Why and how do Munger and Buffett “discount the future cash flows” at the 30-year U.S. Treasury Rate?

Buffett and Munger use several methods which are at odds with traditional financial theory. Here is one of those nontraditional approaches:

Buffett: “We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”

There is no law of nature requiring that a capital allocation process account for risk, uncertainty and ignorance by adjusting the interest rate. Buffett and Munger instead use the concept of margin of safety. Having a margin of safety and also adjusting the interest rate would be redundant in their view. They:

1. Assemble options to invest that involve businesses which have a future that is “quite certain” and is within their circle of competence
2. Use the 30 year rate to do the DCF in their head on all these opportunities
3. Apply a margin of safety
4. Compare every option available to then anywhere on Earth and chose the best one.

This makes some people nuts since they were trained to adjust the interest rate to account for risk. I’m not taking a personal position here and am instead trying to better explain the Buffett/Munger approach.

The two methods are different ways of accomplishing the same thing, so why do Buffett and Munger use their own approach? I believe they prefer their method since it frames the ultimate question in a way that they prefer. They hate the idea of someone saying “invest in X since the return is above your hurdle rate” since that decisions can be made only by looking at every other alternative in the world. By using the same 30 year US Treasury rate for every DCF he has created a “system to compare things.” The things Buffett compares side-by-side must be “quite certain” and available to buy at a significant discount to intrinsic value reflecting a margin of safety.

My friend John Alberg a co-founder of http://www.euclidean.com/ puts it this way:

“Another way of saying it is that all investments share the same discount rate. You can’t apply a different discount rate to company A than company B because $1 in the future is worth the same amount of money regardless of whether it comes from company A or B. So instead an investor should focus on the cash that a business can generate within a margin of safety and compare them by that measure. With respect to DCF, the reason that it can be “done in the head” is because it simplifies to a simple ratio when you use margin of safety. That is, if most future cashflows from company A are going to be greater than some number c_A and the discount rates are going to be greater than some other value r then the quantity c_A / r is less than the result you would get from a DCF. Put another way, the quantity c_A / r is a lower bound on the DCF or it is an estimate of intrinsic value with a margin of safety. But notice that if you are comparing the intrinsic value of two companies with cashflows of at least c_A and c_B then the discount rate r is constant between the two and therefore not the important part of the equation.”

Buffett and Munger have a flow of deals that cross their desks. We don’t see them but Byron Trott recently said that many investors would cry over losing what they turn down. That flow established their opportunity cost. 30-year US treasury rates can be 3%, but if they have a flow of deals that return 10% that is “sort of” their hurdle rate.

Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”

Munger: “There is this company in an emerging market that was presented to Warren. His response was, ‘I don’t feel more comfortable buying that than I do of adding to Wells Fargo.’ He was using that as his opportunity cost. No one can tell me why I shouldn’t buy more Wells Fargo. Warren is scanning the world trying to get his opportunity cost as high as he can so that his individual decisions are better.”

Under the Buffett/Munger approach the risk free rate used in the discounted cash flow (DCF) and the “next best opportunity” are not connected. Sometimes you will hear people incorrectly say Buffett is hinting at adjusting the discount rate or inconsistent in his approach. If you read him carefully his “sort of” hurdle rate is the next best investment (which can have a number attached to it) based on the deals crossing his desk. In looking at next best he’s looking broadly thinking about what may cross his desk in a few years. Right now his next best opportunity is probably at a bit less than the customary 10%. What he is adjusting is not the discount rate but the next best opportunity rate.

Buffett: “The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.”

Buffett: “We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations. Just because interest rates are at 1.5% doesn’t mean we like an investment that yields 2-3%. We have minimum thresholds in our mind that are a whole lot higher than government rates. When we’re looking at a business, we’re looking at holding it forever, so we don’t assume rates will always be this low.”

Buffett: “In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”

Buffett: “We don’t formally have a discount rate. We want a significantly higher return than from a government bond–that’s the yardstick, but not if government bond rates are 2-3%. It’s a little of wanting enough that we’re comfortable. It sounds fuzzy because it is. Charlie and I have never talked in terms of hurdle rates.

Buffett: “We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher? If government bonds are at 2%, we’re not going to buy a business that will return 4%. I don’t call Charlie every day and ask him, “What’s our hurdle rate?” We’ve never used the term.

Munger: “The concept of hurdle rates makes nothing but sense, but it doesn’t work. Hurdle rates don’t work as well as a system of comparing things. Finance departments ignore it, because it’s not easy to teach. Just because you can measure something doesn’t mean it’s the determining variable in an uncertain world. The concept of opportunity cost is overlooked. In the real world, your opportunity costs are what you want to base your decisions on.”

Buffett: “If [corporate] boards would’ve burned all their charts of IRR [internal rate of return], they would’ve been better off. [They create] nonsense numbers to give their audience what they want to hear and get CEOs what they want.”

Munger: “I have a young friend who sells private partnerships promising 20% returns. When I asked how he arrived at that number, he said, “I chose that number so they’d give me the money.”

Buffett: “There’s nobody in the world who can earn 20% with big money. I’m amazed at the gullibility of big investors.”

Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”

Buffett: 10% is the figure we quit on — we don’t want to buy equities when the real return we expect is less than 10%, whether interest rates are 6% or 1%. It’s arbitrary. 10% is not that great after tax.”

Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”
We could take the $16 billion we have in cash earning 1.5% and invest it in 20-year bonds earning 5% and increase our current earnings a lot, but we’re betting that we can find a good place to invest this cash and don’t want to take the risk of principal loss of long-term bonds [if interest rates rise, the value of 20-year bonds will decline].”

Buffett: “We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher?”

Munger: “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”


Munger: You say there is some vaguely established view in economics as to what is an optimal dividend policy or an optimal investment?
Professor William Bratton of the Rutgers-Newark School of Law: I think we all know what an optimal investment is.
Munger: No, I do not. At least not as these people use the term.
Bratton: I don’t know it when I see it but in theory, if I knew it when I saw it this conference would be about me and not about Warren Buffett.
Munger: What is the break point where a business becomes sub-optimal or when an investment becomes sub-optimal?
Bratton: When the return on the investment is lower than the cost of capital.
Munger: And what is the cost of capital?
Bratton: Well, that’s a nice one and I would…
Munger: Well, it’s only fair, if you’re going to use the cost of capital, to say what it is.
Bratton: I would be interested in knowing, we’re talking theoretically.
Munger: No, I want to know what the cost of capital is in the model.
Bratton: In the model? It will just be stated.
Munger: Where? Out of the forehead of Job or something?
Bratton: That is correct.
Munger: Well, some of us don’t find this too satisfactory.
Bratton: I said, you’d be a fool to use it as a template for real world investment decision making. We’re only trying to use a particular perspective on human behavior to try to explain things.
Munger: But if you explain things in terms of unexplainable sub-concepts, what kind of an explanation is that?
Bratton: It’s a social science explanation. You take for what it’s worth.
Munger: Do you consider it understandable for some people to regard this as gibberish?
Bratton: Perfectly understandable, although I do my best to teach it.
Munger: Why? Why do you do this?
Bratton: It’s in my job description.
Munger: Because other people are teaching it, is what you’re telling me.

Charlie Munger AMA: How does Charlie Munger recommend dealing with adversity?


Charlie Munger has recommended many books, one of which is Viktor E. Frankl’s Man’s Search for Meaning. In that book Frankl writes: “When we are no longer able to change a situation, we are challenged to change ourselves…. Everything can be taken from a man but one thing: the last of the human freedoms—to choose one’s attitude in any given set of circumstances, to choose one’s own way.”

Charlie Munger believes that adversity can cause some people to transform themselves into a victim: “Whenever you think that some situation or some person is ruining your life, it’s actually you who are ruining your life. It’s such a simple idea. Feeling like a victim is a perfectly disastrous way to make go through life. If you just take the attitude that however bad it is in anyway, it’s always your fault and you just fix it as best you can – the so-called “iron prescription” – I think that really works.” In another context he said: “Generally speaking, envy, resentment, revenge and self-pity are disastrous modes of thought, self-pity gets pretty close to paranoia, and paranoia is one of the very hardest things to reverse, you do not want to drift into self-pity.”

Joshua Kennon writes about Munger:

“In 1953, Charlie was 29 years old when he and his wife divorced. He had been married since he was 21. Charlie lost everything in the divorce, his wife keeping the family home in South Pasadena. Munger moved into “dreadful” conditions at the University Club and drove a terrible yellow Pontiac… Shortly after the divorce, Charlie learned that his son, Teddy, had leukemia. In those days, there was no health insurance, you just paid everything out of pocket and the death rate was near 100% since there was nothing doctors could do. Rick Guerin, Charlie’s friend, said Munger would go into the hospital, hold his young son, and then walk the streets of Pasadena crying. One year after the diagnosis, in 1955, Teddy Munger died. Charlie was 31 years old, divorced, broke, and burying his 9 year old son. Later in life, he faced a horrific operation that left him blind in one eye …” http://www.joshuakennon.com/if-charlie-munger-didnt-quit-when-he-was-divorced-broke-and-burying-his-9-year-old-son-you-have-no-excuse/

“Recently, someone told me a story about Charlie Munger worth mentioning here. Charlie was developing a condition in his remaining eye that was causing it to fill up with blood. He would eventually go blind in his one remaining eye and lose his eyesight completely. Blindness. When you are an obsessive reader like Charlie, losing your ability to see would seem to be a prison sentence. However, Charlie was undeterred. He told someone close to him, “It’s time for me to learn braille.” He has been taking braille lessons since. Most recently the worrisome eye condition has receded but the story is a good example of Charlie’s philosophy on life. No self-pity. No emotional wallowing. Staying rational. It is hard enough to learn new things, but … Charlie remains an inspiration of a life well lived.” http://joekusnan.tumblr.com/post/7113195673/charlie-mungers-last-meeting

This passage is from Brian Keng:

“Charlie Munger’s two things NEVER to do: 1) NEVER feel sorry for yourself. 2) NEVER have envy. The first point can be restated as never have a victim mentality. This is important to NEVER do because once you’re a victim, you no longer have control and that’s scary and depressing. More importantly, incredibly counter-productive. I’ve read that there was a holocaust prisoner who was about to be sent to the gas chamber but was in high spirits. When asked how he could be so joyful, he replied that his mood was the one thing he had control of. If he isn’t a victim, then NO ONE is a victim.” http://www.briankeng.com/2010/10/two-things-to-never-do/

More from Munger on adversity:

“Assume life will be really tough, and then ask if you can handle it. If the answer is yes, you’ve won.”

“Life will have terrible blows in it, horrible blows, unfair blows. And some people recover and others don’t. And there I think the attitude of Epictetus is the best. He said that every missed chance in life was an opportunity to behave well, every missed chance in life was an opportunity to learn something, and that your duty was not to be submerged in self-pity, but to utilize the terrible blow in constructive fashion. That is a very good idea. You may remember the epitaph which Epictetus left for himself: “Here lies Epictetus, a slave maimed in body, the ultimate in poverty, and the favored of the gods.”

“I have a friend who carried a big stack of linen cards about this thick, and when somebody would make a comment that reflected self-pity, he would take out one of the cards, take the top one off the stack and hand it to the person, and the card said, ‘your story has touched my heart, never have I heard of anyone with as many misfortunes as you.’ Well you can say that’s waggery, but I suggest that every time you find you’re drifting into self-pity, I don’t care what the cause, your child could be dying of cancer, self-pity is not going to improve the situation, just give yourself one of those cards. It’s a ridiculous way to behave, and when you avoid it you get a great advantage over everybody else, almost everybody else, because self-pity is a standard condition and yet you can train yourself out of it.”

“Like Nietzsche once said: ‘The man had a lame leg and he’s proud of it.’ If you have a defect you try to increase, you’re on your way to the shallows. Envy, huge self-pity, extreme ideology, intense loyalty to a particular identity – you’ve just taken your brain and started to pound on it with a hammer. You’ll find that Warren is very objective.”

“I can’t imagine any experience in life worse than losing a child inch by inch.”

Here is one more quote attributed to Munger for which I can’t find the original source. It sounds like him, but I am not sure he said it:

“I think I developed courage when I learned I could deal with hardship. You need to get your feet wet and get some failure under your belt.”


Man’s Search for Meaning: http://www.amazon.com/s/?ie=UTF8&keywords=man%27s+search+for+meaning&tag=mh0b-20&index=aps&hvadid=1695600881&hvqmt=e&hvbmt=be&hvdev=c&ref=pd_sl_5kiyzxr9lm_e

AMA on Charlie Munger: What did Charlie Munger Learn from Phil Fisher?


Phil Fisher had a significant influence on Charlie Munger’s decision to invest in stocks based on a bargain relative to the quality of the business. On the basis of my research that included a few e-mail exchanges with Phil Fisher’s son Ken, I am skeptical that Fisher’s view was the source of Munger’s emphasis on quality. However, Fisher’s ideas probably made Munger more confident that this focus on the quality of the business was the right approach. In any event, it really does not matter at this point in time who between them had this idea or that or any other idea first. It is entirely possible and even likely that these ideas about the quality of a business in value investing evolved independently since the “cigar butt” stocks that Ben Graham talked about were disappearing.

Munger has said that adopting a multidisciplinary approach in making decisions comes naturally to him. Once quality is made part of the valuation of a business, the investing process is very different than when it is mostly about accounting and finance. This change to consider quality places an emphasis on what Munger calls “worldly wisdom” which is based on a latticework of mental models from many disciplines. I have discussed this latticework process in a previous blog post on mental models. If you want to know more about this approach some of the best writing and thinking on this topic has been done by Robert Hagstrom.

In Munger’s view: “All intelligent investing is value investing — acquiring more that you are paying for. You must value the business in order to value the stock.” If you are buying an asset for more than it is worth and instead hope to find a greater fool to buy that asset in the future, that is speculation and not investing. That Munger and Buffett may not buy securities like Facebook or Google is a question of “circle of competence” not whether the shares in these businesses can be a value stock. Munger and Buffett do not have a circle of competence that includes valuing pure technology businesses. That Munger and Buffett have a more limited circle of competence does not mean that a technology stock can’t be evaluated using value investing as an analytical style. Analyzing technology stocks on a bottoms-up basis is not easy, but that does not mean that it is not possible. Robert Hagstrom wrote in his book The Essential Buffett: Timeless Principles for the New Economy that Buffett’s reluctance to invest in technology businesses “is not a statement that technology stocks are unanalyzable.”

When people say things like “value stocks have not done well lately” or “value stocks have outperformed lately” they are inevitably referring to the use of value as a statistical factor in a manner described by Eugene Fama. That style of factor investing has nothing to do with buying a small number of securities based on value investing as an analytical bottoms-up style based on the characteristics of that particular business. I would rather put a viper down my shirt than buy shares in a business just because it is way below its high water mark in a stock market. Just because the price of particular share of stock in a company like IBM or HP is currently beaten down from formerly high levels does not make it a value stock. GE or even Berkshire are not necessarily value stocks at any given time since that depends on the price paid for the security by any given investor.

The private company See’s Candies was a value stock for Buffett and Munger when they purchased the business based on quality even though based on traditional Ben Graham math, they were overpaying. I can assure you that if you bought See’s Candy tomorrow from Buffett and Munger the price they would accept would mean it was no longer a value stock.

Apple can be a value stock in just the same way that See’s Candies was a value stock. Or not. That depends on the outcome of a current bottoms up analysis of the Apple business and the price quoted. As an example of a technology stock being a value stock based on quality, one of Phil Fisher’s long term holdings was Motorola before its big fall from grace. Fisher bought Motorola stock in 1955 and held those shares until his death. Texas Instruments was another Phil Fisher investment. Fisher bought Texas Instruments shares in 1956 before its IPO.

For fun, here’s a set of statements in Twitter Tweetstorm format:

1/ Value stocks as defined by a firm like Fidelity: any stock that is not a growth stock https://www.fidelity.com/learning-center/investment-products/mutual-funds/growth-vs-value-investing

2/ Fidelity uses the term “value” to sell indexes using Fama-style statistical factor. That has nothing to do with Munger/Buffett-style value investing based on a bottoms up analysis of a given business.

3/ For example, business X has greater than average rates of growth in earnings and sales and greater than market price-to-earnings/price-to-sales ratios.

4/ Business X can be bought a 30% discount to intrinsic value based on quality. Using Buffett/Munger standards: business X can be a value stock.

5/ For example, business Y has less than average rates of growth in earnings and sales and less than market price-to-earnings/price-to-sales ratios.

6/ Business Y can’t be bought a 30% discount to intrinsic value based on quality. Using Buffett/Munger standards: business X is a not value stock.

Munger/Buffett’s performance should not be evaluated by the performance stocks using the value investing definition of Fidelity. Vast numbers of stocks that fit in Fidelity’s definition of “value” (any stock that is not a growth stock) would never be bought by Buffett/Munger.

Yes, Buffett/Munger tend to buy most successfully in years like 2009. But that does not mean it is not possible to buy a quality company at a discount in 2015.

Apple or Google shares bought at the right time would have been just like See’s Candies (a value stock). That Buffett or Munger would not buy a tech stock like Google or Apple is a circle of competence issue. Tech company A is not a value stock simply because they have less than average rates of growth in earnings and sales and less than market price-to-earnings/price-to-sales ratios. Many non-profit education stocks have less than average rates of growth in earnings and sales and less than market price-to-earnings/price-to-sales ratios as defined by Fidelity are not a value stock as defined by Buffett. It is possible to have greater than average rates of growth in earnings and sales and greater than market price-to-earnings/price-to-sales ratios and still be a bargain with a margin of safety. That making this determination in a pure play technology business goes in the Buffett/Munger “too hard” pile is an orthogonal point.

It is likely that Fisher had an influence on other aspects of Munger and Buffett’s investing style including: a preferred holding period of “forever” and a less concentrated portfolio than many other investors. Clearly there was much mutual admiration and swapping of ideas and views. They are all strong characters and they probably found comfort in that fact that they shared the same views. Even if you asked them questions at this point in their life about who influenced who and who had what idea first there is always the likelihood of a Rashomon effect wherein the same people remember the same events in different ways.

Charlie Munger has made at least three direct public references to Phil Fisher that have been captured in print:

“Phil Fisher believed in concentrating in about 10 good investments and was happy with a limited number. That is very much in our playbook. And he believed in knowing a lot about the things he did invest in. And that’s in our playbook, too. And the reason why it’s in our playbook is that to some extent, we learned it from him.”

“Phil Fisher believed in concentrated investing and knowing a lot about your companies — it’s in our playbook, which is partly because we learned from 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, so concentrate in a few, seems to me to be an obviously good idea. But 98% of the investment world doesn’t think this way.”

There are other references to Fisher that might be attributable to Munger relayed indirectly through people like Warren Buffett:

“I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.”

Munger realized the Graham system had to change since the world had changed:

“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.”

Munger believed his investing style had to evolve:

“Grahamites … realized that some company that was selling at 2 or 3 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.”

“If you can buy the best companies, over time the pricing takes care of itself.”

Munger believes the greater the quality of a company, the greater the strength of the wind at your back over the long term. Other Graham-style value investors wish Munger and Buffett the best of luck with looking at quality as a factor in their decision-making and are comfortable with their own “cigar butt” approach.

How do Munger and Buffett assess quality? This passage from the 1992 Berkshire Chairman’s letter set out the key test:

“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.”

Central to business quality is pricing power. If you need to hold a prayer meeting before raising prices you do not have pricing power. Munger:

“The ideal investment in many respects is one where anybody who owned it could make a lot more money with no risk simply by raising prices. You say that there can’t be such opportunities lying around anymore than there’d be lots of $100 bills lying around unpicked up on the streets. How could there be? But if you read that book, you’ll realize that in the early days of network television, it was a cinch. All they had to do was sit there and keep raising the prices.”

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

Buffett was introduced to the ideas of Phil Fisher by Bill Ruane writes Alice Schroeder in footnote 29 in the book Snowball:

“Part of Brandt’s job for Buffett was finding scuttlebutt, a term used by investment writer Phil Fisher, the apostle of growth, who had said many qualitative factors like the ability to maintain sales growth, good management, and research and development characterized a good investment. These were the qualities that Munger was searching for when he spoke of the great businesses. Fisher’s proof that these factors could be used to assess a stock’s long-term potential was beginning to creep into Buffett’s thinking, and would eventually influence his way of doing business.” …” Bill Ruane introduced Buffett to Fisher’s ideas. Philip A. Fisher, Common Stocks and Uncommon Profits (Harper and Row 1958).”

It appears that Buffett read Fisher’s book before meeting Munger for the first time in 1959 or at least before the started talking about evolving Graham’s ideas to consider quality. Buffett has said this about Fisher:

“The basic principles are still Ben Graham’s [but] they were affected in a significant way by Charlie and Phil Fisher in terms of looking at better businesses. And I’ve learned more about how businesses operate over time.”

“I am 85% Graham and 15% Fisher.” (1990) [The ratio would different today but Buffett has never quantified it]

“I sought out Phil Fisher after reading his book. When I met him, I was as impressed by the man as his ideas.”

“Phil Fisher was a great man. He died a month ago, well into his 90s. His first book was Common Stocks and Uncommon Profits in 1958. He wrote a second book, and they were great books. You could get what you wanted from the books. Like Ben Graham, it was in the books – the writing was so clear, you didn’t need to meet them. I thoroughly enjoyed meeting him. I met Phil in 1962. I just went there. I’d go to New York and just drop in on people. They thought that because I was from Omaha, they’d only have to see me once and be rid of me. Phil was nice to me. I met Charlie in ’59; he was preaching a similar doctrine, so I got it from both sides.”

“I’m glad you brought up Phil Fisher. I recommend his books highly, especially the early ones. We don’t break off the relationships we’ve formed with companies we own when we’re offered a higher price. That actually helps us buy companies. A lot of companies have been built with love. The seller wants the company to be in a good home. We’re just about the only ones who’ll commit to care for it forever. I commit to the seller that the only one who would betray them would be me. There won’t be a takeover of Berkshire. With stocks, we’re not 100% with Phil Fisher. We love buying stocks that we can stick with forever. We used to think that newspapers, TV, were the most solid things around. But things change. In my first 20 years, I’d sell when I found something better. Now I have lots of money and no ideas. The opposite of the earlier days.”

“I’ve mainly learned by reading myself. So I don’t think I have any original ideas. Certainly, I talk about reading [Benjamin] Graham. I’ve read Phil Fisher. So I’ve gotten a lot of ideas myself from reading. You can learn a lot from other people. In fact I think if you learn basically from other people, you don’t have to get too many new ideas on your own. You can just apply the best of what you see.”

“Read Ben Graham and Phil Fisher, read annual reports, but don’t do equations with Greek letter in them.”

My blog post on Phil Fisher is here: http://25iq.com/2013/10/27/a-dozen-things-ive-learned-from-philip-fisher-and-walter-schloss-about-investing/


Common Stocks and Uncommon Profits and Other Writings http://www.amazon.com/Common-Stocks-Uncommon-Profits-Writings/dp/0471445509

Fisher’s 15 Points: http://news.morningstar.com/classroom2/course.asp?docId=145662&page=3&CN=

What we can learn from Phil Fisher. (interview) Warren E. Buffett; Thomas Jaffe. http://www.rbcpa.com/What_we_can_learn.html

Obituary http://www.nytimes.com/2004/04/19/business/philip-a-fisher-96-is-dead-wrote-key-investment-book.html

A Dozen Things I’ve Learned from Charlie Munger (Distilled to less than 500 Words)

This is the last post in a 12 part “Dozen Things” series on Charlie Munger.  Collectively the first 11 posts are nearly as large as a book.

The intent with this post is to distill Charlie Munger’s approach to making decisions to less than 500 words.  If you don’t have the patience to read 500 words, I can’t help you.

1. STAY IN YOUR CIRCE OF COMPETENCE: Know the edge of your own competency. It is not a competency if you don’t know the edge of it.

2. MAINTAIN A MARGIN OF SAFETY: Buy assets at a bargain so your investing results can be financially attractive even if you make a mistake. Price is not always the same as value. Avoid big mistakes. Reputation and integrity are your most valuable assets. Reputation earned over a lifetime can be lost in seconds.

3. THINK INDEPENDENTLY AND WITH OPPORTUNITY COST IN MIND: Markets and crowds are not always wise. Allocate your time and other resources to your most attractive opportunities. The highest and best use of a resource is always measured by the next best use.

4. BE INTELLECTUALLY HUMBLE: Recognize that the world is genuinely complex and that what you know is a fraction of what you still don’t know. Wait for what you expect rather try to forecast timing. Think about second order and above impacts of anything.

5. BE SMART BY NOT BEING STUPID: Tune out stupidity. The greatest and most important risk is permanent loss of capital, not just volatility in price. Only accept risk when you are properly compensated for assuming that risk. Activity for its own sake is not intelligent.

6. BE PATIENT, BUT AGGRESSIVE WHEN IT IS TIME: Great opportunities do not appear that often, but when they do appear they won’t last long so you must be aggressive when the time is right. When the odds of success are very substantially in your favor, bet big.

7. BE PREPARED: Great investments are hard to find but by consistently working hard you might find a few of them. You only need to find a few great investments in a lifetime.

8. KEEP IT SIMPLE: Apply organized common sense when solving a problem or when doing an analysis of an opportunity. Think more and calculate less. Avoid false precision and unnecessary transaction costs. Try not to interrupt interest that is compounding. Focus on being a business analyst, not a macroeconomic forecaster. Pay attention to the business cycle, but don’t try to predict it.

9. ACCEPT CHANGE: Avoid master plans since change is the only constant in life. Adapt. Look for evidence that would dis-confirm your own ideas. Understand arguments from all sides. Face your problems.

10. THINK BROADLY: Use multiple models from many disciplines in doing an analysis. Borrow the great ideas of the best thinkers in every discipline. The antidote to man with a hammer syndrome is a full set of tools.

11. AVOID HUBRIS: Try to avoid fooling yourself, which is hard since it is easy to do. Understand that more of success in life is luck than you imagine.

12. KEEP LEARNING: Be a learning machine. Never stop reading. Be curious. Surround yourself with smart people. Set aside time to read and think.

Warren Buffett: “There’s no successor to Charlie Munger. You’re not going to find anyone like him. He’s got a real fan club, but for good reason. I’m a member, too.” http://www.rbcpa.com/Munger_FT_20090712.html

A Dozen Things I’ve Learned from Charlie Munger about Ethics

It is important to consider a post like this in the context of the other posts in this series, like the post on mistakes. No one is perfect. Everyone makes mistakes.


  1. “Ben Franklin said: ‘I’m not moral because it’s the right thing to do – but because it’s the best policy.’” “We  knew early how advantageous it would be to get a reputation for doing the right thing and it’s worked out well for us. My friend Peter Kaufman, said ‘if the rascals really knew how well honor worked they would come to it.’ People make contracts with Berkshire all the time because they trust us to behave well where we have the power and they don’t. There is an old expression on this subject, which is really an expression on moral theory: ‘How nice it is to have a tyrant’s strength and how wrong it is to use it like a tyrant.’ It’s such a simple idea, but it’s a correct idea.”  Thinking about this sentence raises the question about difference between ethics and morality. Opinions on the distinction between these two words vary. For purposes of this post I refer to “morality” as relating to shared communal or societal norms about right and wrong.  For the companion term this post will use this definition from US Supreme Court Justice Potter Stewart: “Ethics is knowing the difference between what you have a right to do and what is right to do.” Returning to the ideas in the quotations, what Ben Franklin and Charlie Munger are saying is that not only is unethical and immoral behavior wrong, it is a bad business practice.


  1. “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich–who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich–in money–not just in reputation.” Being ethical is just good business. As an example, I have a close friend who owns and leases commercial office building space and when he walks the streets of Seattle everyone seems to know him and they wave and smile. He is vastly better known than the mayor and certainly more popular. He is ethical to the core and people love to do business with him. The quality of his life is excellent and he is a multi-millionaire. He is wealthy both in terms of assets and friends.  Buffett has said: “You have certain things you want to achieve, but if you don’t have the love and respect of people, you are always a failure. That is the one thing you must earn, it can never be bought. No one that has the love and respect of others is ever a failure.”


  1.  “We believe there should be a huge area between everything you should do and everything you can do without getting into legal trouble.  I don’t think you should come anywhere near that line.” This is the application of a margin of safety principle to ethics. Why risk coming anywhere near a legal problem when there are so many other actions to be taken and opportunities to pursue that do not have the same risk? It is truly amazing when someone with massive wealth ends up disgraced over some minor incremental crime, especially when the person involved already has massive wealth. Munger said once: “Last night, referring to some of our modern business tycoons – specifically, Armand Hammer – I said that when they’re talking, they’re lying, and when they’re quiet, they’re stealing. This wasn’t my witticism; it was used [long ago] to describe the robber barons.”



  1. “Firms should have the ethical gumption to police themselves: Every company ought to have a long list of things that are beneath it even though they are perfectly legal.” “We don’t claim to have perfect morals, but at least we have a huge area of things that, while legal, are beneath us.  We won’t do them.  Currently, there’s a culture in America that says that anything that won’t send you to prison is OK.”  There is a big difference between what is legal and what is ethical.  Knowing the difference is critically important. Character and sound ethics means not doing what is unethical even if it may be legal. There is also the gray area of what business do you avoid. Buffett has said: “Charlie’s favorite company, Costco. They are the #3 distributor in the US of cigarettes, but you wouldn’t avoid buying it because of that. You’ll drive yourself crazy trying to keep track of these things. Our philosophy is … we just won’t be in certain businesses.” Munger puts it this way: “Warren told the story of the opportunity to buy Conwood, the #2 maker of chewing tobacco. I never saw a better deal, and chewing tobacco doesn’t create the same health risks as smoking. All of the managers chewed tobacco – it was admirable of them to eat their own cooking. Warren and I sat down and said we’re never going to see a better deal; it’s a legal product; and we can buy it at a wonderful price; but we’re not going to do it. Another fellow did and made a couple of billion easy dollars. But I don’t have an ounce of regret. I think there are a lot of things you shouldn’t do because it’s beneath you.”


  1. “Once you start doing something bad, then it’s easy to take the next step – and in the end, you’re a moral sewer.” I have seen this set of issues play out multiple times in my life. As an example, the caretaker or trustee decides that they will “borrow” from funds entrusted for a beneficiary. They may say: “I will just borrow a small amount for a short time and I pay it back with interest.” Another example is an investment manager hiding a loss from clients.  From this small seed a massive fraud can grow and often does grow. Creeping incrementalism is a huge source of ethical problems. Once unethical behavior starts you have a very slippery slope to deal with.


  1. “If your ethics slip and people are rewarded, it cascades downward.” “Terrible behavior spreads.” “Sometimes you have to resist sinking to the level of your competitors. But fomenting bad practices often becomes its own punishment. “If you do things that are immoral and stupid, there’s likely to be a whirlwind” that sweeps you away.” If people see other people cheating, particularly if they are viewed by the public as leaders, the ethical lapses can start to spread like the flu.


  1. “You’re never going to have perfect behavior in a miasma of easy money.” “When the financial scene starts reminding you of Sodom and  Gomorrah, you should fear practical consequences even if you would like to participate in what is going on.” “Investment banking at the height of this last folly was a disgrace to the surrounding civilization.”  “You do not want your first-grade school teacher to be fornicating on the floor or drinking alcohol in the closet and, similarly, you do not want your stock exchange to be setting the wrong moral example.” “The SEC is pretty good at going after some little scumbag whom everybody regards as a scumbag. But once a person becomes respectable and has a high position in life, there’s a great reticence to act. Madoff was such a person.” “You should have personal standards that are way better than the criminal law requires. Why should the criminal law determine your behavior? It would be crazy. Who would behave that way in marriage, or in partnership, or anything else? Why should you do it in your general dealing? I think this mess, and, of course, it’s a little dispiriting to find that many of the people who are the worst miscreants don’t have much sense of shame and are trying to go back as much as they can to the old behavior.  The truth of the matter is, once you’ve shouted into the phone, “I’ll take x and y,” and three days later, you have an extra 5 million, once that has happened, the people just become hopeless addicts, and they lose their bearings.” There will always be some measure of ethical problems. But during times like the Internet bubble or the run up to the credit crisis the presence of easy money can make things worse.


  1. “With so much money riding on reported numbers, human nature is to manipulate them. And with so many doing it, you get Serpico effects, where everyone rationalizes that it’s okay because everyone else is doing it. It is always thus.” These sentences describe an ancient problem. For example Augustine of Hippo once said: “Right is right even if no one is doing it; wrong is wrong even if everyone is doing it.” The problems that can be created by social proof can go beyond ethics. Warren Buffett has said that: “The five most dangerous words in business are: ‘Everybody else is doing it’.” Munger puts it this way: “Once some banker has apparently (but not really) solved his cost-pressure problem by unwise lending, a considerable amount of imitative ‘crowd folly,’ relying on the ‘social proof,’ is the natural consequence.”


  1. “If we mix only a moderate minority share of turds with the raisins each year, probably no one will recognize what will ultimately become a very large collection of turds.” A manager must be careful about the negative impact of a few bad apples on the quality of the other apples in the barrel. Hire slow, and in the case of a turd, fire fast.


  1. “I talked to one accountant, a very nice fellow who I would have been glad to have his family marry into mine.  He said, ‘What these other accounting firms have done is very unethical.  The [tax avoidance scheme] works best if it’s not found out [by the IRS], so we only give it to our best clients, not the rest, so it’s unlikely to be discovered.  So my firm is better than the others.’  I’m not kidding.  And he was a perfectly nice man.  People just follow the crowd. Their mind just drifts off in a ghastly way.” What Charlie Munger is talking about in these sentences is the power of the psychology of human misjudgment. A lollapalooza of biases kicks in to cause this accountant to fall into unethical behavior. There is self-interest bias and social proof and psychological denial and other heuristics at work in a case like this.


  1. “It’s hard to judge the combination of character and intelligence and other things. It’s not at all simple, which explains why we have so many divorces. Think about how much people know about the person they marry, yet so many break up.” “Avoid dealing with people of questionable character.” “One of the reasons the original Ponzi scheme was thrown into the case repertoire of every law school is that the outcome happens again and again. So we shouldn’t be surprised that we have constant repetition of Ponzi schemes.” Judging the ethical nature of anyone is not simple. One clue is how they treat people generally.  I has an assistant for many years who would let me know how job applicants treated the receptionist and others they met. People who are rude and condescending to anyone reveals much about who they are as people. Munger has said: “I think track records are very important. If you start early trying to have a perfect one in some simple thing like honesty, you’re well on your way to success in this world.”


  1. “The best single way to teach ethics is by example.” “Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat.” It is far easier to preach about ethical standards than to live up to them. And living up to ethical standards is the best possible teaching method anyway. Children especially know when someone is walking the talk. Both Munger and Buffett have said that it is wise to “take the high road, since it is less crowded.”



A Dozen Ways Charlie Munger Thinks like Philip Tetlock Suggests in his New Book Superforecasting



Philip Tetlock has written a fantastic new book entitled: Superforecasting: The Art and Science of Prediction that I strongly suggest you read. In the book Tetlock identifies a “rough composite portrait” of a what he calls a “superforecaster” and to me it looks like a picture of Charlie Munger. In my post this week I identify statements from Charlie Munger which I believe fit the Philip Tetlock profile.


  1. Munger: “It’s kind of fun to sit there and out think people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary.” “I would argue that what Berkshire has done has mostly been using trivial knowledge…if you absorb the important basic knowledge…and you absorb all the big basic points across a broad range of disciplines, one day you’ll walk down the street and you’ll find that you’re one of the very most competent members of your generation, and that many people who were quicker mentally and worked harder are in your dust.” “Isn’t reality multidisciplinary, so that you have to use the tools of all the disciplines to solve the complex problems?”


Tetlock: “[Foxes (as distinguished from hedgehogs)] pick and choose their ideas from a variety of schools of thought.”


  1. Munger: “What I’m against is being very confident and feeling that you know, for sure, that your particular intervention will do more good than harm given that you’re dealing with highly complex systems wherein everything is interacting with everything else.” 


Tetlock: “Reality is infinitely complex.”


  1. Munger: “If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest.”


Tetlock: “[Be] probabilistic. Judge using many grades of maybe.”


  1. Munger: “You can progress only when you learn the method of learning.” “I think it’s dishonorable to stay stupider than you have to be.”


Tetlock: “[Be] intellectually curious”


  1. Munger: “Any year that passes in which you don’t destroy one of your best loved ideas is a wasted year.”  


Tetlock: “Beliefs are hypotheses to be tested, not treasures to be guarded.”


  1. Munger: “Bias [arises] from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled.” “what are the factors that really govern the interests involved here rationally considered (i.e. macro and micro level economic factors) and what are the subconscious influences where the brain at a subconscious level is automatically forming conclusions (i.e. influences from instincts, emotions, cravings, and so on)”


Tetlock: “Check thinking for cognitive and emotional biases.”


  1.  Munger: “You can learn to make fewer mistakes than other people- and how to fix your mistakes faster when you do make them.”


Tetlock: “[Be] reflective- introspective and self-critical.”


  1. Munger: “Not drifting into extreme ideology is a very, very important thing in life.”


Tetlock: “[Don’t be] wedded to any idea or agenda.”


  1. Munger: “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. That’s a trained response.” 


Tetlock: “Believe it’s possible to get better.”


  1. Munger: “You must force yourself to consider arguments on the other side.”


Tetlock: “Consider other views…. “


  1. Munger: “You must know the big ideas in the big disciplines and use them routinely—all of them, not just a few. Most people are trained in one model . . . and try to solve all problems in one way . . . This is a dumb way of handling problems.”


Tetlock: “Value diverse views.”


  1. Munger: “The only way to win is to work, work, work, work, and hope to have a few insights.”


Tetlock: “[Be] determined to keep at it no matter how long it takes.”




Superforecasting: The Art and Science of Prediction  http://www.amazon.com/gp/product/0804136696/ref=as_li_qf_sp_asin_il_tl?ie=UTF8&camp=1789&creative=9325&creativeASIN=0804136696&linkCode=as2&tag=valueinves08c-20&linkId=MNXIFQUUJMSLDKDK

A Dozen Things I’ve Learned from Charlie Munger about Moats



1. “We have to have a business with some inherent characteristics that give it a durable competitive advantage.” Professor Michael Porter calls barriers to market entry that a business may have a “sustainable competitive advantage.” Warren Buffett and Charlie Munger call them a “moat.”  The two terms are essentially identical. Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” A complete discussion about the nature of moats can’t be done well in a ~3,000 word blog post since it is one of the most complex topics in the business world.  For this reason, in my book on Charlie Munger I put the material on moats in an appendix since I feared readers would bog down and not focus on the more important points such as making investment and other decisions in life. But the complexity of the topic does not change the fact that to be a “know-something” investor you must understand moats. Even the fate of the smallest business like a bakery or shoe store will be determined by whether they can create some form of moat.  The small business person may not now what a moat is called but the great ones know that they must generate barriers to entry to create a profit. The underlying principle involved in moat creation and maintenance is simple: if you have too much supply of a good or service, price will drop to a point where there is no long-term industry profit above the company’s cost of capital. Michael Mauboussin, in what is arguably the best essay ever written on moats put it this way, “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive return, which will drive aggregate industry returns to opportunity cost of capital.” The best test of whether a moat exists is quantitative, even though the factors that create it are mostly qualitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for a period of years, it does not have a moat.  If a business must hold a prayer meeting to raise prices it does not have a moat. A business may have factors that may create a moat in the future, but the best test for a moat is in the end mathematical.  The five primary elements which can help create a moat are as follows: 1. Supply-Side Economies of Scale and Scope; 2. Demand-side Economies of Scale (Network Effects); 3. Brand; 4. Regulation; and 5. Patents and Intellectual Property.  Each of these five elements is worthy of an entire blog post or even a book. These elements and the phenomenon they create are all interrelated, constantly in flux and when working together in a lollapalooza fashion often create nonlinear positive and negative changes. For me, questions related to the creation, maintenance and destruction of moats are the most fascinating and challenging aspects of the business world.  There are no precise formulas or recipes that govern moats but there is enough commonality that you can get better at understanding moats over time.

2. “We’re trying to buy businesses with sustainable competitive advantages at a low – or even a fair price.” “Everyone has the idea of owning good companies. The problem is that they have high prices in relations to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case.” Buying a business with a moat is a necessary but not a sufficient condition for achieving financial success in a business. What Charlie Munger is saying in these sentences is that if you pay too much for a moat you will not find success. No one makes this point better than Howard Marks who writes: “Superior investors know – and buy – when the price of something is lower than it should be… 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.” Some people have this idea that value investing is only about buying cheap assets. The reality is that many assets are cheap for good reason. Genuine value investing is about buying assets at a substantial discount to their value. This is why Charlie Munger says that: “All intelligent investing is value investing.” What he means is: is there any type of investing whether the objective is to pay more than an asset is worth? There are some assets for which an intrinsic value can’t be computed, but that is a different question than whether an asset should be purchased at a discount to its value. Buffett writes: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”


3. “You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it.”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 is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins.” While there is no formula or recipe for creating a moat there are many common principles that can be used in trying to create or identify one. For example, Munger has said: “In some businesses, the very nature of things cascades toward the overwhelming dominance of one firm. It tends to cascade to a winner take all result.” On another occasion he said: “Do you know what it would cost to replace Burlington Northern today? We are not going to build another transcontinental.” It is important to note that there is a world of difference between creating a new moat than buying an existing one. For example, the venture capital business is fundamentally about building moats and the value investing discipline, as practiced by Munger and Buffett, is instead about buying existing moats at a discount to the intrinsic value of the business.


4. “The only duty of corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it’s too tough.  But your duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you.” What Charlie Munger is saying in these sentences is that operational excellence in running a business is very important, but the factors that maintain the barriers to entry of the business must also receive proper attention by management. For example, if the moat of a business is based on network effects or intellectual property those factors can’t be ignored. Sometimes playing defense is needed in whole or in part, as was the case when Facebook bought several potential moat destroyers. The Instagram, Oculus and WhatsApp acquisitions were in no small part designed to widen the existing Facebook moat. Of course, the companies were bought to create new moats too, so in that sense they served two purposes (i.e., the acquisitions served both offensive and defensive purposes for Facebook). Startups potentially have an asymmetrical advantage since often they are bought by incumbents just for defensive reasons (i.e., sometimes in an acquisition only consumers benefit since the new service or good is all, or nearly all, consumer surplus).


5. “How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.”  The job of a businessperson is to try to create product or service which are sufficiently unique that constraints are placed on  other companies who desire to provide a competing supply of those goods or services. For this reason moat creation and maintenance is a key part of the strategy of any business. What this means is that the essential task of anyone involved in establishing a strategy for a business is defining how a business can be unique. Creating a business strategy is fundamentally about making choices.  It is not just what you do, but what you choose not to do, that defines an effective strategy. Professor Michael Porter argues that doing what everyone must do in a business is operational effectiveness and not strategy.  The people who most often create unique compelling offerings for customers are true fanatics. Jim Sinegal of Costco is just such a fanatic which is why Charlie Munger serves on their board.  Going down the list of Berkshire CEOs reveals a long list of fanatics.


6. “Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.” This set of sentences is an example of Charlie Munger applying his inversion approach. He believes that when you have a hard problem to solve the best solution often appears when you invert the problem.  For example, Munger applies the inversion process to moat analysis. Instead of just looking at why a moat exists or can be made stronger, he is saying you should think about why it may weaken. He is looking for sources of unique insight that might have been missed by others who may be too optimistic. Not being too optimistic is consistent with his personality. Munger has called himself a “cheerful pessimist.” Over time the forces of competitive destruction will inevitably weaken any moat. Munger has said: “It is a rare business that doesn’t have a way worse future than a past.” “Capitalism is a pretty brutal place.” “Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.” Bill Gates describes what Berkshire is looking for in a business as follows: “[they] talk about looking for a company’s moat — its competitive advantage — and whether the moat is shrinking or growing.”


7. “Kellogg’s and Campbell’s moats have also shrunk due to the increased buying power of supermarkets and companies like Wal-Mart. The muscle power of Wal-Mart and Costco has increased dramatically.”  Wholesale transfer pricing power, also sometimes called supplier bargaining power (e.g., in the Michael Porter five forces model) is a potential destroyer of moats. Understanding who has pricing power in a value chain is a critical task for any manager. As an example of a moat being attacked in this way, the venture capitalist Chris Dixon wrote once about a chain of events in the gaming industry : “In Porter’s framework, Zynga’s strategic weakness is extreme supplier concentration – they get almost all their traffic from Facebook. It is in Facebook’s economic interest to extract most of Zynga’s profits, leaving them just enough to keep investing in games and advertising.” As another example, most every restaurant which does not own its building faces this same wholesale transfer pricing problem.  If you have an exclusive supplier of a necessary input, that supplier controls your profits. It is wise to have multiple suppliers of any good or service, at least potentially.


8. “What happened to Kodak is a natural outcome of competitive capitalism.” “The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors Company, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very Darwinian—it’s tough out there. Technological change is one of the toughest things.” I don’t know of any business in today’s business world that does not face significant disruptive threats. None. It is brutally competitive to be involved any business today. Do some businesses have moats that make their lines of business relatively more profitable? Sure. But I can’t think of any business which is not under attack right now. When I say every business is competitive in todya’s world I mean every business. Life as the owner of a sandwich shop, a food processor, marketing consultancy, etc. is inevitably tough. Pricing power in the business world today is rarer than a Dodo bird. Technology businesses present a special case when it comes to moats since disruptive change is much more likely to be nonlinear. Businesses in the technology sector that seem relatively solid can disappear in the blink of an eye. The factors like network effects that can create startling success for a technology company can be just as powerful on the way down as they were the way up.


9.  “The perfectly fabulous economics of this [newspaper] business could become grievously impaired.” The newspaper business once had a strong moat created by economies of scale inherent in huge printing plants and large distribution networks needed for physical newspapers. The Internet has caused the moats of newspapers to quickly atrophy, which is problematic for owners and society as a whole given that the news itself is what is called a “public good” (i.e., non-rival and non-excludable). Charlie Munger has lamented the decline of newspapers: “It’s not good for the country. We’re losing something.” Buffett has said it “blows your mind” how quickly the newspaper industry has declined. The way commentators on the financial prospects of newspapers ignore the public good problems is amazing really.  Increasing something like quality does not fix a public good problem. Without some scarcity/a moat there will be no ability on the part of newspapers to generate a profit.  Solutions to journalism business model problems are likely to include philanthropy as is the case with other public goods.


10.“Network TV [in its heyday,] anyone could run and do well. If Tom Murphy is running it, you’d do very well, but even your idiot nephew could do well.” Some moats are so strong that even a weak management teams can prosper running the business. The broadcast television moat is not what it once was given the rise of things like over the top viewing. But at one time television had a bullet proof moat. Buffett believes: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Munger certainly wants a business in which he invests to be run by capable and trustworthy managers. Operational excellence is always desired. But having a moat is a protection against a poor manager running a business into the ground. Buffett said once:  “Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.” 


11. “I think it’s dangerous to rely on special talents — it’s better to own lots of monopolistic businesses with unregulated prices. But that’s not the world today.” In these sentences Charlie Munger uses a term that Peter Thiel likes to use when referring to a moat: “monopoly. While it is certainly profitable to own an unregulated monopoly, the number of businesses today that have moats which can be considered a monopoly is vanishingly small.  For this reason I think Peter Thiel takes the monopoly point too far.  The word monopoly is loaded and carries too much baggage to be useful. The reality is that the nature of moats is not binary. Moats come in all varieties, from strong to weak. They are always in flux and vary on multiple dimensions. For example, some big moats are more brittle than others. Some moats protect valuable market segments and some do not. In other words, moats can be classified along a spectrum from strong to weak, valuable to non valuable and from big to small.


12. “The informational advantage of brands is hard to beat.  And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage. Everyone is influenced by what others do and approve.  Another advantage of scale comes from psychology. The psychologists use the term ‘social proof’. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, ‘Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ All told, your advantages can add up to one tough moat.” The most important point made in these sentences by Charlie Munger is that the great moats which exist in the world tend to have an aggregate value that is more than the sum of the parts. Munger calls this a “lollapalooza” outcome. Others may refer to it as synergy. As an example, many moats in the technology business are based on what Munger calls an informational advantage, but there can be many other factors like economies of scale or intellectual property that feed back on each other to create and strengthen the moat.

I am at ~3,400 words in this post and if you are still reading the probability is good that you understand or soon will understand this critical aspect of investing called “moats.” The opportunities to learn never end. I think is the best game on Earth and that fact explains why Munger and Buffett love what they do so much that they plan to continue to be investors as long as they are physiologically able to do so.  Here’s Buffett to finish this post off:

“I will say this about investing: Everything you do earn is cumulative. That doesn’t mean that industries stay good forever, or businesses stay good forever, but in learning to think about business models, what I learned at 20 is useful to me now. What I learned at 25 is useful to me now. It’s like physics. There are underlying principles, but now they’re doing all kinds of things with physics they weren’t doing 50 years ago.
But if you’ve got the principles, if you know what makes a good business, if you know what makes a good manager, if you know what makes a good product, and you learn that in one business, there is some transference to other businesses.”





Mauboussin and Callahan: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf


Chris Dixon  http://cdixon.org/2010/05/08/facebook-zynga-and-buyer-supplier-hold-up/
















A Dozen Things I’ve Learned from Charlie Munger about Capital Allocation


1. “Proper allocation of capital is an investor’s number one job.” Capital allocation is not just the number one job of an investor but of anyone involved in any business. This is a core part of why Buffett and Munger say that being an investor makes you a better business person and being a better business person makes you a better investor. Making capital allocation decisions is core to any business, including a hot dog stand. Everyone must decide how to deploy their firm’s resources. Michael Mauboussin and Dan Callahan describe the core task in allocating capital simply: “The net present value (NPV) test is a simple, appropriate, and classic way to determine whether management is living up to this responsibility. Passing the NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the present value of the long-term cash flow from an investment exceeds the initial cost.” Of course just passing the NPV test is not enough since the investor or business person’s job to seek the most attractive opportunity of all the opportunities that are available. Building long-term value per share is the capital allocator’s ultimate objective. Buffett puts it this way: “If we’re keeping $1 bills that would be worth more in your hands than in ours, then we’ve failed to exceed our cost of capital.”

2. “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” Munger is not a fan of academic approaches to capital allocation. He would rather keep the analysis simple. One issue that concerns both Buffett and Munger is that many CEOs arrive in their job without having sound capital allocation skills. The jobs that they have had previously in many cases do not provide them with sufficient capital allocation experience. Buffett has written: “Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The best way to learn to wisely allocate capital is to actually allocate capital and get market feedback on those decisions. Allocating capital requires judgment and the best way to have good judgment is often to have experienced some effects of bad judgment. This lack of capital allocation experience can create problems since many people tend to focus on short-term stock prices and quarterly results. Munger believes that if an investor or CEO focuses on wise capital allocation and long term value the stock price will take care of itself.

3. “In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics. The game hasn’t changed at all. That’s why Modern Portfolio Theory is so asinine.” “It’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.” “I’ve never heard an intelligent discussion on cost of capital.” Munger has on several occasions expressed his unhappiness with academic approaches to finance. Buffett describes their approach as follows: “Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it.” All capital has an opportunity costs – what you can do with the next best alternative. If your next best alternative is 1%, it is 1% and if it is 10% it is 10%, no matter what some formula created in academia might say. Allocating capital to a sub-optimal use is a mis-allocation of capital. As an example, if you are a startup founder and you are buying expensive chairs for your conference room the same process should apply. Is that your best opportunity to deploy capital? Those chairs can potentially be some of the most expensive chairs ever purchased on an opportunity cost basis. I have heard second hand that if you drive an expensive sports car Buffett has in the past on the spot calculated in his head what your opportunity cost is in buying that car versus investing.

4. “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.” “Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland.” The current interest rate environment is a big departure from the past. Andy Haldane has pointed out that interest rates appear to be lower than at any time in the past 5,000 years. These very low interest rates driven by a “zero interest rate policy” or ZIRP have created new challenges for investors and business people. One issue that seems to exists today is a stickiness of hurdle rate at some businesses. Hurdle rates that were put in place in the past may not be appropriate in today’s world. Buffett has said: “The real test is whether the capital that we retain generates more in market value than is retained. If we keep billions, and the present value is more than we’re keeping, we’ll do it. We bought a company yesterday because we thought it was the best thing that we could do with $3 million on that day.” In 2003 Buffett said: The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.” Warren also recently said that he wasn’t just going to buy using today’s very low rates just because they were his current best opportunity. These sorts of questions are very hard to sort out given the economic environment we are in now is new. The last point Munger makes is that when someone promises you a long term return of something like 20% for 40 years hold on to your wallet tightly and run like the wind.

5. “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.” Munger likes a business that generates free cash flow that need not be reinvested and not just an accounting profit. Some business with an accounting profit require that you reinvest all or nearly all of any cash generated into the business and Munger is saying businesses like this are not favored. Coke and See’s Candies are attractive businesses based on this test. Airlines by contrast are not favored. Munger calls an airlines “marginal cost with wings.” Munger is also not a fan of creative accounting’s attempt to hide real costs: “People who use EBITDA are either trying to con you or they’re conning themselves. Interest and taxes are real costs.” “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” Buffett says: “Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money.”

6. “Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital.” “A phrase like cost of capital means different things to different people. We just don’t know how to measure it. Warren’s way of describing it, opportunity cost, is probably right. The answer is simple: we’re right and you’re wrong.” “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.” Berkshire does not “want managers to think of other people’s money as ‘free money’” says Buffett, who points out that Berkshire imposes a cost of capital on its managers based on opportunity cost. One thing I love about this set of quotes is Munger admitting that Buffett is only “probably” right and that they don’t know how to measure something others talk about. It indicates that Munger is always willing to consider that he is wrong. While he has said that he has a “a black belt in chutzpah,” he has also said that if he does not overturn a treasured belief at least once a year, it is a wasted year since it means he is not always looking hard at whether his beliefs are correct. In his new book Superforecasting, Professor Philip Teltock might as well have been writing about Charlie Munger when he wrote: “The humility required for good judgment is not self doubt – the sense that you are untalented, unintelligent or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.”

7. “We’re partial to putting out large amounts of money where we won’t have to make another decision.” Attractive opportunities to put capital to work at high rates of return don’t come along that often. Munger is saying that if you are a “know something investor” when you find one of these opportunities you should load up the truck and invest in a big way. He is also saying that he agrees with Buffett that their preferred holding period “is forever.” Buffett looks for a business: “where you have to be smart only once instead of being smart forever.” That inevitably means a business that has a solid sustainable moat. Buffett believes that finding great investment opportunities is a relatively rare event: “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.” When he finds a really great business the desire of Charlie Munger is to hold on to it. Munger elaborates on the benefits of not selling: “You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.”

8. “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions.” Centralization of capital allocation decisions at Berkshire to take advantage of Warren Buffett’s extraordinary abilities is an example of opportunity cost analysis at work. Why allow your second best capital allocator or 50th best do this essential work? Here’s Buffett on his process: “In allocating Berkshire’s capital, we ask three questions: Should we keep the capital or pay it out to shareholders? If pay it out, then you have to decide whether to repurchase shares or issue a dividend.” “To decide whether to retain the capital, we have to answer the question: do we create more than $1 of value for every dollar we retain? Historically, the answer has been yes and we hope this will continue to be the case in the future, but it’s not certain. If we decide to retain and invest the capital, then we ask, what is the risk?, and seek to do the most intelligent thing we can find. The cost of a deal is relative to the cost of the second best deal.” As was noted in the previous blog post in this series, nearly everything else other than capital allocation and executive compensation is decentralized at Berkshire.

9. “We’re not going to put huge amounts of new capital into a lousy business. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” This is such an important idea and yet it is often poorly understood. Many investments in a business are only going to benefit customers because the business has no moat. In economic terminology, the investment produces all “consumer surplus” and no “producer surplus.” Some businesses must continue to plow capital into their business to remain competitive in a business that is still going to deliver lousy financial returns. Journalists often talk about businesses that “earn” some amount without noting that what they refer to is revenue not profit. What makes a business thrive is profit and absolute dollar free cash flow. One thing I am struck by in today’s world is how hard nearly every business is in terms of making a significant genuine profit. The business world is consistently hyper competitive. There is no place to hide from competition and potential disruption. If you have a profit margin, it is someone else’s opportunity. Now more than ever. People who don’t think this contributes the inability of central banks to create more inflation are not living in the real business world.  Making a sustained profit in a real business is very hard.

10. “I don’t think our successors will be as good as Warren at capital allocation.” There will never be another Warren Buffett just as there will never be another Charlie Munger. But that does not mean you can’t learn from the way they make decisions, including, but not limited to, capital allocation decisions. Learning from others is strangely underutilized despite its huge rewards. Some of this aversion to learning from others must come from overconfidence. This overconfidence is good for society since it results in a lot of intentional and accidental discovery. But at an individual level it is hard on the people doing the experimentation. Reading widely about how others investors and business people approach capital allocation is wise. As an example, Howard Marks and Seth Klarman are people who have learned from Buffett and Munger and vice versa. Having said that, we are all unique as investors. There is no formula or recipe for successful investing. But there are approaches and processes that are far more sound than others that can generate an investing edge if you are willing to do the necessary work. These better decision making process are applicable in life generally. If you are not willing to do the work that an investor like Munger does in his investing, you should buy a diversified low cost portfolio of index funds/ETFs. A dumb “know nothing investor” can transform themselves into a smart investor by acknowledging that they are dumb. Buffett calls this transformation from dumb to smart of they admit they are dumb an investing paradox.

11. “All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return.” Munger is saying that the more assets you must manage the harder it is to earn an above market return. Putting large amounts of money to work means it takes more time to get in and out of positions and for that reason it becomes hard to effectively invest in relatively smaller opportunities. Buffett puts it this way: “There is no question that size is an anchor to performance. We intend to prove that up to the point that it really starts biting. We can’t earn the same returns on capital with over $300 billion in market cap. Archimedes said he could move the world with a long enough lever. I wish I had his lever.”

12. “Size will hurt returns. We can only buy big positions, and the only time we can get big positions is during a horrible period of decline or stasis. That really doesn’t happen very often.” There are times when Mr. Market turns fearful and huge amounts of capital can be put to work even by Berkshire as was the case in 2008. To be able to take advantage of this requires that the investor (1) be patient and (2) be aggressive when it is time. Jumping in when things are falling apart takes courage. Not jumping is during a period of investing frenzy takes character. Bill Ruane believes: “Staying small in terms of the size of fund is simply good business. There aren’t that many great companies.” The bigger the fund the harder it is to outperform. Bill Ruane famously closed his fund to new investors to be “fair” to his clients. 

In terms of an example of outperforming during what for others was a horrible time, the following example of Munger in action below speaks for itself. Bloomberg wrote at the time: “By diving into stocks amid the market panic of 2009, Munger reaped millions in paper profits for the Daily Journal. The investment gains, applauded by Buffett at Berkshire Hathaway’s annual meeting in May, have helped triple Daily Journal’s own share price. While Munger’s specific picks remain a mystery, a bet on Wells Fargo (WFC) probably fueled the gains, according to shareholders who have heard Munger, 89, discuss the investments at the company’s annual meetings. ‘Here’s a guy who’s in his mid-80s at the time, sitting around with cash at the Daily Journal for a decade, and all of a sudden hits the bottom perfect.’”

Munger having the necessary cash to do this investment in size at the right time in 2009 was not accidental. You don’t have the cash at the right time by following the crowd. As Buffett points out holding cash is not costless: “The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time.” That available cash was a residual of a disciplined buying process focused on a bottoms-up analysis by Munger of individual stocks. His ability to do this explains why he is a billionaire and we are not.


Michael Mauboussin: http://covestreetcapital.com/wp-content/uploads/2015/07/Mauboussin-June-2015.pdf [The bibliography in this essay is extensive.]

Superforecasting  http://www.amazon.com/Superforecasting-The-Art-Science-Prediction/dp/0804136696

A Dozen Things I’ve Learned about Great CEOs from “The Outsiders” (Written by William Thorndike)  http://25iq.com/2014/05/26/a-dozen-things-ive-learned-about-great-ceos-from-the-outsiders-written-by-william-thorndike/

Bloomberg on Munger’s Golden Touch http://www.bloomberg.com/bw/articles/2013-07-25/berkshire-hathaways-charlie-munger-shows-a-golden-touch

A Dozen Things I’ve Learned from Charlie Munger About The Berkshire System

1. “There are two main reasons Berkshire has succeeded. One is its decentralization. Decentralization almost to the point of abdication. There are only 28 people at headquarters in Omaha. The other reason is our extreme centralization of capital deployment. Our centralization is just as extreme as our decentralization.” Systems are important in Charlie Munger’s world. I have already written a blog post in this series about one system called “the value investing system.” This post is about another system known as “the Berkshire System.” These two systems are related, but distinct. A system can be defined as a set of processes and methods that produce a desired result that is more than the sum of the parts. Charlie Munger is an example of a “systems level thinker.” Munger thinks deeply about things like understanding that local optimizations that actually decrease performance of the overall system.  Munger also talks a lot about lollapaloozas and the impact of 2nd and 3rd order effects. Howard Marks is doing this too with his second level thinking idea. Nassim Taleb thinks in the same way, including the nonlinear impact of systems level interactions. The best investors and business people think hard and a lot about systems.

The Berkshire system is not the only system for operating a business but it is a very good one. Attempts have been made to replicate the Berkshire system but they are unlikely to be successful without adopting all of the elements that will be described below. In other words, half of the Berkshire system will not be much of an effective system. For example, delegating control without trustworthy people throughout the organization will fail. Decentralization of everything including capital allocation will fall prey to what Buffett calls “the Institutional Imperative: “rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated…Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.” Professor Lawrence Cunningham, who has written an excellent book on Berkshire writes: “The only qualifications on managerial autonomy at Berkshire appear in a short letter Buffett sends its unit chiefs every two years. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations.”

People sometimes are get confused about what Warren Buffett does at Berkshire. Munger puts it simply: “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions, and we have decentralization among our operations without a big bureaucracy. That’s the Berkshire Hathaway model.” It is worth noting that it is Buffett and not Munger who ultimately who makes the capital allocation decisions. Buffett seeks Munger’s guidance and thoughts but Buffett pulls the capital allocation trigger. I have another blog post in the works on the capital allocation process at Berkshire, which will take the total number of planned posts on Munger up to a Spinal Tap-style #11.  Buffett has said on the capital allocation system: “Berkshire wants the capital in the most logical place. Berkshire is a tax efficient way to move money from business to business, and we can redeploy capital in places that need them. Most of the managers of companies we own are already independently rich. They want to work, but don’t have to. They don’t horde capital they don’t need.” The management at a subsidiary like See’s Candies is given a capital allocation by Buffett, not the reverse. Superior capital allocation skill is one of Warren Buffett’s unique gifts. Some people can do things like skateboard very well and some people can allocate capital very well. Buffett has pointed out: “If all of us were stranded on a desert island somewhere and we were never going to get off of it, the most valuable person there would be the one who could raise the most rice over time. I can say, “I can allocate capital!” You wouldn’t be very excited about that. So I have been born in the right place.”

2. “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.” These three sentences capture the essence of what drives the success of the Berkshire System and the necessary preconditions for that system to work effectively. Firms exist to reduce the cost of coordinating economic activity versus the alternative approach. The Berkshire System implemented in a firm will not generate the desired efficiency and results unless the organization has trust in trustworthy people. That efficiency makes the businesses, managers and employees in the Berkshire system better able to adapt to changes in the environment. Professor Lawrence Cunningham relays this interesting snippet from a private conversation: “Munger told me: take Coase seriously/avoid middlemen.” People talk about capitalism being the most efficient way to allocate resources, but it is capitalism’s ability to drive innovation via discovering new innovation that makes is the best possible economics system. A person saying that socialism is more efficient than capitalism since it is more efficient to have only a few types of phones is an absurdity. Innovation and progress requires failure. Lots of failure. Munger has said, after giving the hat tip to Allen Metzger for the phrasing: “I regard it as very unfair, but capitalism without failure is like religion without hell.” If course, markets sometimes fail too, which is why programs and policies like a social safety net are needed. Munger described this in his typical blunt fashion: “Greenspan was a smart man but he overdosed on Ayn Rand at a young age.” Munger also said once at one of his most famous speeches given at USC: “Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind. … When you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out, what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind.”

3. “The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.” The culture of a business is more than the sum of its parts. The totality of the vision, values, norms, systems, symbols, language, assumptions, beliefs, and habits of a business is what creates the culture of a business. Munger and Buffett are huge proponents of creating a strong organizational culture: “Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.…Cultures self-propagate.” Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior.”

4. “We want people where every aspect about their personality makes you want to be around them. Trust first, ability second.” The greater efficiency that Munger talks about flows from trust. When trust exists you can eliminate lots of inefficient procedures which must exist in a system that must deal with people who are not trustworthy. This means trust is an essential element in hiring people and that exhibiting a lack of trust is something that should result in a dismissal from the business. Buffett’s stated philosophy on this point is well known: “Lose money for the firm and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.” Are they perfect in implementing this philosophy? No. They admit mistakes for the reasons my previous blog posts have discussed.  Mistakes are feedback and if you don’t try to learn from mistakes you are not only missing and opportunity, you are a fool.

5. “Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. But if you’re going to provide minimal oversight, you have to buy carefully.” “The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it.” The acquisition process Berkshire uses is very deliberate. Berkshire only buys businesses that meet certain criteria including having an existing moat and existing high quality management. They do not want to create moats or supply management. They greatly admire people who create moats but know that creating moats is not their best game in terms of circle of competence. Munger has said: “We don’t train executives, we find them. If a mountain stands up like Everest, you don’t have to be a genius to figure out that it’s a high mountain.” The same principle applies to moats: spotting a business with an existing moat is vastly easier than trying to spot a new moat emerging from a complex adaptive system.  Seeing something emerging from nothing is a really hard problem compared to seeing something that is already there. Munger does not like really hard problems.  He likes easy problems that have very favorable odds of a big payoff if he is right.

6. “We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.” Munger is talking about the importance of creating and maintaining the Berkshire culture which enables and depends upon trust. It is tremendously cost efficient to have a culture that is based on trust, since you don’t have the cost or the inefficiency associated with layers of management and complex systems that try to act as a substitute. David Larcker and Brian Tayan in a paper cited in the notes below write:“A trust-based system [requires] the development and maintenance of a culture that encourages responsible behavior. As Munger says, “People are going to adopt to whatever the ethos is that suffuses the place.” Which means that this ethos is worth paying close attention to and developing well including being based on a high degree of trust.

7. “A lot of people think if you just had more process and more compliance — checks and double- checks and so forth — you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.” “I think your best compliance cultures are the ones which have this attitude of trust and some of the ones with the biggest compliance departments, like Wall Street, have the most scandals.” Buffett has said: “Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.” Lawrence Cunningham writes in his book: “At most companies, CEOs might formulate a general acquisition program with little board involvement and then present specific proposals to the board, which discusses deal terms and approves funding. The board’s role in this setting is an example of its service as an intermediary. Berkshire does the opposite, enabling Buffett to seize opportunities that would be lost if prior board involvement occurred…. Berkshire’s success at such internal capital reallocation has vindicated its conglomerate business model that has otherwise been denigrated across corporate America. The strategy skillfully avoids intermediaries. Cash transferring subsidiaries distribute cash to Berkshire without triggering any income tax consequences. Cash-receiving subsidiaries obtain corporate funding without frictional costs of borrowing, such as bank interest rates, loan covenants, and other constraints. Some subsidiaries generate tax credits in their businesses that they cannot use but can be used by sister subsidiaries.”

8. “Everybody likes being appreciated and treated fairly, and dominant personalities who are capable of running a business like being trusted. A kid trusted with the key to the computer room said, ‘It’s wonderful to be trusted.’” “We promised our CEOs that they could spend 100% of their time on their business. We place no impediments on them running their businesses. Many have expressed to me how happy they are that they don’t have to spend 25% of time on activities they didn’t like.” People value working for a business that trusts them. In other words, working for a business that trusts you is a non-financial employee benefit. When this trust exists great people like to work for the business and that makes recruiting other people easier. This attracts other great people since this attribute and success feeds back on itself. One of the attractions of Berkshire as a buyer to a person selling a business is that Buffett and Munger will continue to let them run their business and won’t break it into pieces like an automobile chop shop like most private equity buyers. The managers of Berkshire subsidies love Buffett and Munger for giving them freedom to run their business.

9. “When you get a seamless web of deserved trust, you get enormous efficiencies. … Every once in a while, it doesn’t work, not because someone’s evil but because somebody drifts to inappropriate behavior and then rationalizes it.” “In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s big and whether it’s material. You can do a lot to mitigate bad behavior, but you simply can’t prevent it altogether.” “By the standards of the rest of the world, we over-trust. So far it has worked very well for us. Some would see it as weakness.” There will be instances where someone is not as trustworthy as anticipated. This is a necessary price to pay to harvest the operational efficiencies when trust is deserved. Mistakes will happen and must be corrected. For example, CNBC noted: “Buffett did admit that he “obviously made a big mistake by not saying ‘Well, when did you buy it?’ when Sokol first told him he owned Lubrizol stock in January.  Buffett also apologized for not including more ‘outrage’ in his March 30 letter announcing Sokol’s ‘resignation.” Munger added, ‘I think we can concede that that press release was not the cleverest press release in the history of the world.’” Everyone makes mistakes and will keep making mistakes.  Don’t let one or even a few lousy outcomes throw you off  the right path. If you have a sound process you will make less mistakes overall and come out ahead.

10. “There’s money in being trusted. It’s such a simple idea, and yet everybody rushes into every scummy activity that seems to work.” Munger is saying that not only is being trustworthy the right thing to do morally, ethically and in terms of being happy in life, but it is the most profitable way to live your life. In short, being trustworthy is more profitable than being untrustworthy. “A trust-based system can be more efficient than a compliance-based system, but only if self-interested behavior among employees and managers is low” write Larcker and Tayan in the previously cited paper.

11. “We want very good leaders who have a lot of power, and we want to delegate a lot of power to those leaders. It’s crazy not to distribute power to people with the most capacity and diligence. Every time I see an opportunity to choose somebody, the second best guy is just awful compared to the guy we hire. Usually the decision is a no-brainer. We have to give power to the people who can wield it efficiently in serious game of survival.” “A lot of corporations are run stupidly from headquarters, driving divisions to increase earnings every quarter. We don’t do that. The stupidity of management practices in the rest of the corporate world will last long enough to give us an advantage well into the future.” Tom Murphy once described the best approach to decentralization of operating decisions this way: “don’t hire a dog and try to do the barking.” Managers who are on the line in a business actually interacting with customers and systems are in the best position to make the necessary decisions if they are the right people.  So work really hard to get the right people with the right skills and let them do their job. By accepting that sometimes businesses have lumpy earnings and letting talented managers run their business without interference Berkshire earns a superior long term return. The idea that this advantage is not possible or sustainable because markets are perfectly efficient is rubbish to anyone actually running a business.

12. “One of the greatest ways to avoid trouble is to keep it simple.” “When you make it vastly complicated—and only a few high priests in each department can pretend to understand it—what you’re going to find all too often is that those high priests don’t really understand it at all…. The system often goes out of control.” “We operate Berkshire [via] a seamless web of deserved trust. We get rid of the craziness, of people checking to make sure it’s done right.” “Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional — it isn’t the way things are normally done. We have low overhead, don’t have quarterly goals and budgets or a standard personnel system, and our investing is much more concentrated than average. It’s simple and common sense.” A simpler system results in fewer mistakes and makes life much more pleasant. What could be more simple?


Lawrence Cunningham: Berkshire Beyond Buffett: The Enduring Value of Values http://www.amazon.com/Berkshire-Beyond-Buffett-Enduring-Values/dp/0231170041 and Berkshire’s Disintermediation: Buffett’s New Managerial Model http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2602825

Corporate Governance According to Charles T. Munger https://www.gsb.stanford.edu/sites/default/files/38_Munger_0.pdf

A Dozen Things I’ve Learned from Charlie Munger about Mistakes

1. “There’s no way that you can live an adequate life without many mistakes.” “Of course, there’s going to be some failure in making the correct decisions. Nobody ‘bats a thousand.’” “I don’t want you to think we have any way of learning or behaving so you won’t make mistakes.” Everyone makes mistakes sang Big Bird on the first episode of Sesame Street. Albert Einstein said once that anyone who has never made a mistake (if there is such a person) has never tried anything new. Warren Buffett agrees: “I make plenty of mistakes and I’ll make plenty more mistakes, too. That’s part of the game. You’ve just got to make sure that the right things overcome the wrong.” Charlie Munger has learned about business in the best way possible: by making mistakes and being successful actually being in business. Reading about business is vital, but Munger has said that there is no substitute for wading in and actually taking the plunge as a business manager or owner. Yes, you can learn vicariously by watching others and by reading. Learning from the mistakes of others is essential. To maximize how much he learns Munger reads five newspapers a day and has been described as a book with legs sticking out. It is far better to learn vicariously when it comes to many of the more painful mistakes in life.  At one shareholder meeting Munger when describing Berkshire’s mistakes in the shoe business quoted Will Rogers: “There are three kinds of men. Some learn by reading. Some learn by observation. The rest of them must pee on the electric fence for themselves.”

2. “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” The flip side of mistakes for an investor is that they are not just a source of problems, but also the underlying source of opportunity for investors. Howard Marks writes: “In order for one side of a transaction to turn out to be a major success, the other side has to have made a big mistake. Active management has to be seen as a search for mistakes.” This inescapable math explains the old folk wisdom that if you don’t see who the sucker is at the poker table, it is you. Munger believes: “You have to look for a special area of competency and focus on that…. Go where there’s dumb competition.” If you don’t see who is the dumb competition, it is you. Mr. Market is often not wise so don’t treat him as if he is.  Mr. Market is your servant, not your master.

3. “Forgetting your mistakes is a terrible error if you are trying to improve your cognition. Reality doesn’t remind you.” Hindsight bias is the tendency of people to believe that their forecasts and predictions were more accurate than they were in reality. People tend to forget their mistakes and exaggerate their successes. In retrospect, events often appear to be much more predictable than at the time of any given forecast. One way to reduce hindsight bias is to write down your decisions in a journal and to go back and take an objective look at your decision-making record. Shane Parrish points out: “A decision journal will not only allow you to reduce your hindsight bias, but it will force you to make your rationale explicit upfront. We often get the outcome we think will happen, but for the wrong reasons.” Neal Roese, a professor of marketing at the Kellogg School of Management at Northwestern University, has said: “You begin to think: ‘Hey, I’m good. I’m really good at figuring out what’s going to happen.’ You begin to see outcomes as inevitable that were not.”

4. “Why not celebrate stupidities?” “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” It is through the process of making mistakes and having success in the real world that you can learn and establish sound business judgment. Buying Berkshire Hathaway itself can arguably be put into the mistake category. The New England textile mill when bought in the 1960s was a lousy business. Buying the textile business was certainly valuable in one way in that it taught Buffett and Munger what not to do. Munger notes: “Chris Davis [of the Davis funds] has a temple of shame. He celebrates the things they did that lost them a lot of money. What is also needed is a temple of shame squared for things you didn’t do that would have made you rich.” Learning from mistakes does not mean wallowing in failure too much. Buffett says: “it is better to learn from other people’s mistakes as much as possible. But we don’t spend any time looking back at Berkshire. I have a partner, Charlie Munger; we have been pals for forty years—never had an argument. We disagree on things a lot but we don’t have arguments about it.”

5. “A trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way for people to go broke.” “Warren and I aren’t prodigies. We can’t play chess blindfolded or be concert pianists. But the results are prodigious, because we have a temperamental advantage that more than compensates for a lack of IQ points.” Munger is getting at the importance of temperament to success as an investor. Most mistakes are psychological and emotional. Munger believes that he and Buffett have an advantage that is based more on temperament than IQ. If you can’t handle mistakes, Munger suggests that you buy a diversified portfolio of low fee index funds and leave active investing to others. Unfortunately, even if you do select an index-based approach you still must make some investing decisions such as assets allocation, fund selection and asset rebalancing periods.

6. “Terribly smart people make totally bonkers mistakes.” “Smart people aren’t exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages.” Munger is saying that smart people are not exempt from making mistakes. Overconfidence can cause a person with a high IQ to make more mistakes than someone who has an IQ that is 30 points lower. It is the person with the high IQ who falsely thinks that is 30 points higher than it really is that gets you into serious trouble says Munger. People who are genuinely humble about their IQ can sometimes make far fewer mistakes if they do the necessary work, have a sound investment process and think in rational ways.

7. “Most of Berkshire’s success grew from stupidity and failure that we learned from.” Berkshire has made many mistakes. Paying too much for Conoco Phillips was a mistake as was Berkshire buying US Airways. The best way to become a millionaire is to start with a billion dollars and buy an airline is an old joke in business. Munger has said that: “Hochschild, Kohn the department store chain was bought at a discount to book and liquidating value. It didn’t work [as an investment.” He added on another occasion: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Buying Dexter Shoes was definitely a multi-billion dollar mistake for Berkshire. In doing the Dexter due diligence analysis Buffett and Munger made the mistake of not making sure the business had what they call a “moat” and being too focused on what they thought was an attractive purchase price. Buffett said once about Dexter: “What I had assessed as durable competitive advantage vanished within a few years.” Capitalism inherently means that others will always be trying to replicate any business that is profitable and that means you are always in a battle to keep what you have. Dexter lost that battle in a very swift fashion. If you make a mistake, capitalism’s competitive destruction forces will expose it swiftly and sometimes brutally.

8. “Where you have complexity, by nature you can have fraud and mistakes.” “In terms of business mistakes that I’ve seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations. Warren and I personally don’t drill oil wells. We pay our taxes. And we’ve done pretty well, so far. Anytime somebody offers you a tax shelter from here on in life, my advice would be don’t buy it.” “We try more to profit from always remembering the obvious than from grasping the esoteric.” Complexity can be your friend or your enemy depending on the circumstances. I am somewhat surprised by the fact that fees and incomes in finance are so high when there seem to be a lot of competition. There is clearly an asymmetric information problem in finance. But it would seem like technology should have brought fees and incomes down faster in finance as it has in some other sectors. The answer must lie in the fact that humans tend to make so many psychological and emotional mistakes and what Professor Cialdini calls “compliance professionals” are able to milk that tendency to keep fees high.

9 . “The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes — we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes [of omission]: 1) doing nothing; what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.” “Our biggest mistakes were things we didn’t do, companies we didn’t buy.” “Since mistakes of omission don’t appear in the financial statements, most people don’t pay attention to them.” Munger and Buffett not investing in Wal-Mart is just one example of a mistake of omission. Buffett has said that just this one mistake with Wal-Mart cost them $10 billion. In 1973 Tom Murphy offered to sell some television stations to Berkshire for $35 million and Buffett declined. “That was a huge mistake of omission,” Buffett has admitted.  Buffett also has said: mistakes of omission…are where we knew enough about the business to do something and where, for one reason or another, sat they’re sucking out thumbs instead of doing something. And so we have passed up things where we could have made billions and billions of dollars from things we understood, forget about things we don’t understand.”

10. “It’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it. I regard it as perfectly normal to fail and make bad decisions. I think the tragedy in life is to be so timid that you don’t play hard enough so you have some reverses.” Of course, you can also learn from success, particularly if you remember that success can be a lousy teacher since what you may believe is the outcome of skill may instead be an outcome based luck. As noted above they try to learn from mistakes but them to move on. Use the feedback from mistakes to improve the process if you can’t but spend no time wallowing in failure. If you never make mistakes, you are not being ambitious enough.

11. “Banking has turned out to be better than we thought. We made a few billion [dollars] from Amex while we misappraised it. My only prediction is that we will continue to make mistakes like that.” “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” Munger has said that more than once that he and Buffett have made a mistake only to be bailed out by luck. Confusing luck with skill is easy to do. If luck does happen, embrace it.  Bad luck may arrive soon enough to balance the score. On the topic of the relationship between luck and skill, read Michael Mauboussin. http://www.michaelmauboussin.com/books.html or watch him.  https://www.youtube.com/watch?v=zSgYqwuguPc  One of the luckiest things that ever happened to me was becoming his friend. As just one example, I would not have written my book on Charlie Munger if not for his friendship.

12. “You can learn to make fewer mistakes than other people- and how to fix your mistakes faster when you do make them.”“Confucius said that real knowledge is knowing the extent of one’s ignorance. Aristotle and Socrates said the same thing. …. Knowing what you don’t know is more useful than being brilliant.” “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.”  Charlie Munger freely admits he still makes mistakes even after many decades as a business person and investor. But Munger does advise people to strive to make new mistakes rather than repeat old mistakes. Munger has said that he made more mistakes earlier in life than he is making now. In other words, even though he continues to make mistakes like everyone else, he has marginally improved his ability to avoid mistakes over the years. Munger likes to be able to understand why he made a mistake, so he can learn from the experience. The mistakes can be a source of clues for improving a decision making process. For example, if you can’t explain why you failed, the business was too complex for you to have invested in the first place or outside your circle of competence. Munger is fond of quoting Richard Feynman: “The first principle is that you must not fool yourself – and you are the easiest person to fool.”