Charlie Munger on Sit on your Ass Investing
Charlie Munger was never attached to the deep value, Graham esque mentality like many of his value peers. In fact, Munger always preferred quality over value. A high quality business trading at an attractive valuation was Charlie Munger’s Holy Grail.
It wasn’t until the turn of the century that Munger was able to give a name to this style of investing. The name he chose was; sit on your ass investing.
The concept of sit on your ass investing was introduced at the 2000 Berkshire Hathaway Annual meeting. The essence of this new school of investment theory; find a few outstanding companies, buy them, and hold them forever.
In many ways this style of investment management can be traced back to Berkshire Hathaway’s early days. See’s Candies, Coca-Cola and American Express were all quality business brought at an attractive price with the intention of holding them forever. According to Charlie Munger — a view that’s also affected Warren Buffett’s style — you should only buy a stock if you are willing to hold for ten years, and if you are willing to commit a substantial portion of your money to it.
Up until the late 1980’s, even Warren Buffett didn’t follow this school of thought. He traded in and out of undervalued stocks, selling them when they reached full value and positions were rarely held for more than a year or two.
Buffett’s active style of management didn’t suit Charlie Munger, anyway, the figures showed that a more passive style of management would be better over the long-term.
The power of compounding
The success of sit on your ass investing is driven by a company’s ability to successfully compound shareholder equity at an attractive rate over the long-term — if this isn’t possible, the strateegy won’t work and it’s easier to buy low and sell high.
Charlie Munger’s speech, “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”, breaks it down nicely:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
Similarly, here’s what Warren Buffett said about Coca-Cola, See’s Candies, and Buffalo News at the 2003 Berkshire Hathaway meeting:
“The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn’t earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can’t generate high returns on incremental capital — for example, See’s and Buffalo News. We look for them [areas to wisely reinvest capital], but they don’t exist.
So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It’s an enormous advantage.”
At the same meeting, Charlie Munger added the following statement:
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, 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.”
How do you get into these great companies?
Of course, if good businesses were easy to find, investing would be easy. Half the battle is finding these great companies at great prices.
This is a broad topic and not one that I have space to go into here. Nonetheless, Charlie Munger does have some views on the topic:
“How do you get into these great companies? One method is what I’d call the method of finding them small get ’em when they’re little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it’s a very beguiling idea. If I were a young man, I might actually go into it.
But it doesn’t work for Berkshire Hathaway anymore because we’ve got too much money. We can’t find anything that fits our size parameter that way. Besides, we’re set in our ways. But I regard finding them small as a perfectly intelligent approach for somebody to try with discipline. It’s just not something that I’ve done.
Finding ’em big obviously is very hard because of the competition. So far, Berkshire’s managed to do it. But can we continue to do it? What’s the next Coca-Cola investment for us? Well, the answer to that is I don’t know. I think it gets harder for us all the time….
And ideally and we’ve done a lot of this—you get into a great business which also has a great manager because management matters. For example, it’s made a great difference to General Electric that Jack Welch came in instead of the guy who took over Westinghouse—a very great difference. So management matters, too.
Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks—who was second generation in Marks & Spencer of England—was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man.
These people do come along—and in many cases, they’re not all that hard to identify. If they’ve got a reasonable hand—with the fanaticism and intelligence and so on that these people generally bring to the party—then management can matter much.
However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager.
But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.” — Charlie Munger’s speech, “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”.