Warren Buffett once said, “Charlie Munger can analyze and evaluate any kind of deal faster and more accurately than any man alive. He sees any valid weakness in 60 seconds. He is a perfect partner.” What inspired such high praise? The answer lies in the markedly original approach Charlie Munger applied to life, learning and decision-making.
Charlie counted preparation, patience, discipline and objectivity among his most fundamental guiding principles. When faithfully adhered to, these traits result in one of the best-known Munger characteristics: not buying or selling very often.
Munger, like Buffett, believed a successful investment career boils down to just a handful of decisions. So when Charlie liked a business, he made a very large bet and typically held the position for a long period. Charlie called it “sit-on-your-ass investing” and cited its benefits: “You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two or three percentage points per annum.”
In his view, a portfolio of three companies is plenty of diversification. Accordingly, Charlie Munger was willing to commit high percentages of his investment capital to individual, “focused” opportunities.
Charlie didn’t make a lot of investments. As he said, “We have three baskets for investing: yes, no and too tough to understand.” To identify potential “yes” candidates, Charlie looked for an easy-to-understand, dominant business franchise that can sustain itself and thrive in all market environments. Few companies survived this first cut. Pharmaceuticals and technology, for example, went straight to the “too tough to understand” basket. Heavily promoted “deals” and IPOs earned immediate nos.
Those that survived were subjected to the screens and filters of Charlie’s mental-models approach. The process was intense and Darwinian but also efficient. Charlie detested “placer mining,” the process of sifting through piles of sand for specks of gold. Instead, he applied his “big ideas from the big disciplines” to find the large, unrecognized nuggets of gold that sometimes lie in plain sight.
Charlie took into account all relevant aspects, both internal and external to the company and its industry, even if they were difficult to identify, measure or reduce to numbers. His thoroughness, however, did not cause him to forget his overall ecosystem theme: Sometimes the maximization or minimization of a single factor (notably specialization) would make that single factor disproportionately important.
Charlie treated financial reports and their underlying accounting with a dose of Midwestern skepticism. At best, they were merely the beginning of a proper calculation of intrinsic valuation. The list of additional factors he would examine included such things as the current and prospective regulatory climate; the state of labor, supplier and customer relations; the potential impact of changes in technology; competitive strengths and vulnerabilities; pricing power; scalability; environmental issues; and, notably, the presence of hidden exposures. (Charlie knew that there was no such thing as a riskless investment candidate; he searched for those with a few risks that were easily understandable.) He recasted all financial statement figures to fit his own view of reality, including the actual free or owners’ cash being produced, inventory and other working capital assets, fixed assets and such frequently overstated intangible assets as goodwill.
He also completed an assessment of the true impact, current and future, of the cost of stock options, pension plans and retiree medical benefits. He applied equal scrutiny to the liability side of the balance sheet. For example, under the right circumstances, he would view an obligation such as insurance float—premium income that may not be paid out in claims for many years—more properly as an asset. He would especially assess a company’s management well beyond conventional number crunching—in particular, the degree to which they were “able, trustworthy and owner-oriented.” For example, he would consider: how do they deploy cash? Do they allocate it intelligently on behalf of the owners, or do they overcompensate themselves or pursue ego-oriented growth for growth’s sake?
‘Don’t Do Cocaine’
At the 2004 Berkshire Hathaway annual meeting, a young shareholder once asked Buffett how to succeed in life. After Buffett shared his thoughts, Charlie chimed in: “Don’t do cocaine. Don’t race trains. And avoid AIDS situations.” Many would dismiss his seemingly flippant answer as merely humorous (which it certainly was), but in fact it also faithfully reflected both his general views on avoiding trouble in life and his particular method for avoiding missteps in investing.
Often, as in this case, Charlie generally focused first on what to avoid—that is, on what not to do—before he considered the affirmative steps he would take in a given situation. “All I want to know is where I’m going to die, so I’ll never go there” was one of his favorite quips. In business, as in life, Charlie gained enormous advantage by summarily eliminating the unpromising portions of the chessboard, freeing his time and attention for the more productive regions. Charlie strived to reduce complex situations to their most basic, unemotional fundamentals.
Yet, within this pursuit of rationality and simplicity, he was careful to avoid what he called physics envy, the common human craving to reduce enormously complex systems (such as those in economics) to one-size-fits-all Newtonian formulas. Instead, he faithfully honored Albert Einstein’s admonition: “A scientific theory should be as simple as possible, but no simpler.” Or, in his own words: “What I’m against is being very confident and feeling that you know, for sure, that your particular action will do more good than harm. You’re dealing with highly complex systems wherein everything is interacting with everything else.”
Benjamin Graham played a significant role in forming Charlie’s investing outlook. One of the most enduring concepts in Graham’s The Intelligent Investor is Mr. Market. Usually, Mr. Market is a temperate and reasonable fellow, but some days he is gripped by irrational fear or greed. Graham cautioned the investor to carefully use his own unemotional judgment of value instead of relying on the often manic-depressive behavior of the financial markets. Similarly, Charlie recognized that even among the most competent and motivated of people, decisions are not always made on a purely rational basis. For this reason, he considered the psychological factors of human misjudgment some of the most important mental models that can be applied to an investment opportunity.
Where’s Your Moat?
Charlie referred to a company’s competitive advantage as its moat: the barrier it presents against incursions. Superior companies have deep moats that are continuously widened to provide enduring protection. In this vein, Charlie carefully considered competitive destruction forces that, over the long term, lay siege to most companies. Munger and Buffett laser-focused on this issue: Their long business careers taught them that few businesses survive over multiple generations.
Finally, Charlie sought to calculate the intrinsic value of the whole business and, with allowance for potential dilution, etc., to determine an approximate value per share to compare to market prices. This latter comparison is the fundamental purpose of the whole process—comparing value (what you get) with price (what you pay). He was famous for his viewpoint that “a great business at a fair price is superior to a fair business at a great price.”
By the time he was finished, his analysis reduced the candidate to its most salient elements and achieved a remarkable degree of confidence about whether or not to act. The evaluation, finally, became not so much mathematical as philosophical. Ultimately, a “feel” emerged, a function of both the analysis itself and Charlie’s accumulated experience and skill in recognizing patterns.
At this point, only an exceptionally superior investment candidate would still be in the running. But Charlie did not rush out and buy it. Instead, he applied a “prior to pulling the trigger” checklist.
Charlie’s screening process required considerable self-discipline and resulted in long periods of apparent inactivity. But, as Charlie said, “Hard work is an essential element in tracking down and perfecting a strategy, or in executing it.” For Charlie, the hard work was continuous, whether or not it resulted in current investing activity—and usually it did not. This habit of committing far more time to learning and thinking than to doing was no accident. It was the blend of discipline and patience exhibited by Warren Buffett and Charlie, true masters of a craft: an uncompromising commitment to “properly playing the hand.”
Charlie scored himself not so much on whether he won the hand but rather on how well he played it. While poor outcomes were excusable in the Munger-Buffett world—given the fact that some outcomes are outside of their control—sloppy preparation and decision-making are never excusable because they are controllable. CBM
Here is the checklist methodology Charlie advocated. Note, however, that the following principles were most certainly not employed by Charlie one-by-one or in one-time fashion as the checklist format might seem to imply. Nor can they necessarily be prioritized in terms of any apparent or relative importance. Rather, each must be considered as part of the complex whole of the investment analysis process.
“We’re partial to putting out large amounts of money where we won’t have to make another decision,” Charlie said. “If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you can buy a few great companies, then you can sit on your ass. That’s a good thing.”
All investment evaluations should begin by measuring risk, especially reputational.
- Incorporate an appropriate margin of safety.
- Avoid dealing with people of questionable character.
- Insist upon proper compensation for risk assumed.
- Always beware of inflation and interest rate exposures.
- Avoid big mistakes; shun permanent capital loss.
“Only in fairy tales are emperors told they are naked.”
- Objectivity and rationality require independence of thought.
- Remember that just because other people agree or disagree with you doesn’t make you right or wrong—the only thing that matters is the correctness of your analysis and judgment.
- Mimicking the herd invites regression to the mean (merely average performance).
“The only way to win is to work, work, work, work and hope to have a few
- Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.
- More important than the will to win is the will to prepare.
- Develop fluency in mental models from the major academic disciplines.
- If you want to get smart, the question you have to keep asking is “Why, why, why?”
Acknowledging what you don’t know is the dawning of wisdom.
- Stay within a well-defined circle of competence.
- Identify and reconcile disconfirming evidence.
- Resist the craving for false precision, false certainties, etc.
- Above all, never fool yourself, and remember that you are the easiest person to fool.
Use of the scientific method and effective checklists minimizes errors and omissions.
- Determine value apart from price, progress apart from activity, wealth apart from size.
- It is better to remember the obvious than to grasp the esoteric.
- Be a business analyst, not a market, macroeconomic or security analyst.
- Consider the totality of risk and effect; look always at potential second-order and higher-level impacts.
- Think forward and backward: Invert, always invert.
Proper allocation of capital is an investor’s No. 1 job.
- Remember that the highest and best use is always measured by the next best use (opportunity cost).
- Good ideas are rare—when the odds are greatly in your favor, bet (allocate) heavily.
- Don’t fall in love with an investment—be situation-dependent and opportunity-
Resist the natural human bias to act.
- “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily.
- Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake.
- Be alert for the arrival of luck.
- Enjoy the process along with the proceeds, because the process is where you live.
When proper circumstances present themselves, act with decisiveness and conviction.
- Be fearful when others are greedy and greedy when others are fearful.
- Opportunity doesn’t come often, so seize it when it does.
- Opportunity meeting the prepared mind—that’s the game.
Live with change and accept unremovable complexity.
- Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you.
- Continually challenge and willingly amend your best-loved ideas.
- Recognize reality even when you don’t like it—especially when you don’t like it.
Remember that reputation and integrity are your most valuable assets—and can be lost in a heartbeat. Keep things simple and remember what you set out to do.
- Guard against the effects of hubris and boredom.
- Don’t overlook the obvious by drowning in minutiae.
- Be careful to exclude unneeded information or slop: “A small leak can sink a great ship.”
- Face your big troubles; don’t sweep them under the rug.