Charlie Munger on The Principles of 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.

 

The number one idea is to view a stock as an ownership of the business.

-CHARLIE MUNGER, HARVARD LAW BULLETIN, 2001

 

Understanding how to be a good investor makes you a better business manager and vice versa.

-CHARLIE MUNGER, KIPLINGER, 2005

 

First Principle: Treat a Share of Stock as a Proportional Ownership of a Business

 

THIS FIRST PRINCIPLE of the Graham value investing system is the foundation on which any valuation must begin. Put simply: if you do not understand the actual business of the company, you cannot understand the value of assets related to that business, like a share of stock or a bond. Graham value investors approach any valuation as if they were actually buying a business in a private transaction.

         In buying a business, Munger believes the place to start is at the bottom, with business fundamentals, and work up. What does the company sell and who are its customers and competitors? What are the key numbers that represent the value the business generates? The list of important questions that an investor must answer is extensive. For a true Graham value investor, there is no substitute for a bottom-up valuation process. In undertaking this process, Graham value investors are focused on the present value of the cash that will flow from the business during its lifetime and whether the business generates high, sustained, and consistent returns on capital. Many supplemental variations on this process exist, but the fundamental core of the valuation process is the same for all Graham value investors.

Effective Graham value investors are like great detectives. They are constantly looking for bottom-up clues about what has happened in the past and, more importantly, what is happening now. Graham value investors like Munger stay away from making predictions about how cash flows will change in the future based on projections and forecasts. What Munger looks for is a business that has a significant track record of generating high, sustained, and consistent financial returns. If valuing the business requires understanding how cash flows will change in the future based on factors like rapid technological change, Munger puts that business in the too hard pile and moves on to value other companies. Munger makes it quite clear that he does not have a way to value all companies, which is fine with him because he feels no need to do so. There are more than enough businesses that Munger can value using his valuation method to make him happy as an investor.

The key to understanding this first principle is understanding that Munger believes that a share of stock cannot be divorced from the fundamentals of the specific business. Munger's response to people who doubt his approach can be phrased as a question: if a share of stock is not a partial stake in a business, what exactly is it? Jason Zweig of the Wall Street Journal, who is a hero to Graham value investors, wrote that "a stock is not just a ticker symbol or an electronic blip; it's an ownership interest in an actual business, with an underlying value that does not depend on its share price."1 For a Graham value investor, a share of IBM stock is just a small share of IBM's overall business. Munger believes that treating shares of a company as if they should be valued like baseball cards is a loser's game because it requires that you predict the behavior of often irrational and emotional herds of human beings. A Graham value investor puts short-term predictions about mass psychology in the too hard pile and focuses on what he or she can do successfully with far greater ease. Graham value inves­tors do not spend time with top-down factors like monetary policy, consumer confidence, durable goods orders, and market sentiment in doing a business valuation or investing.

 

Be motivated when you're buying and selling securities by reference to intrinsic value instead of price momentum.

-CHARLIE MUNGER, DAMN RIGHT, 2000

 

As Ben Graham once pointed out, "It's an almost unbelievable fact that Wall Street never asks: how much is the business selling for?"2

That a famous Graham value investor like Munger or Buffett may make a statement about current economic conditions or market indi­cators does not mean that they purchase stocks based on that view or that they think they can make successful predictions about what the macroeconomy might do in the short term. Famous Graham value investors may also make positive statements in the press and at conferences about the future state of the economy in the long term. However, that does not mean they make investments based on those forecasts. There is a huge difference between what is interesting to learn about and what is useful in making an investment decision. For example, both Munger and Buffett are famously bullish on the US. economy in the long term, but that does not mean they make short-­term predictions about the economy or incorporate them into invest­ment decision making.

Munger is adamant about many points, including this core belief: you must value the business in order to value the stock. Graham value investors price assets based on their value to a private investor now (based on data from the present and past) rather than making predictions about markets in the future. If you focus on the value of the business, you have no need to predict short-term changes in the economy because that takes care of itself. When stocks are a bargain, people are fearful; when stocks are expensive, people are greedy.

 

Crowd folly, the tendency of humans, under some circumstances, to resemble lemmings, explains much foolish thinking of brilliant men and much foolish behavior.

-CHARLIE MUNGER, PHILANTHROPY ROUNDTABLE, 2000

 

If you do not follow the business to value the stock approach, in the view of Graham value investors, you are a speculator and not an investor. If you are an investor, you are trying to understand the value of the asset. By contrast, a speculator is trying to guess the price of the asset by predicting the behavior of others in the future. In other words, a speculator's objective is to make predictions about the psychology of large masses of people, which if you are both smart and experienced is a sobering thought. How good are you at predicting what people will do once assembled into a mob? The big danger related to this tendency is that you just end up following the crowd and doing what Munger talked about here:

 

Mimicking the herd invites regression to the mean (merely average performance).

-CHARLIE MUNGER, POOR CHARLIE'S ALMANACK, 2005

 

When speculators spend their time trying to guess what other speculators are trying to guess, the process quickly becomes both circular and absurd. Graham value investors do not treat a share of stock or a bond as a piece of paper to be traded back and forth. They also do not spend any time looking at technical charts of stock price movements, searching for things like double bottoms or Hindenburg omens. The financial performance of speculators is, in a word, dismal, especially after fees, costs, and taxes. Even when speculators are right, it is almost inevitable that they are correct only once in a while. Too often, investors confuse luck with skill.

Munger is a firm believer in the Ben Graham view that "an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." 3 Buffett has his own version:

 

If you're an investor, you're looking on what the asset is going to do; if you're a speculator, you're commonly focusing on what the price of the object is going to do, and that's not our game.

-WARREN BUFFETT, OUTSTANDING INVESTOR DIGEST, 1997

 

If you always bet with the crowd, you cannot beat the market---especially after fees, costs, and taxes. To outperform the market, sometimes you must be a contrarian, and you must be right on enough of those occasions when you're a contrarian.

For example, people who day-trade stocks using charts of past prices and other voodoo-like practices are speculators. You will hear them talk about how the market behaves rather than what the value of a given stock may be. A guess about market behavior based on a chart is just that-a guess! Speculators are focused on price, whether it may be an old baseball card or a share of stock. Graham value investors have a very different view than speculators. Seth Klarman wrote that "technical analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to future stock prices."4

Buffet used a story to illustrate the dangers of herd behavior in one of his Chairman's letters:

 

Ben Graham told a story forty years ago that illustrates why investment professionals behave as they do. An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. "You're qualified for residence," said St. Peter, "but, as you can see, the compound reserved for oil men is packed. There's no way to squeeze you in." After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, "Oil discovered in hell." Immediately, the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. "No," he said, "I think I'll go along with the rest of the boys. There might be some truth to that rumor after all."

-WARREN BUFFETT, 1985

 

John Maynard Keynes defined speculation as "the activity of forecasting the psychology of the market."5 Keynes went on to say that the speculator must think about what others are thinking about, what others are thinking about the market (and repeat). In what is now called a "Keynesian beauty contest," judges are told not to pick the most beautiful woman but instead to pick the contestant they think the other judges will choose as the most beautiful. The winner of such a contest may be very different than the winner of a traditional beauty contest. Keynes said this about such a contest:

 

It's not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

-JOHN MAYNARD KEYNES, GENERAL THEORY, t936

 

How some promoters have learned how to manipulate this process can be illustrated with a story: Once upon a time, a man and his assistant arrived in a very small town and spread the word to the townspeople that the man was willing to buy monkeys for $100 each. The people knew there were many monkeys in the nearby forest and immediately started catching them. Thousands of monkeys were bought at a price of $100 and placed in a large cage. Unfortunately for the townspeople, the supply of monkeys quickly diminished to a point where it took many hours to catch even one.

When the new man announced he would now buy monkeys at a price of $200 per monkey, the town's residents redoubled their efforts to catch monkeys. But after a few days the monkeys were so hard to find that the townspeople stopped trying to catch any more. The man responded by announcing that he would buy monkeys at $500 after he returned with additional cash from a trip to the big city.

While the man was gone, his assistant told the villagers one by one: "I will secretly sell you my boss' monkeys for $350, and when he returns from the city, you can sell them to him for $500 each."

The villagers bought every single monkey, and they never saw the man or his assistant ever again.

Howard Marks advised that Graham value investors focus on what they know now and not where they are going because, rather obviously, your data about the present is extensive while your data about the future will always be zero. Like Marks in making investment decisions, Munger is focused on what is happening in a given business right now. Projections about the future are scrupulously avoided. Buffett put it this way: "I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections but we care very much about, and look very deeply, at track records. If a company has a lousy track record but a very bright future, we will miss the opportunity."6 Munger agreed:

 

[Projections] are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious. They remind me of Mark Twain's saying, "A mine is a hole in the ground owned by a liar." Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself.

-CHARLIE MUNGER, BUFFETT SPEAKS, 2007

 

I don't let others do projections for me, because I don't like throwing up on the desk.

-CHARLIE MUNGER, UNIVERSITY OF CALIFORNIA,

SANTA BARBARA, 2003

 

There is a riddle about people who make short-term forecasts that I have heard many times: Charlie Munger, the Easter Bunny, Superman, and a successful forecaster of an investment bank find themselves in their own corner of a large square-shaped trading floor. In the center of the room is a large stack of $100 bills. If each of them starts racing toward the center of the floor at the same time, who gets the money? The answer is Munger, because the other three don't exist!

By sticking to investing activities that are easy, avoiding questions that are hard, and making decisions based on data that actually exists now, the Graham value investor greatly increases his or her probability of success. Understanding the present is unsurprisingly easier if you know what you are doing and the underlying business is understandable. One must be careful because there are many promoters who can successfully use techniques like "predicting the present" to convey the impression that they can be successful speculators. Predicting the present is, of course, infinitely easier than predicting the future. Consider the following illustrative story about an investor encountering a forecaster. A man piloting a hot-air balloon discovered he had travelled far off course. He took the balloon down to a lower altitude, where he saw that he was above an office building. A man outside the building saw the balloonist and waved.

The balloonist shouted, "Excuse me, can you tell me where I am?"

The man yelled back, "You're in a hot-air balloon, about 150 feet above the headquarters of this investment bank."

The balloonist replied, "You must be a forecaster at the investment bank, then."

Obviously surprised, the man said, "Yes, I am! How did you know »

"Well," said the balloonist, "what you told me is technically correct, but it is of no use to anyone."

The best way to determine the value of a business is to based on the price a private investor would pay for the entire business. For example, Seth Klarman determines the price he would pay for the asset in question and calls that the private market value.

GAMCO Investors defined private market value as follows:

 

Private Market Value (PMV) is the value an informed industrialist would pay to purchase assets with similar characteristics. We measure PMV by scrutinizing on- and off-balance-sheet assets and liabilities and free cash flow. As a reference check, we examine valuations and transactions in the public domain. Our investment objective is to achieve an annual return of 10% above inflation for our clients.7

 

While there are many different ways of making this calculation, as will be explained below, all Graham value investors avoid trying to value shares of stock based on popular opinion. An illustration of this point can be found by examining why Munger does not buy gold. Munger does not own gold as an investment because it is impossible to do a bottom-up fundamental valuation, because gold is not an income-producing asset. Gold has speculative value and commercial value, but in Munger's view it has no calculable intrinsic value. Buffett has said that he would be happy to accept a gift of gold, but he would not buy it as an investment. Determining speculative value is all about making predictions about mass psychology, and that is a game Munger does not want to play. As will be discussed, a private market intrinsic valuation for a Graham value investor requires that the asset generate free cash flow.

 

 

Second Principle: Buy at a Significant Discount to Intrinsic Value to Create a Margin of Safety

 

The idea of a margin of safety, a Graham precept, will never be obsolete.

-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2003

 

No matter how wonderful [a business] is, it's not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.

-CHARLIE MUNGER, BBC INTERVIEW, 2009

 

Munger is making the point that if there is a single principle that should rise above all others in the mind of a Graham value investor, it is margin of safety. No one makes this point better than Ben Graham himself:

 

Confronted with a challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY

-BEN GRAHAM, THE INTELLIGENT INVESTOR, 1949

 

What is a margin of safety? Ben Graham's definition of a margin o f safety is "a favorable difference between price on the one hand and indicated or appraised [intrinsic] value on the other."8 Intrinsic value is the present value of future cash flows. Margin of safety reflects the difference between the intrinsic value and the current market price. The purpose of a margin of safety is quite simple according to Graham: "The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."9 Seth Klarman described the Graham value investing system simply: buy at a bargain defined by a margin of safety and wait. However, as the Tom Petty and the Heartbreakers lyric says, "The waiting is the hardest part."

A margin of safety for investors in public markets is analogous to a safe following distance when driving on the freeway. The intent of both approaches is to avoid having to make predictions. With sufficient distance between you and the car ahead, you must react to what you see in the present moment, but you do not need to predict the actions of the driver ahead of you. If you drive only a few feet behind the speeding car ahead, you need prediction instead of just reaction; otherwise, you are going to crash. Simply put, your objective as a Graham value investor is to buy a share of stock at a sufficiently large bargain that you do not need to predict short-term price movements in the stock market.

The margin of safety principle is natural for a person like Munger, who is trying to succeed by avoiding what is hard (e.g., predicting the future in the short term). He has learned to take the ordinary person's desire to solve hard problems and turn it on its head. Seth Klarman wrote:

 

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.

-SETH KLARMAN, MARGIN OF SAFETY, 1991

 

The last point made by Klarman is essential. Making successful predictions about complex systems is a process in which errors are inevitable. Having a margin of safety means that even if you make mistakes, you can still win. And if you do not make mistakes, your win will be even bigger. Munger has a clear view:

 

In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon.

-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2003

 

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, [Ben Graham] 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.

-CHARLIE MUNGER, UNIVERSITY OF SOUTHERN CALIFORNIA (USC) BUSINESS SCHOOL, 1994

 

Munger believes that the margin of safety process in investing is similar to processes that exist in engineering. For example, if you are building a bridge, as the engineer you want to make sure that it is significantly stronger than necessary to deal with the very worst case. Buffett wrote once: "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same idea works in investing."10 Munger believes investing should be similar. The first rule of investing is: do not make big financial mistakes. The second rule is the same as the first rule.

Behind the margin of safety principle is the simple idea that having a cushion in terms of excess value can protect you against making an error. If you buy at a discount, you have a margin of safety, which will help protect you from making mistakes. This will improve your odds of success. Everyone makes mistakes, so having insurance against those mistakes is wise. Finding an investment opportunity with the right margin of safety is uncommon, so you must be patient. The temptation to do something while you wait is too hard for most people to resist.

As Munger has found over the years, by making certain variables that do not change the four fundamental principles of the Graham value investing system and instead building on top of them, the system has been able to evolve as investing conditions have changed.

 

Ben Graham followers ... started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well.

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

Munger's use of the word bargain in the quote immediately above is important. It is not enough for a stock to be beaten down in price or off its highs. What is cheap to buy relative to the past may in fact not be a bargain in the present. To deliver a margin of safety to the Graham value investor, the stock must be worth significantly more than what he or she paid. How significant the bargain must be will be discussed later. The Graham value investor should always remember this admonition: price is what you pay, and value is what you get. It is common for Graham value investors to say things like, "My goal in buying a financial asset is to buy a dollar for 70 cents." When they say this, they do not mean "buy a dollar for seventy cents" precisely, but they do seek a significant discount from intrinsic value. Put simply: when a Graham value investor can buy a dollar for a few dimes less than actual value, he or she can make significant mistakes and still make a profit.

 

Ben Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay. I think Ben Graham wasn't nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks [companies with limited potential growth selling at a fraction of what they would be worth in a takeover or liquidation] was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can't do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals---probably the only intellectual---in the investing business at the time.

-CHARLIE MUNGER, JASON ZWEIG INTERVIEW, 2014

 

What Munger is saying above is that what Ben Graham did in applying the concept of a margin of safety in his era was quite different from how investors (like Munger and Buffett) use it today. Look at history. In the aftermath of the Great Depression, Graham was spending most of his time searching for companies "worth more dead than alive."11 The stock market crash and the Great Depression caused many people to simply give up on owning stocks. For a long time after the Great Depression, some companies could be purchased at less than liquidation value. While these so-called cigar-butt companies were common during this period of time, as years passed they became harder to find in major markets. Graham himself said this late in his life, which confuses many people to this day: the fact that public companies were no longer trading at less than liquidation value did not mean that it was no longer possible to use the Graham value investing system successfully.

As a result of the new post-Great Depression environment, Munger and many other Graham value investors began to apply the same Graham value investing principles to businesses that were of high quality instead of businesses trading below liquidation value---and the margin of safety process worked just as well. The variables that supplement the Graham value investing system began to evolve for some investors. Considering the quality of a business when valuing a business will be discussed later in the book.

Walter Schloss, Howard Marks, Seth Klarman, and a few other Graham value investors have stayed closer to Graham's cigar-butt style and instead focused on less-traded markets, given that there are only a small number of cigar-butt opportunities in major public markets. Howard Marks pointed out that "active management has to be seen as the search for mistakes."12 In his view, it is in less-traded markets and so-called distressed assets where mistakes are most likely to be found.

 

 

Third Principle: Make "Mr. Market" Your Servant Rather Than Your Master

 

Ben Graham [had] his concept of "Mr. Market." Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, "I'll sell you some of my interest for way less than you think it is worth." And other days, "Mr. Market" comes by and says, "I'll buy your interest at a price that's way higher than you think its worth."

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

In the above statement, Munger is illustrating that Ben Graham's Mr. Market metaphor is as powerful as it is simple. The Graham value investor believes Mr. Market is unpredictably bipolar in the short term; for that reason, when the market is depressed, it will sometimes sell you an asset at a bargain price. Other times, because it is euphoric, the market will pay you more than the asset is worth. Knowing the difference between these two emotional states is of critical importance to the successful use of the Graham value investing system. Mr. Market's emotional problems arise because he is composed of many people who, in the short term, vote to establish a price for an asset based on their emotions and predictions about the predictions and actions of all the other people who make up the market. Ben Graham pointed out that markets are largely composed of such people as "[person] A [who is] trying to decide what B, C, and D are likely to think—with B, C and D trying to do the same."13

For the Graham value investor, it is precisely when Mr. Market is depressed that the greatest opportunities to purchase assets exist. Stocks at that time are likely to be mispriced to an extent that generates a significant bargain. As Ben Graham questioned, why turn something like a drop in stock prices---which is fundamentally advantageous---into something disadvantageous? As long as the fundamentals of the business itself remain in place, a market's short-term views on the price of the shares can be ignored and will be corrected in the long term. This approach reinforces the importance of a fundamental analysis of the business itself. There are essentially three steps in the process: analyze the business to determine intrinsic value, buy the assets at a significant bargain, and wait.

Any discussion about markets inevitably causes arguments related to the so-called efficient market hypothesis (EMH). Proponents of the hard version of the EMH believe that investors cannot beat the market because it is always perfectly priced. Unlike EMH proponents, Munger believes that markets are mostly efficient but not always efficient:

 

I think it's roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don't think it's totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It's efficient enough, so it's hard to have a great investment record. But it's by no means impossible. Nor is it something that only a very few people can do. The top 3 or 4 percent of the investment management world will do fine.

-CHARLIE MUNGER, KIPLINGER, 2009

 

One might say that Munger believes in a mostly efficient hypothesis. He believes that the difference between mostly and always efficient is a huge opportunity for a Graham value investor. Stocks are sometimes underpriced and sometimes overpriced. Anyone who invested through the Internet bubble (as I did) and who still thinks that markets are always efficient (a so-called extreme view of market efficiency) is bonkers.

A fundamental premise of the Graham value investing system is that prices will always move up and down in cycles. Graham value investors do not believe these business cycles are predictable in a way that can generate an above-market financial return in the short term. As the business cycle moves prices unpredictably back and forth over time, the reference point is always intrinsic value. Intrinsic value is, in that way, like a mark on a barometer that sets an important reference point. The investor's job is to patiently watch rather than predict price movements and be ready to quickly and aggressively buy at a significant discount to intrinsic value and sometimes sell at an attractive price in relation to intrinsic value. For a Graham value investor, reacting quickly and aggressively to favorable prices when they unpredictably appear is essential. Munger pointed out:

 

To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

Mr. Market's bipolar nature is his gift to Graham value investors. Occasionally he will present them with great bargains. At other times he'll buy your assets at a premium. Munger's point on this is simple: do not treat Mr. Market as wise; instead, view him as your servant. It is certain that the prices of investment assets will wiggle above and below intrinsic value. Do not try to predict when the wiggle will happen, but rather patiently wait for when it happens. Graham value investors price stocks rather than time markets. Patience is a difficult part of the Graham value investing system. If you expect the market to give you enough profit to buy a car or a speedboat next week, you will inevitably fail to achieve your financial goals.

 

It's an unfortunate fact that great and foolish excess can come into prices of common stocks in the aggregate. They are valued partly like bonds, based on roughly rational projections of use value in producing future cash. But they are also valued partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far.

-CHARLIE MUNGER, PHILANTHROPY, 2009

 

Falling in with the crowd will put you under the sway of Mr. Market because Mr. Market is the crowd. If you are the crowd, then you cannot, by definition, beat the crowd. Munger believes that short-term price movements are not rationally based, based on always-efficient markets, or predictable with certainty. The best advice is simple; Buffet says, "Be fearful when others are greedy, and be greedy when others are fearful." 14 This is easy to say but hard to do, because it requires courage at the hardest possible time.

 

Over many decades, our usual practice is that if [the stock of] something we like goes down, we buy more and more. Sometimes something happens, you realize you're wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices.

-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2002

 

Graham's value investing system is based on the premise that risk (the possibility of losing) is determined by the price at which you buy an asset. The higher the price you pay for an asset, the greater the risk that you will experience a loss of capital. If the price of a stock drops, risk goes down, not up. For this reason, the Graham value investor will often find that price decrease for a given stock is an opportunity to buy more of that stock. Buffett put it this way: "I'm going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the Hallelujah chorus in the Buffett household. When hamburgers go up, we weep.”15

The paradox facing the ordinary investor is that usually only the biggest investors (huge pension funds, university endowments, and the very wealthy) get access to what Munger refers to as the top 3 to 4 percent investment management. This problem for the ordinary investor is reflected in a variant of an old Groucho Marx joke: you do not want to hire an investment manager that would take you for a client! People managing funds based on Graham value investing principles know that experienced and successful investors are much less likely to panic when a market declines and instead view market declines as an opportunity. Graham value investor Marty Whitman has even said that he does not want people in his fund who do not understand Graham value investing system because he must sell shares when they redeem their ownership interest.

 

 

Fourth Principle: Be Rational, Objective, and Dispassionate

 

Rationality is not just something you do so that you can make more money; it's a binding principle. Rationality is a really good idea. You must avoid the nonsense that is conventional in one's own time. It requires developing systems of thought that improve your batting average over time.

-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2006

 

[An] increase in rationality is not just something you choose or don't choose; it's a moral duty to keep up as much as you reasonably can. It worked so well at Berkshire, not because we were so darned smart to start with---we were massively ignorant. Any of the great successes of Berkshire started with stupidity and failure.

-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2011

 

The idea of being objective and dispassionate will never be obsolete.

-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2003

 

As the above quotes indicate, over the years Munger has repeatedly said that the most important quality that makes anyone a successful investor is the ability to make rational thoughts and decisions.  It is difficult to overestimate how important being rational is to the Graham value investing system. Rationality is the best antidote to making psychological and emotional errors. During an interview, Munger once recalled that a person sitting next to him at a dinner party asked him, "Tell me, what one quality accounts for your enormous success?" Munger replied, "I'm rational. That's the answer. I'm rational." This rationality is something he works hard to cultivate, as will be explained shortly. Being rational is neither simple nor easy.

While Graham value investors do not try to predict the behavior of other people, they do spend a lot of time trying to keep their own behavior from getting in the way of being rational, objective, and dispassionate. The best Graham value investors understand that if you think things through from the simplest building blocks in a step-by-step process and employ techniques like checklists, which reinforce the Graham value investing system, you can avoid making most mistakes---or at least making new mistakes. Most of this book will be devoted to this fourth principle of the Graham value investing system. [22-41]

 

Notes

1. Jason Zweig, Intelligent Investor, 2005.

2. Benjamin Graham, Security Analysis, 1934.

3. Benjamin Graham, Intelligent Investor, 2003.

4. Seth Klarman, Margin of Safety, 1991.

5. John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1997.

6. Warren Buffett, Brevelin, 2010

7. Gabelli, "Value Investing," I999

8. Benjamin Graham, The Intelligent Investor, 1949.

9. Ibid.

10. Warren Buffett, The Superinvestors of Graham and Doddsville, 1984.

11. Benjamin Graham, Forbes, I932.

12. Howard Marks, Oaktree Memo, 2012.

13. Benjamin Graham, Security Analysis, 1934.

14. Warren Buffett, "Buy American," 2008.

15. Warren Buffett, Fortune, 2001