Charlie Munger on The Eight Variables in the Graham Value Investing System


         All the passages below are taken from the book “Charlie Munger---The Complete Investor” by Tren Griffin. It was published in 2015.


NOW THAT THE fundamental principles of the Graham value investing system have been discussed, it is time to discuss how investors can differ in their styles and still remain Graham value investors. You will recall that in this book's Principles, Right Stuff, and Variables framework, aspects of a Graham value investor's style that differ are called variables.


First Variable: Determining the Appropriate Intrinsic Value of a Business


The definition of intrinsic value in the Owner's Manual of Berkshire Hathaway is as follows:


Intrinsic value can be defined simply: It's the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it's additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.




Because the cash that can flow from a business is not an annuity and instead is based on a number of fundamental factors that are impossible to predict with certainty, determining the value of a business is an art and not a science. Almost every investor will have a slightly different way of determining the intrinsic value of a business, and there is nothing inherently wrong with that fact. For this reason, it is best to think about intrinsic value as falling within a range rather than an exact figure.

Some businesses have an intrinsic value that is relatively easy to calculate, whereas other businesses have an intrinsic value that value investors have little idea how to calculate. Munger does not even try to value businesses in every possible case:


We have no system for estimating the correct value of all businesses. We put almost all in the "too hard" pile and sift through a few easy ones.



In an ideal situation, the process of determining the intrinsic valuation of a business is easy enough that Munger can do that valuation in his head. While people of more ordinary intelligence may need to use a calculator to do the same mathematics, Munger's point about a desire for simplicity and an obvious result remains true for any Graham value investor. If Munger determines that the valuation of the business is too hard, he simply says, "I pass." This is such a powerful and underutilized idea. To use a baseball analogy, Munger and Buffett love the fact that they are not required to swing the bat as an investor in response to every pitch.

The tendency of many people who are overconfident is just the reverse of Munger's use of a "too hard" pile. In other words, people with a high IQ often relish the opportunity to solve hard valuation problems, thinking that they will be rewarded for having such ample mental skill with a higher return. The reality is that, in trying to solve hard problems, emotional and psychological problems cause the losses rather than a lack of intelligence. Hard problems are hard problems, pregnant with opportunities to make mistakes.

Determining the value of a business is best done and is most reliable when the process is simple. Even in a case where the process is relatively simple, a Graham value investor must remember that the valuation process is inherently imprecise. An imprecise value is perfectly acceptable to a value investor because the Graham value investor is looking for a margin of safety that is so substantial that precise calculation is unnecessary. A good analogy is a waiter trying to decide whether a customer is above the legal drinking age. There are certain restaurant patrons who are obviously older than the legal drinking age, just as there are certain businesses with an intrinsic value that obviously provides the necessary margin of safety.

Buffett and Munger admit they do not have exactly the same definition of intrinsic value. Buffett believes:


Intrinsic value is terribly important but very fuzzy. Two people looking at the same set of facts, moreover---and this would apply even to Charlie and me---will almost inevitably come up with at least slightly different intrinsic value figures.



The definition is fuzzy enough that really smart and experienced investors can do the math in their head.


Warren talks about these discounted cash flows. I've never seen him do one.



In his 1994 Berkshire chairman's letter, Buffett wrote that "intrinsic value [is] a number that is impossible to pinpoint but essential to estimate.... Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses."1 While the views and approaches to valuation may vary in some detail, they are generally consistent. Valuation is not a process in which a Graham value investor makes stuff up as he or she goes along. In the view of Michael Price: "Intrinsic value is what a businessman would pay for total control of the business with full due diligence and a big bank line. The biggest indicator to me is where the fully controlled position trades, not where the market trades it or where the stock trades relative to comparable [businesses]."2

There are some businesses with certain qualities that Munger will not touch with a ten-foot pole:


There are two kinds of businesses: The first earns 12 percent, and you can take it out at the end of the year. The second earns 12 percent, but all the excess cash must be reinvested---there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business.



When Munger and Buffett value a business, they use what they call owner's earnings as the starting point. Owner's earnings can be defined as: Net income + Depreciation + Depletion + Amortization - Capital expenditure - Additional working capital. Berkshire uses the owner's earnings figure in this process to take into account capital expenditures that will be necessary to maintain the business's return on equity. A more complete explanation of an owner's earnings calculation is provided in the section of this book called Berkshire Math.

Owner's earnings is not a typical valuation metric. Other Graham value investors may use different metrics, like earnings before interest and taxes (EBIT), in calculating value. For example, in The Little Book that Beats the Market, Greenblatt says that he views the depreciation part of EBIT as a proxy for capital expenditures and seems to imply that replacing depreciation with capital expenditure would be a better approach.

Buffett has views on the importance of growth in determining the value of a business, which echo Munger's approach:


Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.... Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.



It is more important that the definition of intrinsic value stay consistent in the mind of a given investor than that the calculation be the same as every other Graham value investor. As will be explained, intrinsic value is a reference point in the final analysis for investors as they patiently watch the price of an investment gyrates up and down in price over time. In doing a valuation analysis, Graham value investors like Munger are very conservative.



Second Variable: Determining the Appropriate Margin of Safety


Margin o f safety is a simple idea that is applied in different ways by different investors. Some investors like to have a margin of safety that is much larger than others. For example, one Graham value investor may require a 25 percent margin of safety, whereas another needs 40 percent. Of course, because the concept of intrinsic value itself is imprecise, the calculation of margin of safety is necessarily imprecise. Making things easier is the fact that Munger and Buffett like the amount of a margin of safety to be so big that they need not do any math other than in their heads. Of course, Buffett and Munger can do more mathematics in their heads than an average person can do on a calculator, but the point remains. Munger wants the math involved in evaluating an investment to be simple, overpoweringly clear, and positive. Bill Gates has commented on this point:


Being good with numbers doesn't necessarily correlate with being a good investor. Warren doesn't outperform other investors because he computes odds better. That's not it at all. Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation. He doesn't invest---take a swing of the bat---unless the opportunity appears unbelievably good.

                  -BILL GATES, FORTUNE, I996


Many people make the mistake of assuming that buying a quality company ensures safety. A given company may be a quality company with an attractive business, but that alone is not enough because the price you pay for a share of stock matters. A company like Facebook, Nike, or even Berkshire may be an important company with lots of revenue and profit, but its business is not worth an infinite price. Howard Marks put it best:


Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them.... Elevated popular opinion, then, isn't just the source of low return potential, but also of high risk.



Similarly, just because the price of a share of stock in a company is beaten down from formerly high levels does not make it safe to buy. In other words, that a given company is way off its value of a few years ago does not necessarily make the purchase of the stock safe in terms of a margin of safety.

Munger talked once about the concept of margin of safety in describing Buffett's mentor Benjamin Graham in this way:


Graham had this concept of value to a private owner---what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety---as he put it---by having this big excess value going for you.



While the calculations of the intrinsic value and margin of safety are imprecise and fuzzy, they remain critical tasks in the Graham value investing system. As James Montier wrote:


Valuation is the closest thing to the law of gravity that we have in finance. It's the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.



The golden rule of investing: no asset (or strategy) is so good that you should invest irrespective of the price paid.




Third Variable: Determining the Scope of an Investor's Circle of Competence


We have to deal with things that we're capable of understanding.



We'd rather deal with what we understand. Why should we want to play a competitive game in a field where we have no advantages---maybe a disadvantage---instead of playing in a field where we have a clear advantage? Each of you will have to figure out where your talent lies. And you'll have to use your advantages. But if you try to succeed in what you're worst at, you're going to have a very lousy career. I can almost guarantee it. To do otherwise, you'd have to buy a winning lottery ticket or get very lucky somewhere else.



I don't think it's difficult to figure out competence. If you're 5'2", say no to professional basketball. Ninety-two years old, you're not going to be the romantic lead in Hollywood. At 350 pounds, you don't dance the lead in the Bolshoi ballet ... Competency is a relative concept.



I'm really better at determining my level of incompetency and then just avoiding that. And I prefer to think that question through in reverse. We have a good batting average and that is probably because we are a little more competent than we think we are.

                  -CHARLIE MUNGER, CNBC INTERVIEW, 2014


Understanding the limits of your own competence is very valuable. Venture capitalist Fred Wilson put it simply: "The only way you win is by knowing what you're good at and what you're not good at, and sticking to what you're good at." 3 Munger similarly believes that investors who get outside of what he calls their circle of competence can easily find themselves in big trouble. Within his or her circle of competence, an investor has expertise and knowledge that gives them a significant advantage over the market in evaluating an investment.

The idea behind the circle of competence is so simple that it is arguably embarrassing to say it out loud: when you do not know what you're doing, it is riskier than when you do know what you're doing. What could be simpler? And yet, humans often do not act in accordance with this idea. For example, the otherwise smart doctor or dentist is easy prey for the promoter selling limited partnerships or securities in a company that makes technology for the petroleum industry.

Munger has pointed out that even one of the world's greatest investors stepped outside of his circle of competence during the Internet bubble:


Soros couldn't bear to see others make money in the technology sector without him, and he got killed.



The circle of competence approach is a form of opportunity cost analysis, says Munger:


Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly.



The value of specialization is, of course, at work here too. Munger put it this way:


Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.



Munger has a range of approaches he uses to avoid mistakes. To make this point by analogy, Munger is fond of saying that he wants to know where he will die so he can intentionally never go there. His friend and investor Li Lu described one such approach:


When Charlie thinks about things, he starts by inverting. To understand how to be happy in life Charlie will study how to make life miserable; to examine how a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market.



By adopting this approach Munger is trying hard to limit his investing to areas in which he has a significant advantage in terms of competence and not just a basic understanding. To illustrate this point, he has in the past talked about a man who had "managed to corner the market in shoe buttons---a really small market, but he had it all."4 It is possible to earn an attractive financial return in a very limited domain like shoe buttons, although that is an extreme example of a very narrow circle of competence. The areas in which you might have a circle of competence will hopefully be significantly larger than just shoe buttons. However, if you try to expand that circle of competence too far, it can have disastrous results. Li Lu has written about how Munger has described this point to him:


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.



Once the borders of a circle of competence are established, the challenge is to remain inside those borders. Staying within a circle of competence is obviously not rocket science in theory, but it is hard for most people to do in practice. Lapses by investors are more likely to occur when they meet a slick promoter who is highly skilled at telling stories. This is a case where emotional intelligence, which is very different than intellectual intelligence, becomes critically important. Humans love stories because they cause them to suspend disbelief. Some of the biggest frauds in financial history, like Bernie Madoff and Ken Lay, were excellent storytellers. Stories cause people to suspend disbelief, and being in that state is harmful to any person's investing process.

Too many investors confuse familiarity with competence. For example, just because a person flies on airlines a lot does not mean that he or she understands the airline industry well enough to be competent as an investor in that sector of the economy. Using Facebook a lot does not make you qualified to invest in a social media startup. If you have not gone beyond simply using a product or service and have not taken a deep dive into the business of a company, you should not invest in that company.

Among the people who know how to stay within their circle of competence are the chief executive officers of Berkshire subsidiaries. For example, Buffett once pointed to Rose Blumkin of Furniture Mart as a person who fully understands the dimensions of her capabilities:


[If] you got about two inches outside the perimeter of her circle of competence, she didn't even talk about it. She knew exactly what she was good at, and she had no desire to kid herself about those things.

                  -WARREN BUFFETT, THE SNOWBALL, 2008


Knowing the boundaries of your circle of competence is critically important. He feels that the answer should be obvious:


If you have competence, you pretty much know its boundaries already. To ask the question [of whether you're past the boundary] is to answer it.



Buffett talks about that fact that knowing where the perimeter of your circle of competence may be is far more important than the size of your circle. If you are only competent in spots and stay in those spots, you can do just fine. Munger has said on this point:


There are a lot of things we pass on. All of you have to look for a special area of competency and focus on that.



It is critical that an investor remain focused on avoiding mistakes. If someone tries to sell you something that requires decisions that are too hard, you have the option to just say no. Why would you do what is hard when you can find investments that involve easy decisions? In using a circle of competence filter, Munger is trying to invest only when he has an unfair advantage. Otherwise, he wants to do nothing (which most people find very hard to do).


The reason we are not in high-tech businesses is that we have a special lack of aptitude in that area. And, yes-low-tech business can be plenty hard. Just try to open a restaurant and make it succeed.... Why should it be easy to get rich? In a competitive world, shouldn't an easy way to get rich be impossible.



In a sector of the economy like technology, Munger and Buffett have both said they do not understand the businesses well enough to be technology investors. They don't feel like they can forecast what owners' earnings from a technology-driven business will be like even in five years, let alone for decades. Because every business uses technology, Munger and Buffett are not excluding them from their circle of competence.

Munger's reluctance to invest in the technology sector can be traced to mistakes that he made early in his life because he stepped outside of his circle of competence. Munger received his first taste of the technology business when he bought into a company that made instruments early in his investing career. His experience in that case was not good. His top scientist was hired away by a venture capitalist; then magnetic tape came along, which made the performance of the business even worse. Munger said once that the entire experience nearly made him, in his words, "go broke."


Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies. Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it's going to be very hard to advance that circle. If I had to make my living as a musician---I can't even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.



Munger's personal decision regarding investing in technology companies does not mean that the technology sector is not right for other people who have a circle of competence that includes technology.

Technology presents additional challenges because uncertainty is high and the speed of innovation vastly faster. Buffett has said: "Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter."5 An investor can cope with that difference by being careful about his or her circle of competence within technology. To know a lot about graphics chips is not necessarily to know much about wireless data, for example. To think otherwise is to tempt fate. As Clint Eastwood asked in the movie Dirty Harry: "You've got to ask yourself one question: `Do I feel lucky?' Well, do ya?"



Fourth Variable: Determining How Much of Each Security to Buy


Our investment style has been given a name---focus investing---which implies 10 holdings, not 100 or 400. Focus investing is growing somewhat, but what's really growing is the unlimited use of consultants to advise on asset allocation, to analyze other consultants, etc.



In addition to complaining about consultants and their fees, Munger is saying that diversification is not an approach that is attractive to him. Some Graham value investors diversify, while others like Munger concentrate their investment portfolio. A person can adopt either concentrated or diversified portfolio strategies and still be a Graham value investor. Once he made the decision to become an active investor, Munger became a devotee of concentrating his investments. Typical of Munger's views on these issues is the following:


[With] closet indexing ... you're paying a manager a fortune and he has 85 percent of his assets invested parallel to the indexes. If you have such a system, you're being played for a sucker.



Munger developed this philosophy in no small part by learning from the example of Phil Fisher. When it comes to diversification versus concentration, Munger believes that focus is the better answer for him:


I always like it when someone attractive to me agrees with me, so I have fond memories of Phil Fisher. The idea that it was hard to find good investments, to concentrate in a few, seems to me to be an obviously good idea. But 98 percent of the investment world doesn't think this way.



Each investor who chooses focus investing over diversification has a slightly different reason for doing so, but there is commonality on some points. Seth Klarman pointed out that it is better to know a lot about ten or fifteen companies than to know just a little about many. The number of stocks a person can realistically follow and understand the economics of the specific business better than the market is significantly less than twenty. For example, the idea that a dentist working full time in his or her profession is going to pick technology stocks better than the market, especially after fees and expenses, is unlikely. Remember the task is not just to pick a quality company, but to find a mispriced bet.

There are other Graham value investors who disagree with Munger and instead believe in diversification. Two notable examples were Ben Graham himself and Walter Schloss. Jason Zweig has pointed out that, "Even the great investment analyst Benjamin Graham urged `adequate though not excessive diversification,' which he defined as between 10 and about 30 securities."6 After a significant number of years had passed after the Great Depression, it was no longer possible to be widely diversified and only invest in public stocks. Some investors who seek greater diversification than Munger invest in less liquid and less frequently traded markets, like distressed debt. Of course, these less liquid and traded markets are also places where asset mispricing is more likely to occur, and rational Graham value investors can find bargains. Buffett believes that diversification is protection against not knowing what you're doing---and when it comes to investing, nearly no one knows what they are doing. The most diversified approach is to buy a portfolio of low-fee index funds and exchange-traded funds.

Munger considers one of the saddest cases in investing to be when someone thinks they are an active investor, but in reality they have invested in so many stocks that they have become "closet indexers." Investors who adopt the Berkshire system are focus investors. Munger noted:


The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?




Fifth Variable: Determining When to Sell a Security


Selling [something] when it approaches your calculation of its intrinsic value [is] hard. But if you buy a few great companies, then you can sit on your ass. That's a good thing.



We tend not to sell operating businesses. That is a lifestyle choice. We have bought well. We have a few which would be better if we sold them. But net we do better if we don't do gin rummy management, churning our portfolio. We want a reputation as not being churners and flippers. Competitive advantage is being not a churner.



To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning, and that pays three to one. In other words, we're looking for a mispriced gamble. That's what investing is, and you have to know enough to know whether the gamble is mispriced.



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 is pointing out in the above quotes that Graham value investors have adopted a range of approaches to the question of when or whether to sell a given investment. Munger prefers to buy a business or a portion of a business and own it essentially forever. His preference is in no small part driven by the ability of a long-term holder of an asset to gain certain tax and other advantages. By not incurring these tax costs, transaction costs, and other fees, the compounding benefits for the investor are substantially higher. Unlike Munger, some other Graham value investors choose to sell assets when they reach something approaching their intrinsic value. There is no right answer on whether or when to sell an asset, and how a particular investor answers this question is partially a matter of temperament. However, most Graham value investors seem to prefer Munger's approach.



Sixth Variable: Determining How Much to Bet When You Find a Mispriced Asset


It's not given to human beings to have such talent that they can just know everything about everything all the time. But it's given to human beings who work hard at it---who look and sift the world for a mispriced bet---that they can occasionally find one.



We came to this notion of finding a mispriced bet and loading up when we were very confident that we were right.



The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.



Playing poker in the Army and as a young lawyer honed my business skills.... What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don't get a big edge often.



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 race track.... 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.

                  -CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994


By investing only within his circle of competence, Munger is trying to invest only when he has an unfair advantage. When he has an unfair advantage, which is not that often, he bets big. This means he will be less active than other investors. Munger believes that buying and selling a stock for its own sake (e.g., to stay busy) is a very bad idea. Munger's bias against what he calls investment hyperactivity is quite strong. When in doubt, his suggestion is that you do nothing.


Around here, I would say that if our predictions have been a little better than other people's, it's because we've tried to make fewer of them.



We try and predict what individual investments will swim well in relation to the tide. And then we tend to accept the effects of the tide as those effects fall.



Munger does not like situations where there is a close investment decision to make. He would certainly not invest in anything with a big downside and a small upside. One of the best ways I have ever heard the idea behind his philosophy expressed was by the famed investor Sam Zell:


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 a 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.



In terms of finance theory, what a smart investor is looking for is optionality. Nassim Taleb described what the smart investor is looking for in this way: "Payoffs [that] follow a power law type of statistical distribution, with big, near unlimited upside but because of optionality, limited downside."7 There is a joke that illustrates the value of optionality: An investment banker and carpenter are sitting next to each other on a long flight. The investment banker asks the carpenter if she would like to play a fun game. The carpenter is tired and just wants to have a nap, so she politely declines and tries to sleep. The investment banker loudly insists that the game is a lot of fun and says, "I will ask you a question, and if you don't know the answer you must pay me only $5. Then you ask me one question, and if I don't know the answer, I will pay you $500." To keep him quiet, she agrees to play the game.

The investment banker asks the first question: "What's the distance from the earth to the Saturn?" The carpenter doesn't say a word, pulls out $5, and hands it to the investment banker.

The carpenter then asks the investment banker, "What goes up a hill with three legs and comes down with four?" She then closes her eyes again to rest.

The investment banker immediately opens his laptop computer, connects to the in-flight Wi-Fi, and searches the Internet for an answer without success. He then sends emails to all of his smart friends, who also have no answer. After two hours of searching, he finally gives up. The investment banker wakes up the carpenter and hands her $500. The carpenter takes the $500 and goes back to sleep. The investment banker is going crazy from not knowing the answer. So he wakes her up and asks, "What does go up a hill with three legs and comes down with four?"

The carpenter hands the investment banker $5 and goes back to sleep.



Seventh Variable: 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's approach to valuing a business is influenced in part by Ben Graham and in part by Phil Fisher. The importance of Phil Fisher to the evolution of Munger's thinking on the Graham value investing system is fundamental. For Fisher, wide diversification is essentially a form of closet indexing. He instead believed that an investor should focus on a relatively small number of stocks if he or she expects to outperform a market. Fisher preferred a holding period of almost forever; for example, he bought Motorola in 1955 and held it until 2004. Fisher also believed that a fat pitch investment opportunity is delivered rarely and only to those investors who are willing to patiently work to find them. Fisher felt that business cycles and changes in Mr. Market's attitude are inevitable. Unlike many other investors, Fisher assigned significant weight to the quality of the underlying business. For this reason, Fisher was able to outperform markets as an investor, even though he did not look for cigar-butt stocks.

An approach that incorporates the ideas of Fisher is very different from the approach of a Graham value investor like Seth Klarman. Both Munger and Seth Klarman want a margin of safety, which is a Graham value investing principle, but each investor chooses to calculate both intrinsic value and margin of safety in different ways. For Mnnger, the approach used by Fisher was clearly superior:


If I'd never lived, Warren would have morphed into liking the better businesses better and being less interested in deep-value cigar butts. The supply of cigar butts was running out.... The natural drift was going that way without Charlie Munger. But he'd been brainwashed a little by worshiping Ben Graham and making so much money following traditional Graham methods that I may have pushed him along a little faster in the direction that he was already going.



The trouble with what I call the classic Ben Graham concept is that gradually the world wised up [after enough time had passed after the Great Depression] and those real obvious bargains disappeared.... Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.



Buffett today is arguably more like Fisher than the 15 percent he once specified, but only he knows how much of my assertion is true. It was the influence of Munger that moved Buffett a considerable distance away from a pure Ben Graham approach. Their investment in See's Candies was an early example in which Berkshire paid more for a quality company. What Munger and Buffett found was that See's Candies had untapped pricing power which was able to increase its financial return in a very significant way. The two investors found after they bought See's Candies, they could regularly raise prices and customers did not seem to care. Munger calls this ability to raise prices and not cause a significant drop in sales "pricing power." Buffett said once, "More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price."8 What Charlie is talking about here is the idea that a business with superior quality bought at the right price can still be a bargain purchase consistent with the principles of the Graham value investing system.

Part of the reason this shift to Fisher's approach to valuing a business happened is that the sorts of companies that Graham liked to buy started to disappear the further away the time period was from the Great Depression. The other push toward Fisher's ideas came because of the success Munger and Buffett were having in markets. Because of their consistent and persistent financial success, Berkshire must put massive amounts of cash to work every year, and finding enough cigar-butt investments at that scale is an impossible task.

Unlike more pure Graham style investors, Munger believed his investing style had to evolve.


Grahamites ... realized that some company that was selling at two or three times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.



For Munger, not considering the quality of the underlying business when buying an asset is far too limiting.


The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It's just that simple.



We've really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high-quality businesses. And most of the other people who've made a lot of money have done so in high-quality businesses.



Munger believes the greater the quality of a company, the greater the strength of the wind at your back over the long term.

How do Munger and Buffett assess quality?


Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite---that is, consistently employ ever-greater amounts of capital at very low rates of return.



 Munger and Buffett are very focused on both the magnitude and persistence of the ability of a business to earn a return on capital. Return on invested capital (ROIC) is the ratio of after-tax operating profit divided by the amount of capital invested in the business. In short, how much a business earns on the capital employed in its business determines the quality of that business for Munger and Buffett. Growth of the business is, by itself, neither good nor bad. In the same I992 letter, Buffett wrote:


Growth benefits investors only when the business in point can invest at incremental returns that are enticing---in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.




Eighth Variable: Determining What Businesses to Own (in Whole or in Part)


We need to have a business with some characteristics that give us a durable competitive advantage.



You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to compare those values with other values available in the stock market.



Judge the staying quality of the business in terms of its competitive  advantage.   



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.



We're partial to putting out large amounts of money where we won't have to make another decision.



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.



Why do some businesses create easy decisions for entrepreneurs and investors? A significant part of the answer lies in microeconomics: if there's no significant barrier to entry that creates a sustainable competitive advantage, inevitable competition will cause the return on investment for that business to drop to opportunity cost and there will be no economic profit for the producer. The analogy they use at Berkshire is that the business itself should be viewed as the equivalent of a castle and the value of that castle will be determined by the strength of the protective moat.

Whether a business has a durable moat is without question the most important attribute for an investor like Munger. He describes a moat in two different ways, each emphasizing the importance of the moat being able to maintain itself over time:


We have to have a business with some inherent characteristics that give it a durable competitive advantage.



We're trying to buy businesses with sustainable competitive advantages at a low---or even a fair price.



A more detailed description of the elements of a moat is set out in the appendix titled Moats. If you have made it this far in this book and have decided to "operationalize" Buffett and Munger's version of the Graham value investing system (which includes considering the quality of the business), you will need to deeply understand the nature of moats. Cigar-butt Graham value investors may argue that they have less need to understand the nature of the moats that companies have, but I believe a sound knowledge of moats is still valuable even for them. As I have written previously in this book, to evaluate the quality of a business, you must understand the fundamentals of business. For some people this will be boring, while others (like me) find it fascinating. If you find this topic boring, the odds that you will be a successful Graham value investor drop substantially. [113-138]



1. Warren Buffett, 1994 Berkshire Shareholder Letter, 1995

2. Michael Price, Graham and Doddsville Newsletter, 2011

3. Fred Wilson, Le Web Conference, 2014.

4. Alice Schroeder, The Snowball, 2008.

5. Warren Buffet, 1999 Berkshire Shareholder Letter, 2000.

6. Jason Zweig, "More Stocks May Not Make a Portfolio Safer," 2009.

7. Nassim Taleb, Anti-fragile. 2012.

8. Warren Buffett, 2012 Berkshire Shareholder Letter, 2013.