Chapter 1: The Difference between a Good Business and a Bad Business
Charlie Munger learned about business in the best way possible: by making mistakes and being successful actually being in business. Reading about business is vital Charlie has said many times, but there is no substitute for wading in and actually taking the plunge as a business manager or owner. It is through the process of making mistakes and having success in the real world and getting feedback from the market that you can learn and establish sound business judgment.
Making mistakes is, of course, inevitable. After all, as Einstein once said, anyone who has never made a mistake (if there is such a person) has never tried anything new. Munger advises that people strive to make *new* mistakes and learn as a consequence:
“There’s no way that you can live an adequate life without many mistakes. In fact, one 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.” http://boundedrationality.wordpress.com/quotes/charlie-munger/
“I don’t want you to think we have any way of learning or behaving so you won’t make mistakes. http://boundedrationality.wordpress.com/quotes/charlie-munger/
“I don’t think it’s necessary to be as dumb as we were.” http://bitly.com/YsZny5
Where would Apple be if Steve Jobs did not make the mistakes he did at NeXT? What we call “experience” is not only the successes we have, but the mistakes we make.
Charlie Munger admits he still makes mistakes even after many decades as a business person and investor. He has also said that it is important to “rub your nose” in your mistakes.
“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.” http://theinvestmentsblog.blogspot.com/2011_12_01_archive.html
“Forgetting your mistakes is a terrible error if you are trying to improve your cognition. Reality doesn’t remind you. Why not celebrate stupidities in both categories?” http://news.morningstar.com/article/article.asp?id=169398
Munger especially recommends paying attention to so-called “mistakes of omission” (mistakes you make by not doing something):
“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: 1) doing nothing; what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.” http://www.tilsonfunds.com/motley_berkshire_brkmtg01notes.php
“Our biggest mistakes were things we didn’t do, companies we didn’t buy.” http://money.cnn.com/magazines/moneymag/moneymag_archive/1998/07/01/244582/index.htm
The list of big business mistakes is long. But for an ordinary investor the simple act of not saving or contributing to a 401(k) can be a huge mistake of omission.
For Charlie, thinking in terms of “opportunity cost” is essential when it comes to mistakes:
“We are apparently slow learners. These opportunity costs don’t show up on financial statements, but have cost us many billions.” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3
“Since mistakes of omission don’t appear in the financial statements, most people don’t pay attention to them.” http://www.buffettfaq.com/
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. .
By paying attention to your mistakes, you can learn from your errors and improve your methodology argues Charlie:
“You can learn to make fewer mistakes than other people- and how to fix your mistakes faster when you do make them.” http://www.scribd.com/doc/86728974/3-Lesson-in-Elementary-Worldy-Wisdom-Revisited-1996
Charlie has cited “Shell paying double for Belridge Oil” due to “a technical mistake” in a closed bid auction is an example to learn from. Berkshire 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 the old joke in business.
As for mistakes others have made, Groupon rejecting Google’s $6 billion purchase offer at one point was a wonderful mistake from Google’s standpoint but not for Groupon shareholders. AOL buying Time Warner for $182 billion is among the very worst business mistakes ever made. Quaker Oats buying Snapple was also a monster mistake in the annals of business.
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 be luck. Charlie has said that more than once that he and Buffett have made a mistake only to be bailed out by luck:
“Banking has turned out to be better than we thought. We made a few billion [dollars] from Amex while we misappraisal it. My only prediction is that we will continue to make mistakes like that.” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php
“Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” http://www.tilsonfunds.com/wscmtg05notes.pdf
“The amazing thing is we did so well while being so stupid. That’s why you’re all here: you think that there’s hope for you. Go where there’s dumb competition.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Munger has said repeatedly that he made more mistakes earlier in life than he is making now. One of his early mistakes was to own a company that made electrical transformers. He has also said that he has found himself in real estate ventures which would only be enjoyed by a masochist. In another case, he and Warren Buffett bought department stores. Charlie has said:
“Hochschild, Kohn the department store chain was bought at a discount to book and liquidating value. It didn’t work [as an investment.]” http://bitly.com/RzDIys
For Buffett, 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 that wasn’t worth putting an new capital into since it would never generate more return on capital investment than alternative investments available to Buffett. Berkshire was valuable in one way in that it taught Buffett and Charlie what *not* to do. He has said: “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.” http://bit.ly/U31gzU
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.
The Chinese automaker BYD may end up being a mistake for Berkshire perhaps because Munger and Buffett drifted too far from what they call their “circle of competence.” Charlie has said that it was fun to make the investment and particularly at his age and level of success he is entitled to do so. But the jury is still out on BYD as an investment and they are having some significant problems. That is arguably to be expected since: “It is fun to watch a business tackle the biggest problems we face in this world. Cheaper solar power and better batteries are holy grails.” But the BYD investment was really out of scope for Munger and should be viewed as an aberration like when they invested in US Airways.
Charlie’s view is that one great way to avoid mistakes is to own a business that is simple to understand given your education and experience:
“Where you have complexity, by nature you can have fraud and mistakes.” http://www.tilsonfunds.com/brkmtg05notes.pdf
“If you can’t understand it, don’t do it” is a simple rule of thumb.
If, after you have made a mistake, you can’t explain why you failed, the business was too complex for you to have invested in says Buffett. In other words, Munger and Buffett like to be able to understand why they made a mistake, so they can learn from the experience. If you can’t understand the business you can’t determine what you did wrong. In a sector like technology Munger and Buffett have both said they do not understand the business well enough to be investors. The other problem with investing in technology is that they don’t feel like they can forecast what the business will be like even if five years let alone for decades.
Not trying to be too clever with things like taxes is another way to avoid mistakes argues Munger. Complexity can be your friend or your enemy depending on the circumstances. For example,
“…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.” http://ycombinator.com/munger.html
Other investors like complexity and spend a lot of time deferring or avoiding taxes in complex ways. While someone like John Malone may like to do deal with complex tax strategies, it is not something Charlie likes to do.
Regarding the desire for simplicity in a business Charlie once talked at a Wesco meeting about a place he knows where poker is played. He then pointed out that” the more complex the game, the easier it is for the best players to beat the patsies.” And, of course, if you do not know who the patsy in the game is, it is you.
Munger likes to find areas where the competition is “dumb”:
“Don’t go where the big boys have to be. You don’t want to look at the drug pipelines of Merck and Pfizer. Go where there are inefficiencies in which you can get an advantage and where there are fewer people looking at the stocks. Go where the competition is low.” http://www.gurufocus.com/news/93302/2010-wesco-financial-corp-annual-meeting-notes
Charlie once described a friend who is a chess master and said in business rather than competing with the equivalent of him, you want to find an area where you are the best and competitors are not so talented. He likes investing in businesses which have “no or dumb competition” and the investors who want to invest in them are similar.
Another way to avoid mistakes is to have someone who you can run your decision by so you can improve your odds of success. Buffett and Munger have the ability to do that for each other. Warren Buffett calls Charlie “The Abominable No-Man” since his answer on a given investment is so often “no.” Having a diverse “posse” of experienced people that you trust look at a potential investment is wise if you want to avoid making too many mistakes. Philip Fisher, an investor who Munger learned a lot from, liked to have a “scuttlebutt” network of people who he would call for advice or expertise and Charlie is similar in his approach. Munger has said:
“Even Einstein didn’t work in isolation. But he never went to large conferences. Any human being needs conversational colleagues.” http://www.gurufocus.com/news/93302/2010-wesco-financial-corp-annual-meeting-notes
Buffett once, when discussing his mistakes, gave a huge compliment to Munger’s value as a collaborator when he said:
“I try to look out 10 or 20 years when making an acquisition, but sometimes my eyesight has been poor. Charlie’s has been better; he voted ‘no’ more than ‘present’ on several of my errant purchases.” http://articles.businessinsider.com/2012-02-25/wall_street/31098427_1_charlie-munger-warren-buffett-berkshire-hathaway
Another important source of mistakes is overconfidence.
“[GEICO] got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses. All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there.” http://ycombinator.com/munger.html
Smart people are not exempt from making mistakes. A person with a high IQ can actually make more mistakes that someone who’s IQ is 30 points lower due to overconfidence. It is the person with the high IQ who falsely thinks that is 30 points higher than it really is that gets you in serious trouble. 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. Munger has said on this: “Terribly smart people make totally bonkers mistakes.” http://ycombinator.com/munger.html
On numerous occasions Charlie has warned people that “the easiest person to fool is yourself” as Richard Feynman once said. Charlie puts it this way:
“The ethos of not fooling yourself is one of the best you could possibly have. It’s powerful because it’s so rare.” http://www.fool.com/news/foth/2002/foth020515.htm
People have a tendency to make assumptions that enable a desired result even if that assumption is obviously false. This tendency for people to “goal seek” the result they want is a fundamental flaw in human nature in Charlie’s opinion. “As a man wants, so shall he believe” says Charlie quoting a Greek philosopher from long ago. For this reason Charlie spends a lot of time examine anything from first principles from the ground up. Assume nothing and” think for yourself” is his mantra. Optimism is the enemy of the rational investor. Rationality comes from a combination of clear thinking and relatively unemotional temperament when it comes to investing.
Charlie over the years has repeatedly said that the most important quality that makes him a good investor is that he is rational. That rationality helps Charlie not follow others over the edge of a cliff. If you think things through from the simplest building blocks in a step-by step process you can avoid making so many mistakes or at least make more new mistakes.
“Rationality is not just something you do so that you can make more money, it is a binding principle. Rationality is a really good idea. You must avoid the nonsense that is conventional in one’s own time. It requires developing systems of thought that improve your batting average over time.” http://news.morningstar.com/article/article.asp?id=169398
“[An] increase in rationality is not just something you choose or don’t choose, it’s a moral duty to keep up as much as you reasonable can. It worked so well at Berkshire , not because we were so darned smart to start with…we were massively ignorant…many of the great successes of Berkshire started with stupidity and failure.” http://www.sancaptrustco.com/documents/7.19.11NotestoMunger.pdf
Nothing seduces rational thinking and turns a person’s mind in mush like a big pile of money that was easily earned. About Berkshire, Charlie said once: “This is a very rational place.” http://jeffmatthewsisnotmakingthisup.blogspot.com/2007/06/pilgrimage-concluded-this-is-rational.html
Not being patient can also be a huge source of mistakes as well says Munger:
“We don’t feel some compulsion to swing. We’re perfectly willing to wait for something decent to come along. In certain periods, we have a hell of a time finding places to invest our money.” http://www.tilsonfunds.com/motley_berkshire_brkmtg01notes.php
“Most people are too fretful, they worry too much. Success means being very patient, but aggressive when it’s time.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
Munger and Buffett believe that the passage of time is the friend of the investor or business person and impatience his or her enemy. When asked once about whether he was worried about a big drop in the value of Berkshire Munger said in a very direct way:
“Zero. This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” http://www.psyfitec.com/2009/10/buffett-and-munger-on-bbc.html
Buffett has said about the importance of patience: “The Stock Market is designed to transfer money from the Active to the Patient.” Both Munger and Buffett believe that so-called chasing performance (“buying high and selling low”) is one of the worst mistakes an investor can make. “Be greedy when others are fearful and fearful when others are greedy” they both advise. People being greedy and fearful at the wrong times are what creates many significant investing opportunities Munger has said.
Another way to avoid making mistakes is to own businesses that even what Charlie calls your “idiot nephew” could run fairly well.
“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.” http://www.designs.valueinvestorinsight.com/bonus/bonuscontent/docs/Tilson_2006_BRK_Meeting_Notes.pdf
Having to make one hard financial decision after another in running a company can be damaging to your financial health even if you or your mangers are very talented. Munger is emphatic on this topic:
“We’re partial to putting out large amounts of money where we won’t have to make another decision.” http://www.tilsonfunds.com/motley_berkshire_brkmtg01notes.php
ESPN is an example of a company that could probably be run by your “idiot nephew” since its moat is so strong (moats will be the subject of the next post in this series). Coca-Cola, Snickers and Wrigley’s are strong businesses that pass this test.
It is worth emphasizing that Munger is not saying management does not matter (another subject this series of posts will get to later). Instead what Charlie is saying that he would prefer to have a business that passes the “idiot nephew” test *and * for the business to have talented management. Owning a business with lousy underlying economics of the business facing one hard problem after another may not have a good financial outcome even with a top-notch management team according to Charlie. In that sense, having a moat and talented management such as the team that runs the Berkshire portfolio company Iscar gives Warren and Charlie an extra margin of safety when making an investment.
Finally, after achieving some level of financial success mistakes can actually make the investing process more fun. If there was not at least some chance that your investment would end up in the business equivalent of a sand trap in golf once in a while the process that is investing would be boring, even if it was lucrative.
Postscript and what is still to come:
What I wrote above is the first post in a series about “methods” used by Charlie Munger to do things such as invest capital. This series of posts is not about topics like whether he likes to fish, his unusual personality or his political views. The focus will be on the investment methodology of Charlie Munger. Other methods he uses in life are also discussed. Regardless of your political persuasion, personality or hobbies, Munger’s methods are uniquely valuable. Even if you disagree with any or all of his methods it is very hard to argue that they are not interesting.
Much of the task here is to organize what Charlie has said or written into something that is easier to understand since he has never explained his investment thesis in a well-organized way. The raw material for this book consists of snippets from interviews and a few articles and papers he has written over the years. Writing these posts is a bit like assembling a jigsaw puzzle. Sometimes the quoted passages may seem a bit too long, but nothing says more about what Munger thinks than what he has actually said.
I will try to make the posts more interesting and current by applying Munger’s methods to companies that are in the news today and companies that are outside their circle of competence.
P.s., I decided to begin this series with a discussion of Charlie’s view on “mistakes” since it introduces some humility in the process at an early stage. Janet Lowe in her Charlie Munger biography “Damn Right” http://www.amazon.com/Damn-Right-Berkshire-Hathaway-Billionaire/dp/0471446912 , quotes Charlie Munger as admitting that he “was behind the door when humility was handed out.” As I said above, my next post will be about the value of economic “moats” in business.