one by one.

I remember the first time I read Fairfax Financial’s annual reports. It was clear that Prem Watsa was an unusual CEO and that Fairfax was an unusual company. The data was all there and the way it was presented spoke volumes. Berkshire’s shareholder letters are the same way.

History doesn’t repeat itself, but it rhymes.

Another lesson here is not just to read annual reports, but to go back and study the histories of great companies and also great failures in order to build a set of mental models that you can draw upon in analyzing and evaluating prospective investments.

When I read Munger’s description of John Henry Patterson, I could not help but be struck by how much it reminded me of his description of Wang Chuanfu, the chairman of BYD. “This guy,” Munger told Fortune, “is a combination of Thomas Edison and Jack Welch – something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.” Did Munger’s study of NCR put him in a position to see and appreciate the merits of investing in BYD when the opportunity came along?

The lessons learned from investing and studying businesses are cumulative. That’s why Munger argues Buffett is better now than he’s ever been and that he continues to get better. You should make it a point to study these past winners and losers and add them to your library of mental models. Henry Singleton of Teledyne is another example, about whom I posted recently.

As always, I welcome your own thoughts and feedback.

A Blueprint for Being a Lousy Investor

In 1986, Charlie Munger gave the commencement speech at the Harvard School, a prep school that five of his sons attended. Munger took his inspiration from a prior commencement speech given by Johnny Carson in which Carson, using inversion, told the students how they could guarantee a miserable life. Here’s Carson’s prescription:

  1. “Ingesting chemicals in an effort to alter mood or perception;
  2. Envy; and
  3. Resentment”

Munger offered his own reflections on Carson’s prescription, and added four more of his own:

  1. Be unreliable;
  2. Ignore the experience of others, both living and dead;
  3. If you get knocked down in life, stay down; and
  4. Ignore the advice of the rustic who said, “I wish I knew where I was going to die, and I’d never go there.”

Inversion allows you to see a problem or situation from a different perspective in order to gain fresh insights that you did not previously notice or that you took for granted. It is in that spirit that I offer the following advice for how to be a poor investor.

1. First, don’t spend much time looking for new investment ideas. Don’t look for ideas off the beaten path, but rather stick with ideas and themes that enjoy a strong consensus. Also, be inconsistent in searching for investment ideas and lose interest when the market is going down and everyone is negative and afraid.

2. Second, be content with superficial analysis of your investment ideas and count on being able to quickly dump your stocks if things go wrong. Don’t do your homework like you would if you were investing substantially all of your net worth in a local business or farm.  Save yourself a lot of time by making your purchase decision based on a write-up in a business magazine, analyst report or blog post.

3. Third, don’t limit yourself to simple, boring investments that are easy to understand. Look for ideas in more exotic, “fast-moving” sectors – biotech, commodities, options, alternative energy, and emerging markets – where you have little experience or competence. Ignore the examples of others – including sophisticated institutions – who have lost their capital by speculating in areas they did not understand.

4. Fourth, invest in businesses with mediocre or poor returns on invested capital that do not enjoy any durable competitive advantages. Reach for more speculative returns by betting on the turnarounds of poorly performing businesses. Count on the fact that, even though you have no expertise in a given industry, you’ll be able to predict if a struggling company will be able to turn around. Ignore the advice of investors like Buffett and Greenblatt who have found that good businesses have a much better chance of delivering satisfactory investment results.

5. Fifth, don’t take the time to investigate the track record of a company’s management. That way you won’t be troubled if management has a poor record of allocating capital, if they will be highly compensated regardless of how the business performs, or if there is evidence that they have been dishonest or unethical in their prior dealings.

6. Sixth, don’t worry about the price you pay for an investment as long as the company’s story is sufficiently exciting, loved by the media or a consensus winner. If you do decide to look at how much you’re paying, don’t spend a lot of time thinking about valuation, normalizing earnings power, and future growth prospects. Instead, rely on simple (simplistic) metrics like price-earnings ratios or price-to-book ratios where you don’t have to think too much or that don’t require as much research. Be content with a superficial valuation and assume that the factors that led to the business’ past success will be firmly in place for the next five to ten years.

7. Seventh, buy a lot of small positions. That way, you’ll never miss out on the excitement of betting on your latest hunch, and you’ll never need to worry too much about a position because it won’t overly matter if the investment works out or not. You’ll always have plenty of action and you can hedge against not really knowing much about any of your investments.

8. Eighth, embrace the newer short-term oriented approach to investing and don’t fall for an out-of-fashion strategy like patiently buying and holding an investment. Who wants to wait three to five years for an investment to work? Focus on investments that will be up big in the next six to twelve months – or sooner. Ignore the fact that there is no rational basis for consistently making short term predictions of prices.

9. Ninth, ignore the lessons of your past mistakes. It’s psychologically painful to go back over your failed investments and it takes time. Ignore developments in behavioral finance and assume that you’re above all that anyway – that you already know what you’re doing. Assume that you’ll get better results in the future without changing any of the methods and behaviors that led to your past results.

10. Finally, take pride in the fact that you already know what you need to know and that learning the lessons of financial history are a waste of time. Also, don’t take the time to study all the great investors who have generously shared their investing methods. Ignore the fact that business is an evolving, complex reality and that investing is a highly competitive endeavor where you go up against the best and the brightest. Ignore the examples of investors like Munger and Buffett – and most successful investors – who are life-long learners.

Charlie Munger: What Would he Make of Stock Recommendations and Incentives?

Charlie Munger has wisely drawn attention to the power of incentives to drive human behavior. For example, he cites the case of FedEx’s challenge of having the night shift finish processing packages on schedule. FedEx tried all kinds of things to accomplish this objective without success. Finally, they stopped paying the night shift workers by the hour and started paying them a fixed amount for the entire shift. Workers were free to go home when all the packages were processed. Problem solved.

If you are using any type of service that produces stock recommendations on a regular basis – monthly, weekly, or even daily – it makes sense to examine the recommendations in light of Munger’s thoughts on incentives. For this post, I’m not talking about the obvious incentive bias involved when someone is touting a stock. Here I’m talking about legitimate services that produce a steady stream of recommendations.

Is it possible to find such a stream of stock picks that are available at a compelling bargain price according to some fixed cycle or publishing schedule? Would subscribers keep coming back to a stock recommendation service that announced week after week that no compelling bargains were available?

In spite of Munger’s staunch disdain for efficient market theory as traditionally taught in academia, Munger teaches that the market is actually quite efficient most of the time. He likens the market to a pari-mutual race track where the odds generally reflect the capabilities of the various horses.

Here’s Munger in a talk at the USC Business School in 1994.

The model I like – to sort of simplify the notion of what goes on in a market for common stocks – is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2.  Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

Munger goes on to say that in spite of this situation, there are a select few people who are able to make good money betting on horses, even after the track taking 17% off the top. They do it by totally focusing on nothing but the performance of the horses and waiting – as long as it takes – until they see an anomaly where the odds are clearly in their favor. Then they bet heavily.

It’s something to think about the next time you turn to a source that cranks out recommendations like clockwork for scores of stocks. Think about whether it would be possible to make a living at the track trying to bet every race because you thought you could accurately handicap them all – or you used a publication that purported to do so – in a way that profitably exploited the available odds net of all transaction costs.

Opportunity Cost: Buffett & Munger’s Powerful Investing Filter

In the past year there has been a lot of discussion within the value investing community about the use of checklists. The idea has been around for awhile. For example, Poor Charlies’s Almanac, which is a compendium of Munger’s teachings and speeches, contains a copy of Munger’s investing checklist. Munger got the idea from pilots who religiously use checklists to avoid errors.

Also, for years Buffett and Munger have discussed their basic investing filters or checklist:

  1. Is it a good business?
  2. Does it have a durable competitive advantage?
  3. Does it have capable, honest management?
  4. Is it available at a good price?

The idea of investing checklists took on renewed interest as a result of the recent financial crisis as bloodied investors did post-mortems on their dismal performance and searched for tools and insights that might help them do better going forward. One source of insight was an article by Atul Gawande in The New Yorker, “The Checklist”, that showed how a simple checklist could make an enormous impact on outcomes in both simple and complex life-threatening medical procedures. Gawande went on to develop the article into a book, The Checklist Manifesto: How To Get Things Right, that expands his ideas and includes a discussion of how checklists are used by investors Monish Pabrai and Guy Spier.

At the 1998 Berkshire Hathaway annual shareholders meeting, Buffett and Munger discussed another of their basic investment filters – opportunity cost – and how they use it. (1)

Munger explained that if you have the opportunity to purchase an investment that is better than 98% of all businesses, then you can use it as a filter to automatically eliminate the other 98%. Munger conceded that it’s a simple idea and wondered aloud why it has not been more widely imitated because 1) Berkshire Hathaway was proof that it worked, 2) if practiced it tends to lead to a concentrated portfolio (which Buffett and Munger believe is the rational way to invest), and 3) it saves you a lot of time because you can quickly eliminate investment ideas that aren’t in the top 2%.

Buffett went on to explain it this way. Whenever they look at a possible investment, they immediately compare it to Coke, which Buffett views as about as perfect an investment as you will ever find. Coke not only has superior economics and growth prospects far into the future, but also its future prospects are highly certain.

Buffett puts a high premium on certainty. According to Buffett, when you invest you are trying to peer into the future. With many, if not most businesses, it’s either impossible or fraught with uncertainty. With a few businesses, however, if you do your homework, you can develop real and rational conviction about their future prospects.

If a prospective investment does not pass Buffett’s “Coke” or “Gillette” (Gillette was purchased by P&G in 2005) test, he’s unlikely to buy. Buffett went on to say that CEO’s should apply the same filter when sizing up an acquisition. If it doesn’t pass the “Coke” test, Buffett asks why not buy stock in Coke or repurchase shares in their own business? According to Buffett this would have prevented a lot of unsound deals.

This is a simple, yet powerful, filter that you can put to use immediately.

(1) Berkshire Hathaway annual meeting, 1997, Outstanding Investor Digest, August 8, 1997, p. 15.