Charlie Munger on His Investment Evaluation Process
All the passages below are taken from the book “Poor Charlie’s Almanack” edited by Peter D Kaufman. It is the Expanded Third Edition, tenth printing 2015.
The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage. It's very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. We just keep our heads down and handle the headwinds and tailwinds as best we can, and take the result after a period of years."
As we noted, Charlie doesn't make a lot of investments. His approach is perhaps best summarized by Thomas Watson Sr., the founder of IBM: "I'm no genius. I’m smart in spots, and I stay around those spots." If Charlie knows anything, he knows his "spots": his carefully identified circles of competence. To stay within these circles, he first applies a basic, overall screen, designed to limit his investment field to only "simple, understandable candidates." As he says, "We have three baskets for investing: yes, no, and too tough to understand." To identify potential "yes" candidates, Charlie looks for an easy to understand, dominant business franchise that can sustain itself and thrive in all market environments. Understandably few companies survive this first cut. Many investors favorites such as pharmaceuticals and technology, for example, go straight to the "too tough to understand” basket. Heavily promoted "deals" and IPOs earn immediate “no’s.” Those that do survive this first winnowing are subjected to the screens and filters of Charlie’s mental model approach. The process is intense and Darwinian, but also efficient. Charlie detests “placer mining,” the process of sifting through piles of sand for specks of gold. Instead, he applies his "Big Ideas from the Big Discipline” to find the large, unrecognized nuggets of gold that sometimes lie in plain sight on the ground.
Throughout his exhaustive evaluation, Charlie is no slave to a database: He takes into account all relevant aspects, both internal and external to the company and its industry, even if they are difficult to identify, measure, or reduce to numbers. His thoroughness, however, does not cause him to forget his overall “ecosystem” theme: Sometimes the maximization or minimization of a single factor (notably specialization, as he likes to point out regarding Costco’s discount warehouses) can make that single factor disproportionately important.
Charlie treats financial reports and their underlying accounting with a Midwestern dose of skepticism. At best, they are merely the beginning of a proper calculation of intrinsic valuation, not the end. The list of additional factors he examines is seemingly endless and includes such things as the current and prospective regulatory climate; state of labor, supplier, and customer relations; potential impact of changes in technology; competitive strengths and vulnerabilities; pricing power; scalability; environmental issues; and, notably, the presence of hidden exposures (Charlie knows that there is no such thing as a riskless investment candidate; he's searching for those with few risks that are easily understandable). He recasts 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 completes an assessment of the true impact, current and future, of the cost of stock options, pension plans, and retiree medical benefits. He applies equal scrutiny to the liability side of the balance sheet. For example, under right circumstances, he might 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 especially assesses a company's management well beyond conventional number crunching---in particular, the degree to which they are “able, trustworthy, and owner-oriented." For example, 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?
Above all, he attempts to assess and understand competitive advantage in every respect---products, markets, trademarks, employees, distribution channels, societal trends, and so on---and the durability of that advantage. Charlie refers to a company's competitive advantage as its "moat": the virtual physical barrier it presents against incursions. Superior companies have deep moats that are continuously widened to provide enduring protection. In this vein, Charlie carefully considers "competitive destruction" forces that, over the long term, lay siege to most companies. Munger and Buffett are laser-focused on this issue: Over their long business careers they have learned, sometimes painfully, that few businesses survive over multiple generations. Accordingly, they strive to identify and buy only those businesses with a good chance of beating these tough odds.
Finally, Charlie seeks 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). On this subject he is famous for his viewpoint that “a great business at a fair price is superior to a fair business at a great price." Warren Buffett often credits Charlie with convincing him of the wisdom of this approach: "Charlie understood this early. I was a slow learner." Charlie's insight helped Buffett move from pure Benjamin Graham-style investing to focusing on great businesses such as The Washington Post, GEICO, Coca-Cola, Gillette, and others.
Though extremely thorough, Charlie is able to ignore insignificant detail and the distractions to which others sometimes fall victim. Investment variables, just like all other variables, go through their own process of elimination. By the time he is finished with his analysis, he has reduced the candidate to its most salient elements and achieved a remarkable degree of confidence about whether or not to act. The evaluation, finally, becomes not so mathematical as philosophical. Ultimately “a feel” emerges, a function of both the analysis itself and Charlie’s lifetime of accumulated experience and skill in recognizing patterns.
“Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact Charlie had on me. It took a powerful force to move me on from Graham's limiting views. It was the power of Charlie's mind. He expanded my horizons. "
At this point, only an exceptionally superior investment candidate will still be in the running. But Charlie does not immediately rush out and buy it. Knowing that a necessary companion to proper valuation is proper timing, he applies yet a finer screen, a "prior to pulling the trigger" checklist, which is especially useful in evaluating what he refers to as “close calls” The checklist includes such items as: What are current price, volume, and trading conditions? What disclosure timing or other sensitivities exist? Do contingent exit strategies exist? Are better uses of capital currently or potentially available? Is sufficient liquid capital currently on hand or must it be borrowed? What is the opportunity cost of that capital? And so on.
Charlie’s exhaustive screening process requires considerable self-discipline and results in long periods of apparent "inactivity." But as Charlie says, "Hard work is an essential element in tracking down and perfecting a strategy or in executing it." For Charlie and Warren, the hard work is continuous, whether it results in current investing activity or not---and usually it does not. This habit of committing far more time to learning and thinking than to doing is no accident. It is the blend of discipline and patience exhibited by true masters of a craft: an uncompromising commitment to "properly playing the hand." Like world-class bridge player Richard Zeckhauser, Charlie scores himself not so much on whether he won the hand, but rather on how well he played it. While poor outcomes are 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.
On those relatively few occasions when all the circumstances are just right and Charlie does invest, he will likely make a large, decisive bet. He does not pick around the edges, take "initial positions” or make “small, speculative investment.” Such behavior implies uncertainty and Charlie’s moves, few as they are, are anything but uncertain. As he says, he practices "extreme patience combined with extreme decisiveness." Charlie's self-confidence is based not on who, or how many, agree or disagree with him, but on his ability to objectively view and measure himself. This self-mastery affords him rare objectivity in gauging his actual knowledge, experience, and correctness of thought. Again, we see the important role played by the right kinds of temperamental qualities: self-discipline, patience, calm, independence. Charlie’s level of investment performance is arguably impossible without them.
Okay, it's a good company. But is the price low enough? Is the management made up of people Munger and Buffett are comfortable with? If it is cheap enough to buy, is it cheap for the wrong reason or the right reason? What’s the flip side? What can go wrong that I haven’t seen?
What makes a great business model for Charlie? His recommended reading materials, (see Appendix) provide some guidance. Guns, Germs, and Steel, The Selfish Gene, Ice Age, and Darwin's Blind Spot all have a certain theme: a focus on the aforementioned issue of "competitive destruction" and an examination of why some entities are nevertheless able to adapt, survive, and even dominate over time. When this theme is extrapolated into investment selection, the preferred Munger business emerges: Some thrive by outcompeting (a la Selfish Gene) and others by outcooperating (Darwin’s Blind Spot). Once again, we see Charlie's rich fluency across a broad range of disciplines at work: How many investors ever consider, as Charlie routinely does, such a broad and sophisticated spectrum of factors? To name but a few, he routinely considers factors such as conversion, i.e., how the laws of thermodynamics intersect with laws of economics (for instance how paper and petroleum become a newspaper delivered to a front door), psychological tendencies and incentives (notably the extreme behavior pressures they create, both good and bad), and fundamental sustainability over time (the constant and often deadly interplay between positive factors such as “moats” and the ravages of competitive destruction). Charlie is possibly without peer when it comes to the checklist of atypical investment factors he considers and his deep fluency in the diverse disciplines from which they are drawn.
“All intelligent investing is value investing---acquiring more than you are paying for. You must value the business in order to value the stock." [65-72]
Appendix---Charlie Munger’s Recommended Books
"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---and at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."
· Deep Simplicity: Bringing Order to Chaos and Complexity John Gribbin, Random House (2005)
· F.LA.S.C.O.: The Inside Story of a Wall Street Trader Frank Partnoy, Penguin Books (1999)
· Ice Age John & Mary Gribbin, Barnes & Noble (2002)
· How the Scots Invented the Modern World: The True Story of How Western Europe's Poorest Nation Created Our World & Everything in It Arthur Herman, Three Rivers Press (2002)
· Models of My Life Herbert A. Simon, The MIT Press (1996)
· A Matter of Degrees: What Temperature Reveals About the Past and Future of Our Species, Planet, and Universe Gino Segre, Viking Books (2002)
· Andrew Carnegie Joseph Frazier Wall, Oxford University Press (1970)
· Guns, Germs, and Steel: The Fates of Human Societies Jared M. Diamond, W. W. Norton & Company (1999)
· The Third Chimpanzee: The Evolution and Future of the Human Animal Jared M. Diamond, Perennial (1992)
· Influence The Psychology of Persuasion Robert B Cialdini, Perennial Currents (1998)
· The Autobiography of Benjamin Franklin Benjamin Franklin, Yale Nota Bene (2003)
· Living Within Limits: Ecology, Economics, and Population Taboos Garrett Hardin, Oxford University Press (1995)
· The Selfish Gene Richard Dawkins, Oxford University Press (1990)
· Titan: The Life of John D. Rockefeller, Sr. Ron Chernow, Vintage (2004)
· The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor David S. Landes, W W. Norton & Company (1998)
· The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy Robert G. Hagstrom, Wiley (2000)
· Genome: The Autobiography of a Species in 23 Chapters Matt Ridley, HarperCollins Publishers (2000)
· Getting to Yes: Negotiating Agreement Without Giving In Roger Fisher, William Ury, and Bruce Patton, Penguin Books (1991)
· Three Scientists and Their Gods: Looking for Meaning in an Age of Information Robert Wright, HarperCollins Publishers (1989)
· Only the Paranoid Survive Andy Grove, Currency (1996)
And a few from your editor...
· Les Schwab: Pride in Performance Les Schwab, Pacific Northwest Books (1986)
· Men and Rubber: The Story of Business Harvey S. Firestone, Kessinger Publishing (2003)
· Men to Match My Mountains: The Opening of the Far West, 1840-1900 Irving Stone, Book Sales (2001)