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/

Notes:

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