Chapter 1- Charlie Munger on Mistakes
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.
Chapter 2 – Charlie Munger on Moats (First of the Four Essential Filters)
If there is anything fundamental about what Charlie Munger has learned about business it is this:
“The difference between a good business and a bad business it is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.” http://bit.ly/S5iN7K
Why do some businesses create easy decisions? The answer lies in microeconomics: if there is no significant “barrier to entry” which creates what Harvard Business School Professor Michael Porter calls a “sustainable competitive advantage” (a “moat” in Berkshire parlance), competition will cause return on investment for that business to drop to opportunity cost and there will be no economic profit for the producer. The analogy they use at Berkshire is that the business itself is the equivalent of the “castle” and the value of that castle will be determined by the strength of the “moat.”
The need for a business to have a “moat” is so strong that Munger has made it one of the “four essential filters” he uses in deciding whether to invest in a given business. The four essential filters are:
- A business with a moat,
- A business that can be understood by the investor,
- Management in place with integrity and talent, and
- A business that can be bought at an attractive price that gives an attractive margin of safety. http://www.psyfitec.com/2009/10/buffett-and-munger-on-bbc.html
Before examining each of these four essential filters one-by one, it is important to point out that these “four skills” below which relate to moats are very different that the four essential filters themselves:
- Creating a moat which is something that people like Ray Kroc, Sam Walton Estee Lauder, Mary Kay Ash and Bill Gates have accomplished. Moat creation requires superior management skill always combined with some degree of luck. It is theoretically possible to acquire a moat with no management talent and just luck but I can’t think of an example of this ever happening. Sometimes people who are fantastic managers who have the ability to create a moat have very poor skills when it comes to investing. Stock promoters love these people since they are big targets for scams.
- Identifying a moat that others have created which is something that people like Charlie Munger and Warren Buffett can do. Munger admits that he and Warren Buffett buy moats rather than build them since building them is not something they do particularly well. In addition to a moat Charlie insists that there be a talented management team already in place. For an investor who buys moats instead of creating one, the existence of a moat has special value since they can sometimes survive financially even if management talent does not deliver as expected or if they leave the business.
- Identifying a startup that may acquire a moat before it is evident which is something that some venture capitalists can do at a sufficiently high level of probability that they can generate an attractive return on capital overall. This skill is very rare as evidenced by the fact that the distribution of returns in venture capital is a power law. Moats that emerge from complex adaptive systems like an economy are hard to spot since a moat is something that greater than the sum of the parts emerging from something else that is greater than the sum of its parts. In contrast, a moat being destroyed is easier to spot since it is a process of something transforming into nothing.
- Describing a moat in academic terms which is something that someone like Michael Porter can do. Why this is a rare talent in academia is a puzzle. The reason for this is that simple theories are not the sort of things that will get a person a tenured faculty position. This essay could go on for many pages quoting Munger railing about deficiencies in academia. Here are just two:
“I was recently speaking with Jack McDonald, who teaches a course on investing rooted in our principles at Stanford Business School. He said it’s lonely — like he’s the Maytag repairman.” http://www.fool.com/boringport/2000/boringport00051500.htm “
Warren once said to me, “I’m probably misjudging academia generally [in thinking so poorly of it] because the people who interact with me have bonkers theories.” … We’re trying to buy businesses with sustainable competitive advantages at a low – or even a fair price. The reason the professors teach such nonsense is that if they didn’t], what would they teach the rest of the semester?” http://www.tilsonfunds.com/motley_berkshire_wescomeetings.php (2004)
Each of these four skills which relate to moats is very different and it is unusual for a person to have all four skills. Many people just have one. More importantly, well over 90% of the population of the world has none of these skills. Tragically for them, the population that thinks they have this set of skills is far higher than 10%. For society, this overconfidence is valuable since “even a blind squirrel finds a nut once in a while” via luck.
Merely because a person can identify that a given company has a moat does not mean that they have any ability to create a moat as a manager. At the 2012 Berkshire meeting Munger admitted that the brand-based moats which Berkshire has are bought rather than created. The ability to spot a moat that someone else created is very different from the ability to create a moat, believes Munger. You don’t need to know how to make hamburgers to spot that McDonald’s’ has a moat, but don’t try to build a business like McDonald’s without the abilities that Ray Kroc had.
At the 2012 Berkshire meeting Charlie said:
“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.” http://gongol.com/research/berkshire/2012/
Sometimes great managers can transition to become great venture capitalists and sometimes not. As another example, Michael Porter has done a great job taking some fundamental ideas from microeconomics and introducing it to business schools, but I would not give him five cents to start a business or invest money on my behalf. Perhaps he is a good manager or investor but I have zero data to indicate that this might be true other than he has described some important principles in an academic way.
Recently someone argued on a blog that because some academics affiliated with Michael Porter’s theory on sustainable competitive advantage do not have the management skill required to create a moat themselves, that “sustainable competitive advantage simply doesn’t exist” other than created by government regulation. http://www.forbes.com/sites/stevedenning/2012/11/20/what-killed-michael-porters-monitor-group-the-one-force-that-really-matters/ First and most importantly, as will be explained below, the test of whether a moat exist is quantitative (it is a 100% math-based test). The simple of mathematics reveals that many companies have moats in many sectors of the economy that have existed for many years. Second, as I have explained above, not everyone has all four skills that relate to moats. That a team of academics can’t create a moat does not mean sustainable competitive advantage does not exist. The act of successfully creating a moat is a rare event. Berkshire’s portfolio of companies alone (e.g., See’s Candies) proves that moats are sustainable for a very long time. Google and Oracle are just two of many companies that have generated sustained profitability that meets the test for a moat.
The blogger’s own thesis is that companies should continuously innovate instead. That Porter’s work would not support the need to constantly innovate, create new value or disrupt your own business is a baffling conclusion. The two issues are orthogonal. The thesis that Clayton Christensen’s work invalidates the work of his fellow professor at Harvard Business School Michael Porter is simply false. That profit is hard to sustain does not mean that it is impossible to sustain. Nowhere does Michael Porter say that a moat can be maintained forever.
The blogger’s thesis also suffers in that it has no predictive power. It is consistent with the sort of promotion that you see around hyped IPOs. “It’s disruptive!” is not a substitute for profit unless your goal is to flip the business to someone else. Disruption alone without anything behind it is the management equivalent of EBITDA.
Clayton Christensen’s work around disruptive innovation is super important and wise (you will see links to it below), but don’t kid yourself that disruption without a moat will necessarily lead to actual GAAP profit. Disruption is a fantastic place to look for profit whether the business is a startup or an established business, but sometimes profit is just not there. If you don’t have a moat somewhere and are unable to flip your company to a greater fool or a company that is already profitable who needs it for defensive reasons, you will soon fall prey to the only unforgivable sin in business: running out of cash. Giving away everything for free while generating zero profit is at best an interim strategy or a description of the Java business model that Sun adopted.
Do some companies create something so disruptive that benefits consumers so much that someone must buy that service or product to stay competitive even though it generates no incremental profit? Absolutely. But in such a case only consumers benefit since only positive outcome is the creation of consumer surplus. Producer surplus for that disruptive innovation can be zero or less than zero. That is part of the reason why capitalism benefits consumers. To offer a “loss leader” you must in the medium term at least have a base business that generates a profit that is tied to that loss. But I am getting ahead of myself. You can read more on disruption in a futurepost.
Returning to the discussion of the four essential filters, whether a business has a durable moat is without question the most important filter for an investor like Charlie whose chosen profession is buying moats. For example, Charlie describes a moat in three different ways immediately below, each emphasizing the importance of the moat being able to maintain itself over time.
“We have to have a business with some inherent characteristics that give it a durable competitive advantage.” http://www.youtube.com/watch?v=3XlBrohrIUc
“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage.” http://www.valuewalk.com/charlie-munger-page/
“We’re trying to buy businesses with sustainable competitive advantages at a low – or even a fair price.”
Charlie may reference another of the four essential filters in a statement but invariably the requirement of a moat is present in his statement. My belief is that of the four filters, nothing is more essential than moat. The second filter is about reducing the number of mistakes made and filters three and four essentially layer on a “margin of safety” when making an investment. In other words, moats are the foundation of Munger’s investment process and methodology. Everything starts with the moat (or lack of a moat) for Charlie because he does not create moats, he buys them.
Components of a Moat:
Munger has not explained his theories on what causes a moat as comprehensively as Warren Buffett, but he has made some comments that point people in the right direction. In addition there are all the companies in the Berkshire portfolio that illustrate what a moat is, like Geico, Burlington Northern, See’s Candies.
The primary components of a moat that Charlie has talked about are as follows:
1. Supply-Side Economies of Scale
There are two types of “economies of scale” and the first is supply-side economies of scale. A large firm that is part of an oligopolistic market will generate significant supply-side economies of scale in its production of goods and services as per-unit costs fall with increasing output. Due to factors like the difficulty of managing large firms, economies of scale ar exhausted well before those firms from dominate the entire market.” The economists Varian and Shapiro in their book Information Rules write about supply-side economies of scale via an example: “Despite its supply-side economies of scale, General Motors never grew to take over the entire automobile market.”
Samsung is reaping the benefits of supply-side economies of scale as does Intel. Clayton Christensen argues that the worship false accounting gods like RONA have caused many companies to outsource tasks like the semiconductor fabrication and lose important supply- side economies. He argues that outsourcing has harmed many companies in the long-term even though in the short-term it may have seemed wise. http://gartner.mediasite.com/mediasite/play/9cfe6bba5c7941e09bee95eb63f769421d
In Charlie’s view Wal-Mart has massive supply-side economies of scale through its investments in distribution and other systems. These and other Wal-Mart investments have given the company a moat. Wal-Mart also possesses a high degree of operational effectiveness which adds it its profitability. Like Wal-Mart companies which operate huge steel plants and shipyards can have supply-side economies of scale. Markets like these tend to end up as part of an oligopoly since supply-side advantages only go so far to consolidate an industry.
Munger described two different supply-side economies of scale below:
“On the subject of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power — which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization. If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he’s going to make a lot of dumb decisions. But if you’re buying is done in headquarters for a huge bunch of stores, you can get very bright people who know a lot about refrigerators and so forth to do the buying. The reverse is demonstrated by the little store where one guy is doing all the buying. So there are huge purchasing advantages.
Some [supply-side advantages] come from simple geometry. If you’re building a great circular tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. There are all kinds of things like that where the simple geometry – the simple reality – gives you an advantage of scale.” http://ycombinator.com/munger.html
Munger explains below how changes that have taken place in the advertising industry, which perhaps explain why Procter & Gamble has started to struggle more than it has in the past in delivering the same level of profitability:
“You can get advantages of scale from TV advertising. When TV advertising first arrived – when talking color pictures first came into our living rooms – it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was – say 90% of the audience. Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so damn many cans and bottles. Some little guy couldn’t. And there was no way of buying it in part. Therefore, he couldn’t use it. In effect, if you didn’t have a big volume, you couldn’t use network TV advertising – which was the most effective technique. So when TV came in, the branded companies that were already big got a huge tail wind.” http://ycombinator.com/munger.html
This may also explain in part why Berkshire has dropped its stake in Johnson and Johnson to very low levels. Johnson and Johnson has been a lagging performer for Berkshire and is now out of favor with Munger and Buffett.
Although Berkshire was a bit late to appreciate the attractiveness to an investor of the railroad business, Munger and Buffett clearly value the moat that supply-side economies scale creates in the railroad business. A new competitor in the railroad business is highly unlikely. As the public roads deteriorate as the United States underinvests in infrastructure and energy prices rise, railroads will get even more competitive. Munger has said:
“Do you know what it would cost to replace Burlington Northern today? We are not going to build another transcontinental. And those assets are valuable, have utility. Now they want to raise diesel prices on trucks. … We finally realized that railroads now have a huge competitive advantage, with double stacked rail cars, guided by computers, moving more and more production from China, etc. They have a big advantage over truckers in huge classes of business. http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Railroads are interesting in that long ago they were a growth industry that both created great fortunes and great busts in the aftermath of that success. There were times in history when railroads were very lousy investments.
Regarding the impact of supply-side economies of scale Charlie has pointed out:
“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. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, ‘to hell with it. We’re either going to be number one or two in every field we’re in or we’re going to be out’. That was a very tough-minded thing to do, but I think it was a correct decision if you’re thinking about maximizing shareholder wealth.” http://ycombinator.com/munger.html
Berkshire has recently sold nearly all of its shares in GE, which is a reminder that moats come and go as time passes and conditions change. People who follow Munger and Buffett might have laughed not too long ago if someone were to have predicted that GE would lose favor with Berkshire.
2. Demand-side Economies of Scale (Network Effects):
Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it. Unlike supply-side economies of scale, network effects can be (1) nonlinear and (2) continue to accrue to benefit the company for far longer. Given a choice between supply-side economies of scale and demand-side economies of scale, it is preferable to have the latter. Varian and Shapiro in their book Information Rules write: “Unlike the supply-side economies of scale, demand-side economies of scale don’t dissipate when the market gets large enough.”
eBay, Craigslist, Twitter, Facebook and other multi-sided markets have demand-side economies of scale that operate on their behalf. My view is that ESPN also has demand-side economies of scale, most notable for Sports Center, since the more people who watch the ESPN channels, the more valuable the channels are to each user since those particular images will be the basis of discussion for sports fanatics. Fox and other sports channels just can’t replicate that demand side effects since when someone says “did you see X do Y in the Z game?” If you watched Fox version of Sports Center, you may not have seen the particular video clip.
Google has at least two beneficial demand-side economies of scale (one for search and one for advertising targeting) that are mutually reinforcing that give it a strong moat according. Munger has said:
“Google has a huge new moat. In fact I’ve probably never seen such a wide moat.” http://seekingalpha.com/article/140485-would-buffett-consider-google-a-great-investment
“I don’t know how you displace Google but a lot of the other companies will have competitive troubles.” http://www.investingdaily.com/11313/google-up-13-on-great-earnings-and-google-is-facebook-in-trouble
Some companies have both demand and supply-side economies of scale. Amazon has both supply-side and demand-side economies of scale and they reinforce each other. For example, the more people who provide comments on Amazon the more valuable it becomes to other users due to demand-side economies. Amazon also has huge advantages on warehouses and the supply chain on the supply-side.
There are both weak and strong supply-side demand-side economies of scale and they fall along a continuum in terms of relative strength. Most companies have both supply-side and demand-side economies. The “holy grail” for an entrepreneur is demand-side economies of scale that can cause a market to “tip” and give almost the entire market to one company. The reality is that most demand-side economies do not cause a market to “tip.” For example, GM’s cars were better to a degree at one point since the more people who owned the cars, the easier auto parts were to get, but weak demand-side economies like that were not strong enough to make the market “tip.”
If a market does “tip” and a competitor is the one to reap those benefits, things can go really wrong, really fast. For example, MySpace started to monetize before the social networking market “tipped” and MySpace paid the price and Facebook reaped the rewards. Facebook held off monetizing until its moat was secure. Zuckerberg was patient about waiting for the market to tip and Rupert Murdoch was not.
One illustrative example can be found in the cement industry. Cemex’s cement business gets better the more trucks it has in play in a given geographic area. The service gets cheaper with supply-side scale due to lower COGS (e.g., less gas consumed), it gets better (faster delivery times) due to demand-side economies. And that combination of supply and demand-side economies creates a barrier to entry that helps Cemex.
Which came first, the faster supply of cement to contractors due to more plants (the egg) or greater demand from contractors due to faster delivery times (the chicken)? I believe Cemex intentionally created an egg, knowing there would be greater demand for the service. This solution to the “chicken and egg” problem is typical in multi-sided markets. However, in this case the Cemex demand-side economies were not strong enough to make their market for cement tip.
My thesis about Chinese restaurants is similar: When you have more customers for Chinese food, the food turns over faster and so it is fresher and better, holding the level of cooking constant. More customers for Chinese food not only lowers cost of goods sold (COGS) since they buy in volume, but increases quality. But a market like this is not going to tip
As another example, Costco is a better value the more its “store geographic scope” and density increases since I can, for example, use it when visiting relative in another state. Costco also has supply-side economies of scale. Since a market like Costco is in is not going to tip and so oligopoly is likely.
It could be argued that Cemex, GM and Chinese restaurants with high volumes have some demand-side economies of scale in addition to their supply-side economies of scale. But the demand-side economies are not strong enough to tip to one dominant supplier. Lots of other industries are similar. Credit card markets did not tip enough to prevent multiple providers. Car rentals did not tip and are instead an oligopoly.
Supply-side economies of scale can be really powerful. The jet turbine makers have supply-side advantages that makes them very profitable. Are there advantages to customers of easier access to parts if they buy a Rolls Royce jet turbine that might create some demand-side benefits? Sure. But can China open its checkbook and create a new jet engine competitor? I think so. In the case of jet turbines supply-side benefits are strong, but demand-side benefits are weak.
American Express is another company in the Berkshire portfolio with demand-side economies of scale since the more merchants accept their card the more valuable the service gets and the more people who use the card the more valuable the services is for merchants. Munger continues to believe American Express has a moat despite the rise of upstarts like Square.
“It would be easier to screw up American Express than Coke or Gillette, but it’s an immensely strong business.” http://www.fool.com/boringport/2000/boringport000501a.htm
Visa has a similar moat to American Express as does PayPal. But challengers like Square may change the game enough to take significant share. eBay’s moat is definitely demand-side driven on its original business as well.
A company having beneficial network effects is only one dimension that impacts profit. Sometimes network effects are there but the market is small since it is a niche. Amazon’s market is bigger and that matters greatly in terms of the market capitalization it can generate. Some network effects are very strong like Google’s and sometimes they are weaker like for web sites that crowd source reviews which contain a lot of noise that is hard to automate out.
At the 2011 meeting of Wesco held just before it was merged into Berkshire Hathaway, Munger admitted that he and Buffett really did not understand the value of a brand until they bought See’s Candies. The two investors found after they bought See’s Candies they could regularly raise prices and customers did not seem to care. Buffett and Munger call this ability “pricing power.” Munger notes that before See’s Candies:
“We didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning this changed Berkshire. It was really important.” http://theinvestmentsblog.blogspot.com/2011/07/final-wesco-meeting-morning-with.htm
See’s Candies is also a great A/B test on brand power. To illustrate, if you grew up in a home that bought See’s Candies (mostly on the West Coast, especially in California) and experiences around that candy have very favorable associations, you will pay more for that boxed candy brand.
Someone who grew up in the east cost of the United States is going to shop for boxed candy and not attribute much value to the brand since they do not have those same experiences. For this reason, See’s has found it hard to expand regionally and has done so very slowly..
See’s Candies can also only sell so much candy at that price given the choices it has made. People don’t usually go to a See’s Candies store because they are hungry for food. The box/gift candy business is very seasonal. What See’s sells is not just food, but rather an experience. See’s generates losses two quarters a year and makes all its profit in the other two quarters around three holidays.
Buffett talks about the fact that building some brands took many decades:
“When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. I California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”… “I don’t think See’s means anything to people on the East Coast, where people are also exposed to higher-end chocolate products.” http://management.fortune.cnn.com/2012/08/22/sees-candies-buffett-berkshire/
While some of the power of a brand can come from taste, modern “flavor” firms can replicate most any taste. Trade dress and presentation of a good or service matters more than ever. A lot of Tiffany’s brand power is the blue box the jewelry comes in. Coke made a massive mistake thinking it was flavor in a blind taste test that mattered when it introduced the New Coke. When the taste test is not blind Coke wins and when it is blind Coke does not win. Munger said once about the New Coke episode:
“[Coke spent] 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor…. Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would’ve been the biggest fiasco in modern times. Perfect insanity.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
Although it is not currently doing as well financially as it has in the past, Charlie has admired Procter & Gamble since:
“They just make a fortune on some of the body products. Some of these brands, I mean, if you can make something that actually improves the skin, wow. That’s the last thing people will give up”. http://management.fortune.cnn.com/2012/08/22/buffett-munger-berkshire
As was noted above, it can be argued that TV does not give Procter & Gamble the same benefits supply-side economies in television since post Internet there are so many ways to advertise that do not require supply-side scale. The argument would be that smaller firms and store brands are making big inroads by using new forms of marketing and Procter & Gamble suffers from that new competition as their brand is weakened.
As another example, Charlie said once that customer loyalty to Costco is a big part of their moat:
“If you get hooked on going to Costco with your family, you’ll go there for the rest of your life.” http://bitly.com/YsZny5
I am skeptical that “getting hooked” is a brand advantage and instead suspect that Costco’s moat is more about great business execution by Costco plus supply-side economies of scale. The Costco brand is valuable, but not enough by itself to fully explain its profitability. Most moats are caused by multiple factors. Clayton Christensen makes a very powerful argument that companies like Costco, Zara and Ikea create a moat by integrating around “a job” that a customer need to get done. You can hear Clayton make that argument here in this video: http://gartner.mediasite.com/mediasite/play/9cfe6bba5c7941e09bee95eb63f769421d It sounds similar to arguments that Michael Porter makes about the value of integration of all the aspects of what a company does, but around a task. Perhaps Berkshire believes that this is a source of a moat for Well Fargo.
A moat powered by a brand is something very different from one created via supply-side economies of scale. For example, Warren Buffett has said that for a company like Disney when the brand is mentioned in conversation “you have something in your mind.” He adds:
“How would you try to create a brand that competes with Disney? Coke is a brand associated with people being happy around the world. That is what you want to have in a business. That is the moat. You want that moat to widen.” http://investdigest.blogspot.com/2005/12/untapped-pricing-power-and-share-of.html
One company that is puzzling is the eyeglass maker Luxottica’s (brands like Ray-Ban, Oakley, Persol and other major brands). How that eyeglass company can have that much market share since it has so many brands is unusual. There must be supply-side economies that are driving that business. I just don’t see any real significant demand-side economies that might explain Luxottica’s level of success. Could is be that they reap a lot of benefits from organization around a job a customer need to get done. Perhaps, but that seems to be a stretch.
Brands of course can fail over time. Put a luxury brand on a table or shelf in Costco as some have done and that luxury brand is damaged. License it too broadly and the brand is also damaged. Buffett and Munger see attracted to brand that they use in their own lives. See’s and Dairy Queen are just two examples.
Some brands incur problems with their brand that are completely self-inflected. Buffett went on to say about one his most favorite brands:
“Take See’s candy. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.” http://www.buffettfaq.com/
Regarding brand power, the two Berkshire leaders have often cited Wrigley’s as a brand that creates strong moat. Munger has pointed out:
“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.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
A very important test for Buffett and Munger in determining the strength of a brand-based moat is whether a competitor can replicate or weaken the moat with a massive checkbook. As just one example, here is what Buffett said about Coke at the 2012 Berkshire meeting: “If you gave me $10, $20, $30 billion to knock off Coca-Cola, I couldn’t do it.”
Firms like Nike and BMW each have brands that help maintain their moat that were hard to get and super valuable to have. The creation of a great brand is a rare thing and requires considerable skill and arguably a big dose of luck as well. Charlie has pointed out: “China has great companies already. Just not great brand names yet.” I would quibble with Munger’s conclusion in that the Huawei brand is already strong already in certain business markets. And Chinese firms ZTE and Huawei are making brand inroads in mobile phones. China will in my view surely have many strong global brands over the long-term.
There are certain businesses which have created a competence with regard to regulation that is so high that regulation actually serves as a barrier to entry/moat for their competitors. Rather than helping consumers in these cases on a net basis regulations can end up protecting producers and creating a moat. For example, some people believe banks have created such a powerful layer of regulatory expertise that the regulators have become “captured” by the industry they regulate. There are a number of professional; guilds like lawyers who have been able to use regulation to limit supply.
For Berkshire, the regulation-driven moat that Moody’s had in the bond rating business was a big attraction. To issue bonds regulators actually require that the issuer get an opinion from a very small number of bond rating firms which means the rating firms Moody’s, S&P and Fitch have a moat. Fannie and Freddie also had regulatory created moats, but the result for them in the end was not good.
When regulation disappears, it often becomes quickly evident that it was a major factor in industry profitability. You find out who is otherwise swimming naked when the regulatory-driven moat disappears. For example, said Munger:
“[Airline] Competition was so intense that, once it was unleashed by deregulation, ravaged shareholder wealth in the airline business” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Munger once described airlines as “marginal cost with wings.” http://bitly.com/RzDIys People talk about Virgin Airlines having a great brand and better service, but where are the profits? How long will it be before other airlines begin to imitate the Emirates strategy? Where is the barrier to entry for an airline? You can lease jets and gates. Munger and Buffett have said repeatedly over the years that they hate a commodity business. They learned this lesson the hard way by investing in firms like the New England textile manufacturer that gave Berkshire its name. Buffett ignores insurance lines that are commodities as another example
Returning to the subject of regulatory capture, Berkshire invests so much money in Well Fargo is interesting since arguably the sorts of banking that Wells Fargo does is a commodity business. It can be argued that Wells Fargo benefits from regulation since it is “too big to fail” and therefore has a lower cost of capital than it would otherwise which gives it a moat. We will discuss Wells Fargo again in a future post when the subject of management is covered.
5. Patents and Intellectual Property
Companies which have been granted a patent or other type of intellectual property by a government have in effect been given a legal monopoly. While the justifications for doing so are not the subject of this discussion, this barrier to entry can create a substantial moat for the holder of the intellectual property. Munger has said:
“… In microeconomics, of course, you’ve got the concept of patents, trademarks, exclusive franchises and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out – based on arguments about what was really invented and what relied on prior art. That isn’t altogether clear. But they changed that. They didn’t change the laws. They just changed the administration – so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents. But trademarks and franchises have always been great. Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it’s well-known.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Qualcomm is an example of a company which has created a moat mostly via intellectual property. Qualcomm has so many patents and has managed to get them embedded inside enough important wireless industry standards which have their own demand-side economies of scales, that the company has created a substantial moat.
One example of a company that Berkshire values higher due to intellectual property patents is Lubrizol. Initially Buffett said:
“It struck me as a business I didn’t know anything about initially. You know, you’re talking about petroleum additives… Are there competitive moats, is there ease of entry, all that sort of thing. I did not have any understanding of that at all initially. And I talked to Charlie a few days later…and Charlie says, ‘I don’t understand it either.’” http://advisoranalyst.com/glablog/tag/cnbc-interview/
But eventually Buffett was won over and made the Lubrizol purchase.
“I decided there’s probably a good size moat on this. They’ve got lots and lots of patents, but more than that they have a connection with customers.” http://advisoranalyst.com/glablog/tag/cnbc-interview/
At the 2011 Berkshire meeting Buffet reiterated that he decided to go ahead since he thought that the more than 1,600 patents held by Lubrizol would give the company “a durable competitive advantage.”
Another example of intellectual property proving its value for Munger occurred in the 1970s when Russell Stover Candies started to open stores in markets served by See’s Candies with very similar appearance. The use of the distinctive “trade dress” of See’s Candies was enough of a violation of the law that Munger was able through threat of litigation to get agreement from Russell Stover Candies to stop what they were doing and the moat was proven to be durable.
The Nature of Competition and Moats:
In Charlie’s view, even if you currently have a good business that does not mean you will have it for very long. This puts the durability of a given moat at risk. The process of what Joseph Schumpeter called “competitive destruction” is as powerful as anything in business. Having a moat is the only way to fight against the tide of competitive destruction.
Michael Mauboussin, in what is arguably the best essay ever on moats, writes:
“Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital.” http://www.capatcolumbia.com/Articles/measuringthemoat.pdf
For example, if you open a successful clothing store that success will attract imitators and competitors. Through a process of “competitive destruction” some clothing stores will adapt and survive and thrive and others will fail. The consumer wins because the products and services offered to them get better and better. But this is a painful process for an investor since the outcome can be highly uncertain. It is also the hardest part for a businessperson since failure is an essential part of capitalism.
Given the inevitability of relentless competition, the question to ask is according to Munger:
“How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.” Poor Charlie’s Almanack at 59; http://www.scribd.com/doc/76907884/MOATS-abridged-1-5-70-chapters-a-preview
Jim Sinegal of Costco is just such a fanatic which is why Charlie serves on their board. The founder of Nebraska Furniture Mart “Mrs. B” would be another fanatic. Charlie loves the management team at Iscar. Going down the list of Berkshire CEOs reveals a long list of fanatics.
That moats are hard to create and usually deteriorate over time is one very important reason why capitalism works. What happens over time is so-called “producer surplus” is transferred into “consumer surplus”. Charlie describes the competitive process and why it benefits consumers as follows:
“The major success of capitalism is its ability to drench business owners in feedback and allocate talent efficiently. If you have an area with 20 restaurants, and suddenly 18 are out of business, the remaining two are in good, capable hands. Business owners are constantly being reminded of benefits and punishments. That’s psychology explaining economics.” http://www.fool.com/investing/general/2011/07/02/charlie-mungers-thoughts-on-the-world-part-1.aspx
Munger’s views on the nature of business competition are Darwinian: Capitalism does not pull its punches in markets that are genuinely competitive:
“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.” http://www.valuewalk.com/charlie-munger-page/
“Capitalism is a pretty brutal place.” http://ycombinator.com/munger.html
When it comes to moats, durability matters. Munger wants to avoid a business that has a moat today, but is gone tomorrow. Some moats atrophy gradually over time and some much more quickly. This is not a completely new phenomenon. As Ernest Hemingway once said in his book The Sun Also Rises, a business can go bankrupt in two ways: gradually and then suddenly. The speed of moat destruction has accelerated over time due to advances in technology and the way it spreads information. For some people this increase in speed can at times be disorienting. For example, the speed at which a companies like Kodak or Nortel lost their moats has been shocking to many investors who grew up mostly in another era.
The speed at which a moat disappears should not be confused with cases where a company never had a moat at all like Groupon. Hype about a sales “boiler room” selling coupons online is not a moat. Instead, that is an example of crowd folly (social proof + fake scarcity). Did Zygna ever have a moat or did it just evaporate quickly? It is hard to say. Sometimes causes are hard to tease apart. Facebook definitely has a moat, but once it ceased letting Zynga acquire customers cheaply by leveraging the Facebook moat, the tide arguably turned against Zynga. “To borrow someone’s moat is not to have a moat” might be the lesson of Zynga, since what is borrowed can be taken away.
How long your moat lasts is called your “Competitive Advantage Period” (CAP) writes Michael Mauboussin. http://www.capatcolumbia.com/Articles/FoFinance/Fof1.pdf The speed of moat dissipation will be different in each case and need not be constant. The rate at which a moat atrophies is similar to what academics call “fade” argues Mauboussin.
Even the very best companies can see competition make their moats shrink or even disappear. Charlie has said:
“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.” http://bitly.com/S5iN7K
Sometimes what shrinks a moat is a shift of what Michael Porter has called “the Five Forces”. http://hbr.org/2008/01/the-five-competitive-forces-that-shape-strategy/ar/1 One such force is the power of distributors in a value chain:
“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.” http://www.tilsonfunds.com/motley_berkshire_brkmtg01notes.php3
When someone, such as a downstream distributor, takes a bigger slice of the amount of profit in the “profit pool,” bad things can happen if you are upstream. Whether that happens will depend on who has more bargaining power in that supply chain.
A blogger in an essay discussed above recently argued that the Five Forces do not matter since consumers have more power. Consumers are one of the Five Forces so the argument is even at that level deeply misguided. Suppliers are also a potential problem. Try arguing that the Five Forces do not matter to the many music subscription companies that went bust due to the wholesale transfer pricing power of music suppliers. A restaurant owner who has had a landlord triple their rent knows very well that supplier bargaining power can be a huge problem. Yes, delighting customers is super important, no that does not help if your sole supplier is raising wholesale prices to take your profit.
Sometimes it is buyers that have the ability to “holdup” the seller and sometimes it is the reverse depending on who has the bargaining power. Every aspect of a given business can be made worse if some firm or person in the value has more bargaining power. As an example, big movie stars have had huge wholesale transfer pricing power over the movie business value chain ever since the Hollywood studio system ended.
Newspapers are a good example of an industry which once had a fantastic moat, which is now in decline. Unfortunately for newspapers, changes in technology have been taking down their moat in rather dramatic fashion. Charlie:
“The perfectly fabulous economics of this [newspaper] business could become grievously impaired.” http://www.fool.com/BoringPort/2000/boringport00051501.htm
Munger saw this deterioration before many other people did, mostly likely because Berkshire owned newspaper properties like The Washington Post and The Buffalo News. Berkshire has not given up on all types of newspapers. Papers that cover local news, particularly in a city with a strong sense of community are still attractive for Berkshire even in 2012. They said at the 2012 Berkshire meeting that they may buy more newspapers. These small city newspaper purchases seems to me like a Ben Graham “cigar butt” style investment and for that reason a reversion to an old investing style. But Berkshire have a *lot* of cash to put to work and only so many quality businesses to buy. Too much cash is, as some people say “A high quality problem.” Munger adds: “Excess cash in an advantage, not a disadvantage”. As a pool of investment dollars gets bigger it gets harder to find companies to buy or invest in that have a moat. In this sense size works against investment performance. More than one fund manager has suffered from this problem since the tendency is to ignore the need for a strong moat so you can get large amounts of money put to work.
Kodak is a company which once had a strong moat and then began to lose it in dramatic fashion. Munger describes the competitive destruction that hit the photography business:
“What happened to Kodak is a natural outcome of competitive capitalism.” http://www.businessinsider.com/munger-on-buffetts-cancer-the-fed-berkshires-investment-strategy-2012-5#ixzz2CB0ay5jG
It is true that what happened to Kodak was rough, but the full story according to Munger should take into account that there was a part of Kodak that did have a moat and will survive:
“People think the whole thing failed, but they forget that Kodak didn’t really go broke, because Eastman Chemical did survive as a prosperous company and they spun that off.” http://management.fortune.cnn.com/2012/08/22/buffett-munger-berkshire
Why did Eastman Chemical survive? Most probably Eastman survived due to supply-side economies of scale and intellectual property. Kodak probably has some great patents for chemically-based photography too. But in the case of Kodak and photography the entire process changed to digital and the Kodak moat was swiftly gone.
Research in Motion losing its Blackberry moat is another example of competitive destruction. Will they recover? The challenge the Blackberry faces is substantial. Once a feedback loop turns negative, it is hard for any company to regain what it once had. What builds you up can tear you down. And if the ride up was nonlinear, it is very possible that the ride down will be nonlinear as well.
As another example, Munger has said that department stores in downtown areas once had a very strong moat given economies of scale and a central location near mass transit. But then the way people lived started to change as cars became more affordable and people migrated to suburbs with shopping centers. The arrival of Amazon.com has further damaged the moat of the big-box retailers of all kinds whether in the city or the suburbs.
How Can the Quality of the Moat be Quantified?
The test of whether you have a moat with a given company is quantitative (i.e., it’s a math-based test). If (1) you are earning profits that are greater than your weighted average cost of capital (WACC) and (2) that level of profitability has maintained for some reasonable period measured in years, you have a strong moat. If the size of the positive difference between ROIC and WACC is large and if that “spread” is persistent over time, your moat is relatively strong. Mauboussin is the one to read on this as is usual. The essay: Measuring the Moat at http://www.capatcolumbia.com/Articles/measuringthemoat.pdf is a classic. Exactly how long the moat must be persistent to meet this test is an interesting question. If it is not a period of at least two years you are taking a significant risk. Five years of supporting data give you more certainty that you moat is sustainable. For a look at this see:
What determines whether a business a company has a moat is qualitative (e.g., supply-side and demand-side economies of scale, brand, regulation and intellectual property) but how you test to determine the strength of your moat is quantitative (i.e., it’s a mathematical exercise). Mathematical formulas won’t tell you how to get a moat but they can help prove that you have one, at least for now.
A company like Salesforce.com has not yet passed this quantitative test since management has been running their business at a loss or a tiny profit. Management at Salesforce.com can argue that they are doing this intentionally which seem to be true. But until Salesforce.com proves that it can pass the moat test with evidence that the mathematics satisfy the test, the assertion that the company has a moat is an unproven thesis. In other words, whether Salesforce.com has significant pricing power right now is just a theory. Until GAAP profit margins rise and stay high for a significant period the jury is still out. Any claims that prop0fiost have been earned non-GAAP basis or that the business generated or EBITDA (jokingly referred to by many people as “earnings before everything bad”) should be ignored. On this Munger has said: “I don’t even like to hear the word EBTDA.” He suggests inserting the word “bullshit” whenever you hear the term EBITDA
Spotting the existence of a moat that has not been fully taken advantage of by its current ownership in terms of raising prices can be profitable for an investor buying that business. Warren Buffett points out:
“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. … Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells … came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies… At Berkshire Hathaway, Warren and I raised the prices of See’s candy a little faster than others might have. And, of course, we invested in Coca-Cola—which had some untapped pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise prices. It was perfect.” http://ycombinator.com/munger.html
Starting with See’s Candies, Munger and Buffett learned that when you have a great moat (in this case driven by a powerful but primarily regional brand), the business can raise prices to improve profitability. On the December 29 of the year that they bought See’s prices were raised 20-30 cents a pound. They also learned that some brands translate less well to new markets and there is a limit on how many stores one can profitably build in a given geographic area.
Buffett has said that Kellogg’s has at times pushed their pricing too far and damaged their moat. Buffet believes that they didn’t have the moat they thought they had versus General Mills and other major breakfast cereal competitors.
At a very practical level the discussion above illustrates that there are some rules of thumb one can use to test the strength of a moat. At the top of the list is whether the business has pricing power. For example, if you must hold a prayer meeting before you try to raise prices, then you don’t have much of a moat, if any, argues Buffett.
Finally, it should be emphasized that is nothing sinister about the term “moat.” Business is, by its very nature, a competitive process. Even a small restaurant selling barbecue can have a moat. A company that has a return on capital significantly greater than their opportunity cost over time has a moat whether they know it or not.
Chapter 3- Charlie Munger on “Circle of Competence” (The Second Essential Filter)
“We have to deal in things that we are capable of understanding.” Charlie Munger http://www.youtube.com/watch?v=3XlBrohrIUc
“An Investor’s got to know His or Her Limitations” (Apologies to Clint Eastwood in Dirty Harry)
Charlie believes that investors who get outside of what he calls their “Circle of Competence” can easily find themselves in big trouble. Within a Circle of Competence a given investor has expertise and knowledge that gives him or her significant advantage over the market in evaluating an investment.
The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing. What could be simpler? And yet humans often don’t do this. For example, the otherwise smart doctor or dentist is easy prey for the promoter selling cattle limited partnerships or securities in a company that makes technology for the petroleum industry.
Really smart people fall prey to this problem. As an example, if you lived through the first Internet bubble like I did you saw literally insane behavior from people who were highly intelligent. Munger has pointed out that even one of the world’s greatest investors stepped outside of his Circle Competence during the bubble:
“Soros couldn’t bear to see others make money in the technology sector without him, and he got killed.” http://everythingwarrenbuffett.blogspot.com/2009/02/motley-fool-notes-from-2000-berkshire.html
In many cases so-called “old money” became so upset at Internet nouveau riche talking about their money and possessions, they jumped in to the market for technology stocks at the worst time possible, with disastrous results.
Professors who leave their university can make similar mistakes. Charlie has talked about the Nobel Prize winner who left academia to help found Long Term Capital Management: “[When] one of the economists who… shared a Nobel Prize … went into money management himself, he sank like a stone.” Larry Summers, who is a very intelligent and capable person in Charlie’s view, made a huge mistake investing Harvard’s cash account alongside the endowment leaving exposing the university to a huge liquidity risk. That decision by Larry Summers was clearly outside of his Circle of Competence and both he and the university paid the price. As a more current example, a talented venture capitalist who is within his or her circle of competence may not do as well running a macro hedge fund.
One way to think about what Munger is trying to achieve with this Circle of Competence filter is this: if you make fewer mistakes, your investment performance will be better. So invest in areas where you are competent. Why would you buy more of X which you know little about when you can buy Y (or more of Y) which is right in your Circle of Competence? The Circle of Competence approach is in part a form of opportunity costs analysis which will be discussed later in this series of posts.
“[Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent and you have to allocate it smartly.” http://www.watheeqa.com/App_Themes/watheeqa/pdf/Conversation%20with%20Charlie%20Munger.pdf
The value of specialization is, of course, at work here too. Munger in an interview put it this way:
“Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.” http://mungerisms.blogspot.com/2009/08/stanford-lawyer.html
The investor Li Lu describes how Charlie arrives at this approach:
“When Charlie thinks about things, he starts by inverting. To understand how to be happy in life, Charlie will study how to make life miserable; to examine how a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. His way of thinking comes from the saying in the farmer’s philosophy: I want to know is where I’m going to die, so I will never go there.” http://blog.enochko.com/2010/06/my-teacher-charlie-munger-english.html
To make wise decisions, stay away from domains where you will make unwise decisions.
By applying this filter, Munger is trying hard to limit his investing to areas in which he has a significant advantage in terms of competence and not just a basic understanding. Munger has talked several times in the past about a man who had “managed to corner the market in shoe buttons- a really small market but he had it all.” That’s an extreme example of a very narrow Circle of Competence. The areas in which you might have a Circle of Competence will hopefully be significantly larger than just shoe buttons. But if you try to expand that Circle of Competence too far, it can have disastrous results. Li Lu writes about how Charlie has described this “Mungearian” view to him:
“The true insights a person can get in life are still very limited, so correct decision-making must necessarily be confined to your ‘Circle of Competence.’ A ‘competence’ that has no defined borders cannot be called a true competence.” http://blog.enochko.com/2010/06/my-teacher-charlie-munger-english.html
In the book Snowball Alice Schroeder argues that Buffett: “believed in what he called the Circle of Competence, drew a line around himself, and stayed within the three subjects with which he would be recognized as absolutely expert: money, business and his own life. “(P25) I find Schroder’s conclusion that Buffett and Munger apply the Circle of Competence rule broadly outside of investing to be unconvincing, especially since Charlie in particular has strong opinions on just about everything. Warren may be more circumspect about offering his opinions on everything that Charlie, but the topics that are off limits for Buffett at a Berkshire shareholder’s meeting have not been tightly defined to those three topics in the past. When Charlie does express his opinion on a subject like modern academia he does not have money on the table and the Circle of Competence concept does not provide the same restraining effect as when money is involved.
Staying within a Circle of Competence is obviously not rocket science, but it is hard to do when you meet a slick promoter who is highly skilled at telling stories. This is a case where emotional intelligence, which is very different than IQ, becomes critically important. Humans love stories since it causes them to suspend disbelief. Madoff and Ken Lay were story tellers. I put this problem in the form of a tweet recently:
“Promoters know muppets love narrative & actual facts detract from desired state of suspended disbelief. Circle of Competence…”
Munger’s advice on why staying within your Circle of Competence is important is direct as is usual:
“You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own Circle of Competence.” http://www.ritholtz.com/blog/2012/02/a-lesson-on-elementary-worldly-wisdom-as-it-relates-to-investment-management-business/
Too many investors confuse familiarity with competence. For example, that a given person may fly on airlines a lot does not mean that they understand the airline industry well enough to be competent as an investor in that industry. Using Facebook, that does not make you qualified to invested in a social media start up. If you have not taken a deep dive into the business of a company and its value chain/industry, and you nevertheless decide to invest in that company, you are asking for trouble.
It’s important to ask yourself whether you have a personality that fits with the qualities needed to make your own investment decisions that involve individual stocks bonds and other investments. Do you enjoy reading extensively about companies you may invest in and their industries? Are you going to be happy spending hours each month doing so? Or would you rather spend that time playing golf or watching sports on TV? Do you find doing the work to make yourself a wise investor is fun? Do you spend more time researching a refrigerator than the stocks you buy? Is doing due diligence on an investment the sort of thing that makes you genuinely happy. Or is it like a root canal?
There are some people who know very well how to stay within the Circle of Competence and the Berkshire CEO list has way more than its fair share of these people. For example, Buffett cites Rose Blumkin of Furniture Mart as a person who fully understands the dimensions of her capabilities:
“[If] you got about two inches outside the perimeter of her Circle of Competence, she didn’t even talk about it. She knew exactly what she was good at, and she had no desire to kid herself about those things.” (Snowball at 495).
Knowing the boundaries of your Circle of Competence is critically important. In Munger’s opinion, if you have to ask the question whether something is within your Circle of Competence, you have already answered your question. He feels that the answer should be obvious:
“If you have competence, you pretty much know its boundaries already. To ask the question [of whether you are past the boundary] is to answer it.” http://www.poorcharliesalmanack.com/pdf/page53.pdf
Buffett talks about that fact that knowing where the perimeter of your Circle of Competence may be is far more important than the size of your circle. If you are only competent in spots and stay in those spots you can do just fine, argues Munger.
Overconfidence, Over-optimism and other Dysfunctional Heuristics
Why do people invest outside their Circle of Competence? The answer can be found in what Charlie calls dysfunctional “mental models” which will be discussed in detail in a later post in this series on Munger’s Methods. As a taste of that what Munger is talking about, I can’t resist inserting on quotation which describes just one dysfunctional overconfidence heuristic:
“In the 5th century B. C. Demosthenes noted that: “What a man wishes, he will believe.” And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.” http://220.127.116.11/search?q=cache:mgSaxC3O1IoJ:www.philanthropyroundtable.org/magazines/1999/march/munger.html+Berkshire+Hathaway%27s+vice+chairman+shreds+the+conventional+wisdom+on+foundation+investing&hl=en&gl=us&ct=clnk&cd=1
Berkshire itself has sometimes failed to properly apply the Circle of Competence filter as has its portfolio companies. As was explained in the first post in this series, Berkshire makes mistakes like everyone else. Buffet arguably was out of his Circle of Competence in the 1960s when he bought the department stores and then bought Associated Cotton Shops which sold women’s dresses. Dexter Shoes is another case where Berkshire wandered outside its Circle of Competence and was badly burned as a result
One example of a Berkshire portfolio straying from its Circle of Competence principle happened in the case of their most profitable insurance company according to Munger.
“[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
Munger himself may have fallen prey to this with his investment in BYD as was discussed in a previous post in this series. Did Charlie really know enough about BYD for it to fall within his Circle of Competence? How is BYD not a technology Company? All Berkshire companies use technology, but BYD is trying to solve technology problems that are core to its business. It can be argued in investing in BYD Charlie was just having a lot of fun in an exotic country and got carried away.
In using a Circle of Competence filter, Munger is trying to invest only when he has an unfair advantage. Otherwise, he wants to do nothing (which most people find very hard to do).
“The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much.” http://www.normanrentrop.de/de/gefunden/index_20602.html
In short, Charlie is looking for betting odds which are substantially in his favor when making an investment. And when he finds such a situation, he bets big. Otherwise he doesn’t bet. It’s that simple. A future post in this series on Munger’s Methods will deal with just that basic idea.
What is critical in following this approach is patience:
“We have this investment discipline of waiting for a fat pitch. If I was offered the chance to go into business where people would measure me against benchmarks, force me to be fully invested, crawl around looking over my shoulder, etc., I would hate it. I would regard it as putting me into shackles.” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3
Doing nothing is a very hard thing for most people to do. People for some reason think there is a bonus of some sort for activity in investing when there most certainly is not. In fact, there is a penalty on being overactive due to costs and expenses.
A Clear View of a Low Downside and a Big Upside
Munger does not like situations where there is a “close” investment decision to make.
“There are a lot of things we pass on. We have three baskets: in, out, and too tough… We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.” http://www.fool.com/news/foth/2002/foth020515.htm
And certainly, Munger would not invest in anything with a big downside and little upside. One of the best ways I have ever heard the idea behind Charlie’s philosophy expressed was by the famed investor Sam Zell.
“Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” http://www.latimespressmen.com/showthread.php?p=1525
In terms of finance theory, what a smart investor is looking for is “optionality.” Nassim Taleb puts what the smart investor is looking for in this way: “Payoffs [which] follow a power law type of statistical distribution, with big, near unlimited upside but because of optionality, limited downside.” Venture capitalists who are “antifragile” benefit from optionality. Investment bankers, who are “fragile” still are able to do this by being too big to fail and therefore socializing the big downside tail risk (i.e., get the taxpayers to pick up the losses from tail risk).
Charlie and Buffett want the financial upside to be big and clear enough that they can do the math in their heads. Munger said at a Berkshire meeting once:
“Warren talks about these discounted cash flows. I’ve never seen him do one.” [“It’s true,” replied Buffett. “If (the value of a company) doesn’t just scream out at you, it’s too close.”] 1996 Berkshire Hathaway Annual Meeting http://www.ndir.com/SI/email/q403.shtml
Of course, Buffett and Munger can do more mathematics in their heads that an average person can do on a calculator, but the point remains. Munger and Buffett want the mentally computable math to be overpoweringly clear and positive. Bill Gates has said on this point:
“… being good with numbers doesn’t necessarily correlate with being a good investor. Warren doesn’t outperform other investors because he computes odds better. That’s not it at all. Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation. He doesn’t invest–take a swing of the bat–unless the opportunity appears unbelievably good.” http://money.cnn.com/magazines/fortune/fortune_archive/1996/02/05/207334/index.htm
Technology Investments and the Circle of Competence
The technology sector is one area which Munger and Buffett have avoided since they feel they don’t understand the business well enough to predict where it will be many years down the road. Munger received his first taste in the technology business when he bought into an oscilloscope company early in his investing career. His top scientist was hired away by a venture capitalist and then magnetic tape came along and made things even worse. Charlie has said the entire experience nearly made him “go broke.”
Munger’s reluctance to invest in the technology sector is not a new phenomenon:
“Warren and I don’t feel like we have any great advantage in the high-tech sector. In fact, we feel like we’re at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies. Again, that is a very, very powerful idea. Every person is going to have a Circle of Competence. And it’s going to be very hard to advance that circle. If I had to make my living as a musician – I can’t even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.” http://ycombinator.com/munger.html
Berkshire recently bought a significant stake in IBM, but in that case the company has really transitioned from a technology company to a provider of services. Munger has said that “IBM is easier to understand than Google or Apple. It is a bit ironic that Berkshire invested in IBM given that Charlie said in 1994:
“In terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after “surfing” successfully for 60 years. And that was some collapse—an object lesson in the difficulties of technology and one of the reasons why Buffett and Munger don’t like technology very much. We don’t think we’re any good at it, and strange things can happen.” http://ycombinator.com/munger.html
Munger’s personal decision regarding does not mean that the technology sector is not right for other people who do have a Circle of Competence that includes technology. When asked recently about where they would start their career over again if they were just starting out today both Munger and Buffett answered: technology (one of them added energy as an alternative).
Technology presents additional challenges since uncertainty is high and the speed of innovation faster. Buffett has said: “Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.” In my view an investor can cope with that difference by being careful about his or her Circle of Competence within technology. To know a lot about graphics chips is not necessarily to know much about wireless data for example. To think otherwise is to tempt fate. As Clint Eastwood asked in the movie Dirty Harry if you break the Circle of Competence rule: “You’ve got to ask yourself one question: Do I feel lucky? Well, do ya, punk?”
Learn Continuously: Read, Read, Read
“You don’t have to pee on an electric fence to learn not to do it” said Munger on one occasion. At the most recent Berkshire meeting he quipped: “Learning from other people’s mistakes is much more pleasant. The best way to do this is simple: When in doubt, read so you can learn vicariously. Charlie loves to talk about the importance of reading:
“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” http://www.quoteswise.com/charlie-munger-quotes-2.html
We read a lot. I don’t know anyone who’s wise who doesn’t read a lot.” http://www.tilsonfunds.com/brkmtg04notes.doc
“Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.” http://www.valuewalk.com/charlie-munger-page/
The other related point is: success is a lousy teacher. Sometimes what seems like success was mostly luck. On that I suggest you read Mauboussin’s book The Success Equation . http://www.amazon.com/Success-Equation-Untangling-Business-Investing/dp/1422184234/ref=la_B001HCX42G_1_1?ie=UTF8&qid=1354820111&sr=1-1
Chapter 4- Charlie Munger on Management With Talent and Integrity (The Third Essential Filter)
Delegate, but not Everything
With only a little over 20 people working at Berkshire, Buffett and Munger must leave it to the managers to run the businesses in the portfolio since they don’t have the staff to do otherwise. This is, of course, by choice since what the two men love most is investing. Munger has said:
“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.” http://mungerisms.blogspot.com/2010/05/charlie-munger-on-how-hed-make-volckler.html
An investor like Munger finds his “comparative advantage” in investing rather than “making sure the trains run on time” like Matt Rose of Burlington Northern. Of course,l what Matt Rose does as a” trains run on time” manager is not only invaluable, but essential. Munger says this about See’s candy and delegation:
“There are a lot of people who would have bought it and would have screwed it up. They would have thought that headquarters knows best.” http://bit.ly/Ug9yV9
When Munger and Buffett do engage in company management, they focus on two tasks:
1. Capital Allocation
Management of the businesses within Berkshire is extremely decentralized, but the management of cash is extremely centralized. The primary management activity at Berkshire is capital allocation. Charlie writes:
“Proper allocation of capital is an investor’s number one job” Poor Charlie’s Almanack (p. 63)
Buffett’s view is no different:
“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.” http://www.economist.com/node/12677005
Munger has pointed out that capital allocation should not be combined or confused with what is essentially what he calls “gambling at a casino” as is the case with many large investment banks. Charlie has said publicly that he “makes Paul Volcker look like a sissy” when it comes to investment banking reform:
“I would separate derivatives from the basic bridges of civilization. We don’t want civilization contaminated by extreme speculation. I’d ban all the derivatives trading except for metals and commodities. The new stuff is a marvelous gambling game. It swamps any commercial transactions that are needed. Gambling does not become wonderful just because it pertains to commerce. It’s a casino.” http://theinvestmentsblog.blogspot.com/2010/05/if-i-were-lee-kwan-yew.html
2. Compensation Systems
This task is not as simple as it might seem since the Berkshire managers in many cases are rich and have little financial need to work. For this reason, Munger and Buffett select managers who love what they do enough that financial motivation is only part of the reason they love the work they do. The best place to see this philosophy set out s in the Berkshire “Owner’s Manual” at: http://www.berkshirehathaway.com/owners.html
Munger believes compensation systems are important- too important to delegate:
“It isn’t enough to buy the right business. You’ve also have to have compensation system that’s satisfactory to the people running them. At Berkshire Hathaway, we have no [single] system; we have different systems. They’re very simple and we don’t tend to revisit them very often. It’s amazing how well it’s worked. We wrote a one-page deal with Chuck Huggins when we bought See’s and it’s never been touched. We have never hired a compensation consultant.” http://www.tilsonfunds.com/wscmtg05notes.pdf
“A man does not deserve huge amounts of pay for creating tiny spreads on huge amounts of money. Any idiot can do it. And, as a matter of fact, many idiots do do it.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“I’d rather throw a viper down my shirt front than hire a compensation consultant.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
As an example, a manager like Mark Hurd might do very well with Larry Ellison keeping watch, but manage the company to maximize his compensation to the detriment of the company if supervised by a weak board of directors.
Micro-managing what their CEOs do is not in the Berkshire playbook:
“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.” http://gongol.com/research/berkshire/2012/
Of course, fear of micromanagement is not a reason to abdicate responsibility as Scott McNealy did with Jonathan Schwartz at Sun. A board of directors letting a parade of managers run down a business is not justified by a fear of micromanagement either. Should Leo Apotheker have been given the freedom to buy Autonomy? No. Buffett writes: “A managerial “wish list” will not be filled at shareholder expense” at Berkshire. http://www.berkshirehathaway.com/owners.html This raises the Institutional imperative problem that will be discussed later in this series. As Buffett has written:
“[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.” http://emlab.berkeley.edu/~ulrike/Papers/OCmergers_Final_JFEformat_20feb2008.pdf
“the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. …CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it. In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about ‘restructuring.’)” http://www.berkshirehathaway.com/letters/1987.html
Delegation to the extent practiced by Munger and Buffett only works if you follow this rule says Munger:
“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. It’s a different model from GE’s. GE’s works – it’s just very different from ours.” http://www.tilsonfunds.com/wscmtg05notes.pdf
Buying a “turn-around” business like Sears is not an example of a Berkshire approach despite what was claimed by investor Eddie Lampert. The idea that Lampert would be “the next Warren Buffett” was and is baffling given their different styles as investors.
Better to Have a Great Moat than a Great Manager (But Get Both When You Can)
Munger would rather have a great moat than great managers, but would love to have both so he as a greater margin of safety. “Good jockeys will do well on good horses, but not on broken down nags” quips Buffett. For example, both the New England textile business and the department stores that Berkshire owned had very competent managers, but the underlying businesses the managers had to run were lodged in quicksand. Ron Johnson who formerly was in charge of Apple’s retail operations may be a great manager of a retail business, but JC Penny’s reputation as a lousy business seems likely to make the critical difference in terms of a financial result. Lots of really great managers will do poorly running startup because the distribution of financial returns in venture capital is a power law distribution.
Munger admits there are rare exceptions to the moat rule:
“So you do get an occasional opportunity to get into a wonderful business that’s being run by a wonderful manager. And, of course, that’s hog heaven day. If you don’t load up when you get those opportunities, it’s a big mistake. … Averaged out, betting on the quality of business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.” http://ycombinator.com/munger.html
The Only Duty of Management is to “Widen” the Moat:
In typical fashion Charlie gets right to the point here:
“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 is too tough. But 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 ball of widening the moat, to be a steward of the competitive advantage that came to you. A General in England said, ‘Get you the sons your fathers got, and God will save the Queen.’ At Hewlett Packard, your responsibility is to train and deliver a subordinate who can succeed you. It is not all that complicated – all that mumbo jumbo. We make bricks in Texas which use the same process as in Mesopotamia.” http://mungerisms.blogspot.com/2009/08/2008-annual-meeting-notes.html
Munger wants managers of the business who have “an ownership mentality” toward the business, not just the attitude of manager.
“Carnegie was always proud that he took very little salary. Rockefeller, Vanderbilt were the same. It was a common culture in a different era. All of these people thought of themselves as the founder. I was delighted to get rid of the pressure of getting fees based on performance. If you are highly conscientious and you hate to disappoint, you will feel the pressure to live up to your incentive fee. There was an enormous advantage [to switching away from taking a percentage of the profits to managing Berkshire, in which their interests as shareholders are exactly aligned with other shareholders].” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3
Munger and Buffet want managers with what Nassim Taleb calls “skin in the game.” They hate situations in which the result is: “heads managers win and tails managers do not lose.” They want risk and benefits to be symmetrical. For Munger the presence of the right incentives for manager is critical. Buffett adds that he wants to see managers have: “a major portion of their net worth invested in the company. We eat our own cooking.”
Munger also fears bureaucracy and Berkshire works hard to prevent it from lowering returns. Munger:
“For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. But, of course, it isn’t. It’s not done until AT&T delivers what it’s supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies…. The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments—because we do. But it’s a terrible problem to get big bureaucracies to behave.” http://ycombinator.com/munger.html
Management Already In Place with Integrity
Munger has made it clear that integrity is just as significant an investment filter as talent. When Munger buys a company or makes an investment he wants both:
“We would vastly prefer a management in place with a lot of integrity and talent.” http://www.youtube.com/watch?v=3XlBrohrIUc
“Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“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.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“When you mix raisins with turds, they are still turds.” http://12valuestocks.com/2012/06/best-value-investment-quotes/
“All investment evaluations should start by measuring risk, especially reputational.” Poor Charlie’s Almanack (p. 61)
“Avoid dealing with people of questionable character.” Poor Charlie’s Almanack (p. 61)
As was noted in the earlier post on mistakes, no one is perfect, including Charlie says Charlie:
“[I know] of a company with a great culture and a great business and he and Warren admire the guy who runs the company. But, the man just made an awful acquisition. … you have to be willing to be disappointed by managers. All managers are going to drift. If [we] could be so wrong as to buy Dexter Shoes then we should not be surprised that others make acquisition mistakes. If you are not frustrated by what you see, you don’t understand it.” http://www.watheeqa.com/App_Themes/watheeqa/pdf/Conversation%20with%20Charlie%20Munger.pdf
It is harder to spot a lack of integrity than many people imagine. Munger:
“Bernie Ebbers and Ken Lay were caricatures – they were easy to spot. They were almost psychopaths. But it’s much harder to spot problems at companies like Royal Dutch [Shell].” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
The David Sokol case involving Berkshire is interesting to think about. http://www.berkshirehathaway.com/news/MAR3011.pdf Why would someone so rich like Sokol take an action that involved relatively little money as potential gain? That very rich people fall from grace in a huge way over small amounts of money defies easy explanation. Why take a risk that has small upside and massive downside like DennisKozlowski the former head of Tyco did in trying to avoid sales taxes on some art? As an analogy: Why cheat on a spouse with prostitutes when you are in a position of power like Eliot Spitzer? The answer, of course, is that humans are often emotional rather than logical and understand statistics in a dysfunctional way. Munger has said that if you think this sort of thing is easily explainable, you do not understand the problem. Complexity, risk, uncertainty and ignorance are impossible to avoid.
At a small scale reading how to respond when a lack of integrity is uncovered, Munger has said:
“Well in the history of the See’s Candy Company they always say, “I never did it before, and I’m never going to do it again.” And we cashier them. It would be evil not to, because terrible behavior spreads.” http://18.104.22.168/search?q=cache:3sSZnXLbvQEJ:www.loschmanagement.com/Berkshire%2520Hathaway/Charlie%2520munger/The%2520Psychology%2520of%2520Human%2520Misjudgement.htm+%22charlie+Munger%22+%22the+way+Zeckhauser+plays+bridge%22&hl=en&gl=us&ct=clnk&cd=1
Regarding where to draw the line, Munger points out
“We think there should be a huge area between what you’re willing to do and what you can do without significant risk of criminal penalty or causing losses. We believe you shouldn’t go anywhere near that line. You ought to have an internal compass. So there should be all kinds of things you won’t do even though they are perfectly legal. That’s the way we try to operate.” http://www.fusioninvesting.com/2011/04/david-sokols-honesty-is-the-question/
Munger makes it clear that he has no desire to buy an otherwise “good” business and they try to find someone to run it:
“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.” http://www.designs.valueinvestorinsight.com/bonus/bonuscontent/docs/Tilson_2006_BRK_Meeting_Notes.pdf#search=%22Charlie%20munger%20and%20foundation%20and%20croupier%22
The two investors are not interested in investing in a company “turnaround,” since they “seldom actually do. Charlie hopes that the moat of the company he is investing in is strong enough to survive bad management. As was discussed in a previous post in this series, Charlie would prefer to have a moat that is so strong that it could survive if the company was run by “an idiot nephew.” Neither Buffett nor Munger is going to buy a business and “let” some friend or relative “run it.” But if they hypothetically did, they would hope that it would still perform adequately as a business due to the moat.
The Rare Exceptions to the Moat Rule
Occasionally Munger and Buffett find a person who they can bet on who has such superior talent that they really don’t need much of a moat (regarding moats see my previous post). This situation is rare, but it does happen.
“Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks – who was second generation in Marks & Spencer of England – was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man. These people do come along – and in many cases, they’re not all that hard to identity. If they’ve got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party – then management can matter much. However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Sometimes, as is the case with Berkshire itself, it is worthwhile to bet on a superior manager. Charlie has said:
“There are people- very few- worth paying up to get in with for a long term advantage’. http://bitly.com/RzDIys
Buffett has pointed out that the talents of Ajit Jain in the reinsurance business are just such a case. Buffett said at the most recent Berkshire meeting: “Ajit Jain has created tens of billions of dollars in value for this company out of nothing but brain and hard work. “ That is high praise indeed since there is no mention of any moat in that business. Wells Fargo as has previously been mentioned is also described by Munger and Buffett as a company that relies mostly on management instead of a moat. I would disagree since I think being “too big to fail” like Wells Fargo is a form of moat since it gives them an artificially low cost of capital. The CEO of Wells thinks his business is all about execution:
“We always say we could leave our strategic plan on an airplane, somebody could pick it up, and it wouldn’t matter. It’s all about execution.” http://management.fortune.cnn.com/2012/11/26/wells-fargo-stumpf/
Certainly the way Wells Fargo “cross-sells” to existing customers in order to lower the cost to acquire new business is about great execution, but the bank in my view starts from a base of “too big to fail” which is a moat.
Charlie feels that the management of a company like Costco is a case in which management adds to the company moat. Charlie is a huge fan of Costco’s James Sinegal for example. But Munger clearly feels that companies which have managers like Costco are not easy to find.
“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. We have made money exercising our talents and will continue to do so. I’m glad we have insurance, though it’s not a no-brainer, I’m warning you. We have to be smart to make this work.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Munger also believes that a skilled manager can sometimes find a relatively safe market niche in some cases:
“I find it quite useful to think of a free-market economy – or partly free market economy – as sort of the equivalent of an ecosystem. Just as animals flourish in niches, people who specialize in some narrow niche can do very well.” http://www.thepracticalway.com/2010/12/20/quotes-charlie-munger/
This strategy is similar to what Professor Michael Porter calls “differentiation.” It can be workable, but is inherently riskier to find a haven from competition in a niche than to have a moat (it is better to have both). An example of a niche market where Munger and Buffett find a gem of a management team is Iscar:
“Judging the management at a company like Iscar is easy—those people are enormously talented and wonderful. But, there aren’t many managements like that and few people with the incentive of such intensity.” http://www.watheeqa.com/App_Themes/watheeqa/pdf/Conversation%20with%20Charlie%20Munger.pdf
“The reason I got so high on it so fast was that the people are so outstandingly talented. The idea of being in business with them just struck me worth straining for. We didn’t know when we were young which things to stretch for, but by the time we reached Iscar, which we never would have bought when we were young, we knew to stretch for the right people. It’s a hell of a business. Everything is right there. Isn’t it good that we keep learning? Better late than never.” http://www.tilsonfunds.com/Whitney%20Tilson’s%20notes%20from%20the%202007%20Wesco%20annual%20meeting-5-9-07.pdf
This post is getting beyond my self-imposed limit so I will let Bill Gates summarize the Munger/Buffett management philosophy:
“[Warren’s] penchant for long-term investments is reflected in another aphorism: “You should invest in a business that even a fool can run, because someday a fool will.” He doesn’t believe in businesses that rely for their success on every employee being excellent. Nor does he believe that great people help all that much when the fundamentals of a business are bad. He says that when good management is brought into a fundamentally bad business, it’s the reputation of the business that remains intact. Warren installs strong managers in the companies Berkshire owns, and tends to leave them pretty much alone. His basic proposition to managers is that to the degree that a company spins off cash, which good businesses do, the managers can trust Warren to invest it wisely. He doesn’t encourage managers to diversify. Managers are expected to concentrate on the businesses they know well so that Warren is free to concentrate on what he does well: invest.” http://money.cnn.com/magazines/fortune/fortune_archive/1996/02/05/207334/index.htm
Chapter 5- Charlie Munger on Margin of Safety (The Fouth Essential filter)
Are you an Investor or a Speculator?
Anyone who wants to understand Charlie Munger must understand this: If you are buying a share of stock, the investing process is the same as if you were buying a business since a share of stock is just a partial stake in a business. For example, a share of IBM stock is just a small share of IBM’s overall business. If you do not follow this approach in Charlie’s view you are a “speculator” and not an “investor.”
Charlie is a firm believer in what Benjamin Graham once said:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” http://en.wikipedia.org/wiki/Benjamin_Graham
Buffett has his own version:
“If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game.” http://en.wikiquote.org/wiki/Warren_Buffett
The objective of a “speculator” is to make predictions about the psychology of large masses of people, which if you are both smart and experienced is a sobering thought. How good are you at predicting what people will do once assembled into a mob? The big danger here is that you just end up following the crowd and doing what Munger talks about here: “Mimicking the herd invites regression to the mean (merely average performance).” http://www.scribd.com/doc/68337347/Charlie-Munger-Investment-Principles If you are not going to do any better than average, what’s the point of doing any works to outperform an index fund (more on this on the next post? Seth Klarman writes: “If you can’t beat the market, be the market.” (Margin of Safety, p. 212).
As an example, people who “day trade” stocks using goofy charts and other voodoo-like practices are speculators. You will hear them talk about how the market “behaves” rather than what the value of a given stock may be. To guess about market “behavior” based on a chart is just that: a guess! Speculators are focused on price whether it may be an old baseball card or share of stock. Seth Klarman writes in his book Margin of Safety: “Technical analysis is based on the presumption that that past share prices meanderings, rather than underlying business value, hold the key to future stock prices.” Talking heads on cable TV barking out recommendations to buy X and Sell Y as if they were on ESPN Sports Center are speculators/entertainers and are not investors. People who trade on inside information are actually investors, albeit ones that may go jail if caught. Some people who call themselves traders only succeed in doing so because they have better information or are taking the other side of trades with “muppets” being sold down the river via false advice.
Keynes put it this way: “Speculation: The activity of forecasting the psychology of the market.” Keynes went on to say the speculator must think about what others are thinking about, what others are thinking about the market, [repeat]. In a Keynesian beauty contest judges are told not to pick the most beautiful woman but instead to pick the contestant they think the other judges will choose as the most beautiful. The winner of such a contest may be very different than the winner of a traditional beauty contest. Keynes wrote about such a contest:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” General Theory of Employment Interest and Money, 1936. http://en.wikipedia.org/wiki/Keynesian_beauty_contest
Much of what went on in the IPOs of Facebook, Zynga and Groupon was a Keynesian Beauty contest: people were trying to guess what other people thought about what other people thought [repeat] about when these stocks would correct with everyone trying to get out just in time. Facebook, Zynga and Groupon investors were trying to “time” when the stock would fall even though the clock had “no hands” and so it was impossible to “time” the exit.
Charlie Munger’s best essay and arguably the one that made him most famous is entitled: “A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management & Business” and it can be found at http://ycombinator.com/munger.html In this wonderful essay (very much worth reading in full) is a long passage which includes this language:
“The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack… Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal….” http://ycombinator.com/munger.html
It is worth pointing out that value investing inherently is at odds with the “efficient market hypothesis” (more on that in the next blog post). In the real world, sometimes stocks are underpriced and sometime they are overpriced. To say that Facebook, for example, had an “efficient” price the day it went public and then a far lower price a short time after the stock substantially dropped in price is to defy common sense. During the first few months Facebook had a value that did not change very much, but the price changed a lot. Price does not always equal value. Anyone who invested through the Internet bubble in 2001 as I did and who still thinks markets are *always* efficient is bonkers.
Business Necessarily Involves Risk, Uncertainty and Ignorance
When you make an investment the laws of probability apply since the decisions involves risk, uncertainty and ignorance (more on this in a later post too, but to jump ahead read: http://www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf). If you are making “bets” on stocks and “the house” has the odds in their favor you are gambling/speculating. If you have the odds in your favor you are instead “investing.” It should be not a surprise that many successful investor and business people are experts at poker and bridge. Some of them, like Charlie Ergen, were once card counters in Las Vegas. Successful business people don’t really gamble since their *big* bets happen when the odds are substantially in their favor.
Many people make the mistake of assuming that buying a quality company ensures safety. Samsung may be a quality company with an attractive business, but that alone is not enough since the price you pay for a share of stock matters. Facebook may be an important company with lots of page views to put advertising on, but it is not worth an infinite price. Howard Marks puts it best:
“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…. Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.” http://ivanhoff.com/2012/12/27/high-quality-assets-can-be-risky-and-low-quality-assets-can-be-safe/
Similarly, just because the price of share of stock in a company is beaten down from formerly high levels does not make it “safe” to buy. As an example, HP is way off its value of a few years ago, but that alone does not necessarily make the purchase of the stock “safe” in terms of a Margin of Safety.
The “Margin of Safety” concept is about making it likely that you have the odds significantly in your favor by trying to find a substantial cushion in terms of the odds. Munger does not believe that this happens very often, particular when it is in your Circle of Competence and the other investing filters are in place. Since finding a significantly mispriced bet does not happen very often, when it does happen you should bet *big*. Charlie believes that this means most of the time an investor should be sitting on their “rear end” reading and talking to people. Munger has said: “Investing is where you find a few great companies and then sit on your ass.” http://wealthymatters.com/2011/02/12/charlie-mungers-quotes-mungerisms/ Buying and selling stocks for its own sake (e.g., to stay busy) is a very bad idea.
“It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It’s just that simple.” http://ycombinator.com/munger.html
One truism about investing is this: for you to find a significant mistake, someone else must be making a mistake too. Seth Klarman writes:
“Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economic growth, market outperformance by one investor is necessarily offset by another’s underperformance.” http://budfox.blogspot.com/2012/11/seth-klarman-goes-nuts-on-fed-in-his_6.html
In other words, when you are investing you are searching for *significant” mistakes made by others. And when you find a *significant* mistake, you bet big.
Everyone Makes Mistakes (No Exceptions).
The first post in this series was about the inevitable mistakes people make. Everyone makes mistakes. If you think you don’t make mistakes, you are in dire need of psychological counseling on that issue alone. Donald Trump would be one example of someone who needs psychological help on this point at least.
What you are trying to do when making an investment is to find a mispriced bet. What Margin of Safety is all about is finding a *significantly* mispriced bet. When you look at the current price of a stock like Apple, do you see a significant mistake being made by the market in terms of the price it is offering you at that moment? Charlie puts it this way:
“[Ben Graham developed this] concept of “Mr. Market.” Instead of thinking the market was efficient; he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think it’s worth.” And other days, “Mr. Market” comes by and says, “I’ll buy your interest at a price that’s way higher than you think its worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.” http://ycombinator.com/munger.html
When the investor faces the challenge of investing he or she faces risk, uncertainty and ignorance. Seth Klarman writes:
“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” http://www.marketfolly.com/2012/04/notes-from-seth-klarmans-margin-of.html#ixzz2FqyYTIon
The bad news for some people in all of this is that investing is hard. But the good news is also that investing is hard and if you have the right temperament and are willing to do the necessary work the process can be fun. As Charlie has said:
“If (investing) weren’t a little difficult, everybody would be rich.” http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471446912,descCd-tableOfContents.html
To better deal with inevitable mistakes we all make as human beings, Charlie believes that you should have built into the process a “margin” of sufficient size which ensures that even if mistakes happen the outcome will be “adequate” as Ben Graham describes. Graham called this a “Margin of Safety.” When you are thinking about buying shares of, for example, Cisco, do you see a value of those shares which is 20-25% less than actual value? If you see a significant discount from value in the current price of an investment, you have a Margin of Safety.
Margin of Safety has evolved since Graham
What Graham did in applying this Margin of Safety concept in his era was quite different than the way Buffett and Munger use it today. In the aftermath of the depression Graham was spending most of his time looking for companies “worth more dead than alive.” These “cigar butt” companies were more common at that time, but as years passed and they more or less disappeared. Buffett, encouraged by Munger, began to apply the same principle to companies that were of high quality and the process worked just as well. Munger:
“Ben Graham followers… started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well.” http://ycombinator.com/munger.html
Munger believes that process in a financial transaction is similar to processes that exist in engineering:
“In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting. http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3
If you are building a bridge as the designer you want to make sure that it is significantly stronger than necessary to deal with the very worst case. Buffett wrote once: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 trucks across it. And the same principle works in investing.” Charlie thinks investing should be similar. The first rule of investing is: don’t make big financial mistakes. The second rule is the same as the first rule.
The size of the minimum Margin of Safety should vary with the magnitude of the risk involved. In his fantastic new book Michael Mauboussin writes:
“As Graham noted, the margin of safety ‘is available for absorbing the effect of miscalculations or worse than average luck.’ The size of the gap between price and value tells you how you’re your margin of safety is. As Grahaham says, the margin of safety goes down as the price goes up. In other words, make you margin of safety as large as possible.” The Success Equation at 169. http://www.amazon.com/The-Success-Equation-Untangling-Investing/dp/1422184234
In terms of the size of the Margin of Safety, Munger and Buffett like the amount to be so big that they need not do any math other than in their heads:
Munger: ”Warren often talks about these discounted cash flows, but I’ve never seen him do Buffett: “It’s sort of automatic. It ought to just kind of scream at you that you’ve got this huge margin of safety.” http://wealthymatters.com/2011/02/12/charlie-mungers-quotes-mungerisms/
Munger talks once about the concept of Margin of Safety in describing Buffett’s one time mentor Benjamin Graham in this way:
“Graham had this concept of value to a private owner—what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety—as he put it—by having this big excess value going for you.” http://ycombinator.com/munger.html
Since nothing is certain in investing, the best approach is to think probabilistically. Michael Mauboussin says it best:
“Margin of safety can be restated as a discount to expected value. Expected value is a function of the weighted probability of potential outcomes.” http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf
“[One] way to cope with noise is to think probabilistically. The basic idea is to intelligently consider value outcomes and their associated probabilities. These probabilities and outcomes allow you to determine an expected value, and you want to buy at a substantial discount to that value. That discount is what Ben Graham would call “margin of safety.” His message about margin of safety is just one of Graham’s enduring lessons.” http://seekingalpha.com/article/163743-interview-michael-mauboussin-chief-investment-strategist-legg-mason-capital-management
In determining the value of a business people make many different mistakes. One reason why so many mistakes are made is that both a business and an economy are unpredictable complex adaptive systems (more on that later). Another reason is that promoters can tell tall very convincing stores and many investor buy into the false narrative to their detriment.
The starting point in the process is setting a valuation. At his core, Munger believes:
“You must value the business in order to value the stock.” http://www.valuewalk.com/charlie-munger-page/
In setting a value Munger and Buffet don’t swallow the stores of promoters that sing songs and tell tall tales about EBITDA and non-GAAP “earnings.” They like genuine free cash flow. Munger:
“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.” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3
Warren Buffett describes the valuation investing process in this simple way:
“Though this … cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.” http://www.berkshirehathaway.com/letters/1993.html
Each of these points made by Buffett on valuation deserves its own blog post, so I will leave it at that for now. But the important point is (1) to have the discipline to do the work; (2) realize that mistakes will inevitably be made; and (3) build in a Margin of Safety. In doing this analysis people like Buffett are very conservative:
”We think about worst cases all the time and we add on a big margin of safety. We don’t want to go back to ‘Go.’” http://articles.chicagotribune.com/2012-05-05/news/sns-rt-berkshiremeeting-highlights2l1e8g52t9-20120505_1_vice-chairman-charlie-munger-berkshire-meeting-berkshire-hathaway
Warren Buffett has views on company valuation which echo Munger’s:
“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” http://alephblog.com/2011/10/20/value-versus-growth/
“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” http://www.buffettsecrets.com/company-growth.htm
In terms of valuing a company and its relation of Margin of Safety, I like a definition Michael Mauboussin once set out in an interview:
“Value, to me, is the present value of future cash flows, which would be relevant for any financial asset – present value of future cash flows. Value would be buying something for substantially less than what it’s worth, based on that stream of cash flows. It’s as simple as that. And the margin of safety, of course, reflects the distance…” http://www.forbes.com/sites/steveforbes/2011/07/11/steve-forbes-interview-michael-mauboussin-professor-and-investor/
To which Mauboussin adds:
“A margin of safety- a concept attributable to Ben Graham- exists when an investor can purchase a stock well below its intrinsic value. Buffett defines intrinsic value in no uncertain terms: ‘it is the discounted value of the cash that can be taken out of a business during its remaining life.’” http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf
Every so often someone will say that the ideas of people like Munger are old-fashioned. One such case was during the 1999-2001 Internet stock bubble and that did not turn out well for people who doubted these principles. Some promoters did well during that bubble, but that it another subject entirely. Munger believes the Margin of Safety idea is timeless:
“The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So, Graham had a lot of wonderful ideas.” (Wesco Annual Meeting 2003) http://wealthymatters.com/2011/02/12/charlie-mungers-quotes-mungerisms/
As I did in the last chapter I will leave it to one person to summarize the ideas set out in this post. James Montier:
“Valuation is the closest thing to the law of gravity that we have in ﬁnance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reﬂects that any estimate of fair value is just that: an estimate, not a precise ﬁgure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.” http://theguruinvestor.com/2011/05/20/the-seven-immutable-laws-of-investing/
Charlie Munger’s summary of all the four investing filters is to the point:
“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.” http://www.peregrineinvest.com/whatwedo.aspx?spid=109675&Title=Investing%20Words%20of%20Wisdom
It’s so simple! Most financial advisors try to make the investing process complex since otherwise they would have nothing to sell. Of course, that the process is simple does not mean the process is not hard work or fun for some people . The next post in this series will discuss whether people should be active or passive investors and whether diversification or concentration of investments makes sense in each case.
Chapter 6 Charlie Munger on Investment Concentration versus Diversification
Active versus Passive Investing
Charlie’s advice to other people on investing is very different depending on the nature of the investor.
“Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund.” http://www.myinvestmentforum.com/category/sgfunds-forum/interview-with-charlie-munger-t1655.html
What is a “know nothing” investor? The answer is simple for Charlie: a no-nothing investor is someone who does not understand the economics of the specific business in question. As was pointed out in the last blog post, to understand the value of an investment, you must understand the value of the underlying business since a share of stock is merely a proportional ownership interest in a business. If you are thinking about price of the stock and not the value of the business you are not an investor believes Munger. Occasionally some academic will claim that Munger and Buffett only know how to buy valuable companies at great prices. This is a moronic academic analysis of Munger and Buffett’s market outperformance (alpha) since that *is* investing.
Buffett makes it clear that being a know-nothing investor is nothing to be ashamed about. Know-nothing investors can know a lot about a lot. Sports, politics, science even some aspects of business can be the forte of a know-nothing investor.
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” http://berkshireruminations.blogspot.com/2007/12/thoughts-on-index-investing.html
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” http://www.berkshirehathaway.com/letters/1996.html
Think about what this means. You can decide to become a long-term investor in the United States/global economy and not spend much time understanding the economics of specific businesses. You can spend that time engaged in things that interest you like skiing, sleeping or watching TV instead. Josh Brown lays it out cleanly here:
“… Prior to comparing your returns to this or that index and then tearing out your hair over them, ask yourself whether or not it should matter. If you are speculating for the sake of speculation, by all means, grade yourself. If you are running a fund, then you won’t need to grade yourself because you are already being judged as we speak. Only 39% of active managers beat their benchmarks in 2o12, which means more than half of the fund industry is under this microscope now and the light in their faces is a harsh one. Not a pleasant place to be.
And never mind comparing yourself to an index, it’s hard enough to keep up with this orange cat from London named ‘Orlando’ who took on a gaggle of supposed market-beating fund managers:
By the end of September the professionals had generated £497 of profit compared with £292 managed by Orlando. But an unexpected turnaround in the final quarter has resulted in the cat’s portfolio increasing by an average of 4.2% to end the year at £5,542.60, compared with the professionals’ £5,176.60.
This cat, a fucking ginger no less, threw a chew toy at the stock table pages of the Financial Times and beat guys with decades of experience and unlimited research at their fingertips.” http://www.thereformedbroker.com/2013/01/15/chasing-the-cat/
The most important thing people need to know in making this decision is their own limitations. As a previous post explained, Charlie believes that not making big mistakes is a huge determinant of whether you will have financial success in life. By understanding your limitations you will make fewer mistakes.
What Warren Buffett is talking about is the question of whether a person should be an “active” or a” passive” investor – concepts he learned from Benjamin Graham:
“The determining trait of the enterprising [active] investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor.” http://blogs.cfainstitute.org/investor/about-us/ben-graham/
Being an active investor and somehow outperforming the market after fees and expenses sounds good, but the catch is that being a successful active investor requires a massive amount of time and work. If you don’t enjoy it, why do it?
Even more importantly, if you are provably not good at it, why do it? If you keep track of your active investing results over the years and you are failing to match the indexes, what is that telling you? An active investor who does not keep written track of their results after fees and expenses and compares that to “being the market” instead is at big risk of fooling themselves. Charlie says that Richard Feynman was right that the easiest person to fool is yourself, and that especially applies to investing skill/results.
Munger agrees with Buffett that index funds make the most sense for almost all investors. Whether they know it or not most all investors should be passive investors. Some people try to escape from this trap by saying essentially: “I can be smart about picking other people who will outperform market via active investing.” Relying on a stock broker to be an active investor on your behalf is no solution says Charlie since “stock brokers, in toto, will do so poorly that the index fund will do better.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
If you are not a passive investor, you must beat the market after fees and expenses. As John Brown notes above, being an active investor and accomplishing that is nontrivially hard to do.
It is at this point that the debate about the so-called “efficient market hypothesis” (“EMH”) raises its ugly head. Munger’s view on EMH are clear:
“I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.” http://www.myinvestmentforum.com/category/sgfunds-forum/interview-with-charlie-munger-t1655.html
The paradox facing the ordinary investor is that usually only the biggest investors (e.g., big pension funds, university endowments and the very wealthy) get access to the top three to four percent investment management. This problem for the ordinary investor is reflected in an old Groucho Marx joke: you don’t want to hire an investment manager that would take you for a client!
Why is the EMF theory so widely advocated? Academics love EMH because they can claim that they have mathematics-based formulas which can predict the future even though the underlying assumptions (borrowed from physics) are provably false. For a professor, the ability to create beautiful mathematics is important since it means that they are less likely to be teased by physicists in the faculty club. Life is infinitely more interesting for an academic if they can create beautiful mathematics in their papers.
“I have a name for people who went to the extreme efficient market theory—which is “bonkers.” It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.” http://ycombinator.com/munger.html
In future posts I will describe Munger’s his views on why behavioral economics invalidates key premises of EMH. They are numerous and detailing them will be more fun that the blog posts made to date by this author. Munger:
“The possibility that stock value in aggregate can become irrationally high is contrary to the hard-form “efficient market” theory that many of you once learned as gospel from your mistaken professors of yore. Your mistaken professors were too much influenced by “rational man” models of human behavior from economics and too little by “foolish man” models from psychology and real-world experience.” http://www.tilsonfunds.com/Mungerwritings2001.pdf#search=%22%20%22charlie%20Munger%22%20Outstanding%20investor%20digest%22
Munger likes to make fun of a few specific economists who have taken their academic theories into the real world and failed in spectacular fashion:
“Efficient market theory [is] a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.” And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
Charlie as similar feelings about other aspects of much of academically generated financial theory:
“Berkshire’s whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to. I think you’d have to believe in the tooth fairy to believe that you could easily outperform the market by seven-percentage points per annum just by investing in high volatility stocks.” http://www.tilsonfunds.com/MungerUCSBspeech.pdf
The problems which arise due to people thinking that they can be successful active investors are huge and made worse due to one a dysfunctional heuristic in particular (more on this later) known simply as “overconfidence”:
“Most people who try [investing] don’t do well at it. But the trouble is that if even 90% are no good, everyone looks around and says, “I’m the 10%.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
The list of dysfunctional heuristics is a long and winding road.
One of the saddest cases in investing happens when someone thinks they are active investor but the reality is that they have invested in so many stocks that they have become “closet indexers.” Munger points out the ugliness simply:
“[With] closet indexing … you’re paying a manager a fortune and he has 85% of his assets invested parallel to the indexes. If you have such a system, you’re being played for a sucker.” http://www.tilsonfunds.com/wscmtg05notes.pdf
On this point, to understand Munger it is best to look again at his wonderful essay which compares investing to betting at a horse racing track:
“the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced bet — that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.
That is a very simple concept. And to me it’s obviously right—based on experience not only from the pari-mutuel system, but everywhere else. And yet, in investment management, practically nobody operates that way. We operate that way—I’m talking about Buffett and Munger. And we’re not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything all the time. To me, that’s totally insane. The way to win is to work, work, work, work and hope to have a few insights.” http://ycombinator.com/munger.html
If you want to go deeper on the closet indexing issue I suggest you read Mauboussin as usual (when in doubt read Mauboussin is my rule of thumb): https://www.lmcm.com/905988.pdf More discussion can be found here: http://online.barrons.com/article/SB50001424052748703792204578221972943824046.html?mod=bol_share_tweet#articleTabs_article%3D2
Concentration is Key for the Active Investor
Munger is clearly a devotee of concentrating his investments since he is not a know-nothing investor.
“The idea of excessive diversification is madness.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
“Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.” http://investingcaffeine.com/2009/12/02/more-eggs-in-basket-may-crack-portfolio/
Seth Klarman believes: “The number of securities that should be owned to reduce portfolio risk is not great; as few as ten to fifteen holdings usually suffice.”
Jason Zweig adds:
“A conventional rule of thumb, supported by the results of Bloomfield, Leftwich, and Long 1977, is that a portfolio of 20 stocks attains a large fraction of the total benefits of diversification. … however, that the increase in idiosyncratic risk has increased the number of stocks needed to reduce excess standard deviation to any given level.” http://kuznets.fas.harvard.edu/~campbell/papers/clmx.pdf
“Even the great investment analyst Benjamin Graham urged “adequate though not excessive diversification,” which he defined as between 10 and about 30 securities.” http://online.wsj.com/article/SB10001424052748704533904574548003614347452.htm
Munger chimes in:
“The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun? http://www.myinvestmentforum.com/category/sgfunds-forum/interview-with-charlie-munger-t1655.html
Seth Klarman points out that it is better to know a lot about 10-15 companies that to know just a little about many stocks. When it comes to diversification vs. concentration Charlie feels like the Maytag repair man:
“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. http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
The number of stocks a person can realistically follow and understand the economics of the specific business better than the market is significantly less than 20. The idea that a dentist working full time in his or her profession is going to pick technology stocks better than the market after fees and expenses is silly. A UPS driver is hoping to the same thing with a health care stock? Remember the task is not just to pick a quality company, but to find a mispriced bet.
The same principles apply to Angel investors who “spray and pray” investments at every start up they can find. Smart VCs and Angels investors make a lot of bets but in a relative sense they are still concentrated. A big VC fund may make 40 bets in a fund and the outcome for the funs may rest on two or three massive financial home runs, but each of the 40 bets must have optionality. To many companies VCs think they can just invest in 4o0 companies regardless of whether they have optionality.
You may recall from an economics class or reading that markets are “efficient.” This means markets take all the available information and create a price for the good or service. The market is often right about that price, but is not always right. It is possible, by finding an area in which you are particularly competent, to find an investment that is being offered to you for substantially less than it is worth. Not a little less than what it is worth mind you, but substantially less than it is worth. “How much is substantially less than it is worth?” you may ask. The price should be so good that it is screaming out at you to buy it. “How often is this likely to happen?” It may happen once or twice in a year or twice in a month and then not again for two or three years. As an example, the VC Fred Wilson is said to have made no investments at all in 2012. Sometimes that happens if you stick to your principles.
It is important to note that mispriced investments will happen more often that once or twice a year as a whole, but the only mispriced investment that is important to you is one that falls within an area in which you are very competent. The smaller the area in which you apply your time and effort to being competent, the more likely is that you will genuinely spot the opportunities. If you try to be competent in all areas and you will never be smart enough to find these investment opportunities.
“We don’t believe that markets are totally efficient and we don’t believe that widespread diversification will yield a good result. We believe almost all good investments will involve relatively low diversification. Maybe 2% of people will come into our corner of the tent and the rest of the 98% will believe what they’ve been told.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
Chapter 7 The Importance of Worldly Wisdom and Consistently Not Being Stupid.
“I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” http://www.scribd.com/fullscreen/110302239?access_key=key-28dmiqkoda00xd7b7mae
A Lattice of Mental Models
Understanding how humans make decisions is critical for any investor. Unless careful attention is devoted to decision making processes the brain can be a mistake-making machine.
“It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471446912,descCd-tableOfContents.html
One way to “be less stupid” is to adopt what Charlie calls a “lattice of mental models” approach to evaluating decisions. He believes that by using a range of different “models” from different disciplines like psychology, history, mathematics, physics, biology and economics, a person can use the combined output to produce something he calls “Worldly Wisdom.”
Munger’s method is to first assemble all the relevant facts and then apply a rational process to produce an analysis of those facts and an investing thesis. To increase the probability that the process is actually rational Munger applies multiple models from various disciplines like psychology, mathematics, statistics history, physics, biology and economics searching for sources of human misjudgment. It is in effect a form of “double/multiple check” on the investing process. Munger believes that by going over your decision making process carefully using these additional “filters” from many disciplines you can more consistently “not be stupid”. You will always make some bone-headed mistakes even if you are careful, but Munger’s process is designed to decrease the probability of mistakes.
Munger refers to this approach to problem solving as a:
“2 track analysis: 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)”
“what are the factors that really govern the interests involved 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” http://moneyarchive.wordpress.com/2008/09/07/the-charlie-munger-checklists/
Munger believes that it is critical for a person think broadly since to not do so is to invite mistakes.
“The theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.” http://www.thinkfn.com/en/content/view/52/?id=124
In creating his “lattice of mental models” approach Munger took his cue from Benjamin Franklin a renaissance man/polymath who he admires greatly.
In the language of Philip Tetlock http://en.wikipedia.org/wiki/The_Hedgehog_and_the_Fox, Munger is a “fox” (knows a little about a lot) by nature rather than a “hedgehog” (knows a lot about very little). In terms of “foxes” that one may encounter in life Charlie is someone truly special. Bill Gates has said about Charlie: “Charlie Munger is truly the broadest thinker I have ever encountered.”
What an investor is dealing with when making investing decisions is a nest of “complex adaptive systems” which makes his or her job genuinely hard. This means, says Munger:
“An investment decision in the common stock of a company frequently involves a whole lot of factors interacting … the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
If one adopts the model of “complex adaptive systems” one accepts the idea that there are many things that can not be modeled with certainty. In Charlie’s view it is better to have common sense and be Worldly Wise than futz around with a lot of models that are precisely wrong rather than approximately right. Munger: ”People calculate too much and think too little.” http://www.fool.com/news/foth/2002/foth020515.htm
Charlie’s breadth of knowledge is something that is naturally part of his character but also something that he intentionally cultivates. To know nothing about an important subject is to invite problems.
“What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head. And you’ve got to array your experience ‑ both vicarious and direct ‑ on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered.” http://www.amazon.com/exec/obidos/ASIN/1578643031/consciousinve-20/104-7644521-2497538
Munger illustrates this idea by pointing out that many professionals often think only about their own discipline and think that whatever it is that they do for a living will cure all problems. A nutritionist may feel as if she can cure anything for example. Or a chiropractor may believe he can cure depression. Munger calls this “man with a hammer” syndrome since to such a person “everything looks like nail” even though it may not be a nail.
Charlie has said many times that someone who is really smart but has devoted all their time to being an expert in a narrow area may actually be dangerous to themselves and others. One example of this are most macroeconomists who think they understand the economy but are disasters in investing their own portfolios. As another example, marketing experts may think that most everything can be solved via that discipline. Financiers tend to think similarly about their own profession. Too many people believe what they do at work is hard and what others do is easy.
Charlie believes that the best approach to dealing with this set of problems can be found in adopting a multidisciplinary approach.
“you’ve got to have multiple models. And the models have to come from multiple disciplines ‑ because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. … You may say, ‘My God, this is already getting way too tough.’ But, fortunately, it isn’t that tough ‑ because 80 or 90 important models will carry about 90% of the freight in making you a worldly ‑ wise person. And, of those, only a mere handful really carry very heavy freight.” http://www.amazon.com/exec/obidos/ASIN/1578643031/consciousinve-20/104-7644521-2497538
Munger believes that by learning to recognize certain dysfunctional decision making processes an investor can learn to make fewer mistakes. As was noted in the first post in this series mistakes can’t be eliminated. The best one can hope for is to reduce their frequency and hopefully magnitude. Charlie:
“Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain can’t use what it can’t remember or when it’s blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it…” “…the deep structure of the human mind requires that the way to full scope competency of virtually any kind is learn it all to fluency – like it or not.” http://www.poorcharliesalmanack.com/pca.php
To sum up is blog post it is useful I think to just quote Charlie on the benefits of his approach:
“I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.…so if civilization can progress only with an advanced method of invention, you can progress only when you learn the method of learning. Nothing has served me better in my long life than continuous learning. I went through life constantly practicing (because if you don’t practice it, you lose it) the multi-disciplinary approach and I can’t tell you what that’s done for me. It’s made life more fun, it’s made me more constructive, it’s made me more helpful to others, and it’s made me enormously rich. You name it, that attitude really helps.” http://www.valueinvestingworld.com/2007/05/charlie-munger-usc-law-school.html
In blog posts to follow I will try to apply “Munger’s methods” to a series to specific problems. For example, in looking at a decision: are there dysfunctional decision making heuristics from psychology that may have caused an error? As another example, Charlie likes to use a model from Algebra and “invert” to find a solution for problems. Looking for models to explain mistakes so one can accumulate “Worldly Wisdom” is actually lots of fun. It is like a puzzle to be solved.
Charlie likes checklists.
“You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.” http://investdigest.blogspot.com/2006/02/charlie-mungers-investing-mental.html
His most comprehensive checklist can be found in Poor’s Charlie Almanack http://www.amazon.com/Poor-Charlies-Almanack-Wisdom-Charles/dp/1578643031 which is reproduced below. Some of the topics have been covered to date and some have not. I hope to get to most if not all of them eventually.
Risk – All investment evaluations should begin by measuring risk, especially reputational
- Incorporate an appropriate margin of safety
- Avoid dealing with people of questionable character
- Insist upon proper compensation for risk assumed
- Always beware of inflation and interest rate exposures
- Avoid big mistakes; shun permanent capital loss –
Independence “Only in fairy tales are emperors told they are naked”
- Objectivity and rationality require independence of thought
- Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
- Mimicking the herd invites regression to the mean (merely average performance)
Preparation “The only way to win is to work, work, work, work, and hope to have a few insights”
- Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
- More important than the will to win is the will to prepare
- Develop fluency in mental models from the major academic disciplines
- If you want to get smart, the question you have to keep asking is “why, why, why?”
Intellectual humility – Acknowledging what you don’t know is the dawning of wisdom
- Stay within a well-defined circle of competence
- Identify and reconcile disconfirming evidence
- Resist the craving for false precision, false certainties, etc.
- Above all, never fool yourself, and remember that you are the easiest person to fool –
Analytic rigor – Use of the scientific method and effective checklists minimizes errors and omissions
- Determine value apart from price; progress apart from activity; wealth apart from size
- It is better to remember the obvious than to grasp the esoteric
- Be a business analyst, not a market, macroeconomic, or security analyst
- Consider totality of risk and effect; look always at potential second order and higher level impacts
- Think forwards and backwards – Invert, always invert –
Allocation – Proper allocation of capital is an investor’s number one job
- Remember that highest and best use is always measured by the next best use (opportunity cost)
- Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
- Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven –
Patience – Resist the natural human bias to act
- “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
- Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
- Be alert for the arrival of luck
- Enjoy the process along with the proceeds, because the process is where you live –
Decisiveness – When proper circumstances present themselves, act with decisiveness and conviction
- Be fearful when others are greedy, and greedy when others are fearful
- Opportunity doesn’t come often, so seize it when it comes
- Opportunity meeting the prepared mind; that’s the game –
Change – Live with change and accept unremovable complexity
- Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
- Continually challenge and willingly amend your “best-loved ideas”
- Recognize reality even when you don’t like it – especially when you don’t like it –
Focus – Keep things simple and remember what you set out to do
- Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
- Guard against the effects of hubris (arrogance) and boredom
- Don’t overlook the obvious by drowning in minutiae (the small details)
- Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
- Face your big troubles; don’t sweep them under the rug [checklist from http://www.valueinvestingworld.com/2007/12/investing-principles-checklist-from.html quoting Poor Charlie’s Almanack]
Chapter 8: Charlie Munger of the Psychology of Human Misjudgment
“…the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes…” Charlie Munger http://www.rbcpa.com/Mungerspeech_june_95.pdf
To cope with information and computation overload, humans have developed simple “rules of thumb” called “heuristics” which allow them to make decisions. It would be great if people could do what Charlie describes above, but it is just not possible. Decision making heuristics are sometimes beneficial and sometimes not. Catching a fly ball in a baseball games involves a heuristic which works very well. Really skillful people who know their limitations well can sometimes use heuristics to their advantage including his partner Warren Buffett and Ajit Jain. Munger points out:
“There is a close collaboration between Warren and Ajit Jain. I’ve known both a long long time and if there are two better people on this earth to do this [super cat underwriting], I don’t know who they are. We can’t guarantee results, but they’ve done fine — in fact, more than fine. Sometimes they will do things where it’s a straight Pascalian calculation — the odds are x and we get paid at a rate that give us better odds than Las Vegas. The reason other people won’t do it is because if they’re wrong, it’ll be a big money loss, but Berkshire can handle a big number loss. I’m quite comfortable watching those two people do it. I wish I could do it, but I can’t. It’s reasonable heuristics by two tough, sharp-minded men.” http://www.tilsonfunds.com/motley_berkshire_wscmtg03notes.php
Unfortunately, particularly in the context of human activities that are not really part of our evolutionary past (such as investing), euristics can produce boneheaded mistake after mistake. Zeckhauser, who Charlie Munger admires greatly for his decision making processes in bridge, writes that “individuals tend to extrapolate heuristics from situations where they make sense to those where they do not.” Charlie notes:
“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” http://www.rbcpa.com/Mungerspeech_june_95.pdf
Why does this happen?
“The simple truth is that we aren’t adapted to face the world as it is today. We evolved in a very different environment, and it is that ancestral evolutionary environment that governs the way in which we think and feel. We can learn to push our minds into alternative ways of thinking, but it isn’t easy as we have to overcome the limits to learning posed by self-deception. In addition, we need to practice the reframing of data into more evolutionary familiar forms if we are to process it correctly.” James Montier http://papers.ssrn.com/sol3/papers.cfm?abstract_id=373321
“Sometimes heuristics are good for making decisions, while at other times heuristics are bad for making decisions. The reason for this mixed or nuanced answer is namely heuristics act faster than rational deliberation, but precisely because of their speed, heuristics can mislead us into systematic errors in making decisions”. Huang http://papers.ssrn.com/sol3/papers.cfm?abstract_id=474661
Some of Charlie’s most powerful writing consists of a narrative list of the various dysfunctional heuristics that impact human decision making. Munger’s writing and speaking in not as academic as others like Dan Ariely, Daniel Kahneman, James Montier and Michael Mauboussin (see generally http://www.theatlantic.com/business/archive/2013/01/the-irrational-consumer-why-economics-is-dead-wrong-about-how-we-make-choices/267255/ ), but he is often more amusing and practical. He is certainly more direct in many cases. For a great graphic see: This is your brain on behavioural economics http://www.ritholtz.com/blog/2013/01/this-is-your-brain-on-behavioural-economics/
As was discussed previously in this series of blog posts, investing is less than a zero sum game due to expenses. If you are buying an investment someone else is selling and vice versa. Someone is by definition wrong. If the other person does not understand behavioral economics and you do, that is a potential edge. As a professor at Colombia business school noted recently: “There is a lot of behavioral finance confirming Ben Graham’s original judgment.” http://www4.gsb.columbia.edu/valueinvesting/news/item/7232425/Greenwald%3A+How+to+Beat+the+Market+with+Discipline#
The essay in Poor Charlie’s Almanack is his most recent and comprehensive version of what he calls “The Psychology of Human Misjudgment.” There is not much point in rewriting what Charlie says in different words, but perhaps I can find more recent examples that are informative and/or amusing.
- “Reward and Punishment Super-response Tendency”
“almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition and behavior. But this is not often so. For instance, I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.” Munger
Structuring compensation incentives is critical. For example, it is surprising how many people fail to recognize how performance suffers if you pay someone in advance. As was noted in an earlier post in this series, Munger and Buffet delegate most management activity, but they keep compensation decisions from themselves.
It is easy to find examples of how improper incentives are, in Munger’s words, “damaging civilization.” A current example of this problem is raised by Nassim Taleb
“… instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of “skin in the game” when it comes to financial oversight: “The captain goes down with the ship; every captain and every ship.” In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed.” http://www.fooledbyrandomness.com/sais.pdf
Investment bankers who spend their days creating and selling toxic derivatives have long since abandoned their moral principles driven by the financial incentives that motivate their actions. The Libor rigging scandal is just one recent example.
On the positive side, stock options can motive people to work to create new value in a start up like nothing else really. The idea that a person can win the lottery like an early Instagram employee is a powerful motivator (which is not fully rational but this is getting to another heuristic). Unfortunately, that incentive can go too far and people can end up living in their parent’s basement due to overinvestment in a technology sector.
2. Liking/Loving Tendency
Munger is pointing out that people tend to ignore or deny the faults of people they love and even distort facts to facilitate that love. There are obviously positive aspects to this tendency for society, but they rarely have place in making investment decisions. You may like or even love your friend, but that does not mean that you should trust him or her with your money. I suspect that Charlie is saying that one needs to be particularly careful with decisions when you like/love someone. Rihanna getting back together with Chris Brown seems fraught with risk.
3. Disliking/Hating Tendency
This is of course the inverse of the previous tendency. Munger is clear that life is too short to do business with people you don’t like. Charlie advises: “Avoid evil, particularly if they’re attractive members of the opposite sex.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
That someone is “family” does not mean they fall outside of the dislike/hating tendency. Munger quotes Buffett in this section: “a major difference between rich and poor people is that the rich people can spend more of their time suing their relatives.” Again, being extra careful in your decision making process when you dislike someone seems to be the suggestion from Charlie. Stay rational.
4. Doubt-Avoidance Tendency
Particularly in the face of stress or puzzlement people tend to remove any doubt that might interfere with a decision. It is in Munger’s words: “counterproductive for a prey animal that is threatened by a predictor to take a long time in deciding what to do.” Munger feels this tendency can express itself in religion. As another example: What were Madoff’s investors thinking when month after month they received financial statements that were positive with little volatility? A blogger puts it this way in reviewing one of Munger’s favorite books (Influence by Cialdini): “Faced with vast amounts of data and a shortage of time we opt for simplicity, and focus on a few salient signals which generally work.” http://www.psyfitec.com/2011/09/robert-cialdini-and-weapons-of.html
5. Inconsistency-Avoidance Tendency
“The brain of man conserves programing spaces by being reluctant to change.” Munger
Munger believes that if you combine Doubt-Avoiding Tendency with a desire to resist any change in that conclusion, ugly things can result. An example might be DEC which refused to recognize that the personal computer was a threat to its business. Steve Wozniak has said that HP turned down making the Apple I five times.
A positive example of how this heuristic might operate may be found in how very young company founders who are not wedded to old ideas can sometimes create disruptive business more easily. Mark Twain’s statement comes to mind on this tendency: “All you need in this life is ignorance and confidence; then success is sure.” Twain should have added that 19 people adopting that approach will lose everything and one might strike it rich, but that is another set of topics (e.g., optionality; survivor bias).
6. Curiosity Tendency
I have a hard time with Munger’s description on this one when it comes to downside risk. He describes curiosity as something good for society. There must be some flip side that I he does not reveal along the lines of “curiosity kills the cat.” Perhaps he is referring to the tycoon who is curious to see whether he or she can finally be the person to make a profit in the airline business. Kingfisher in India is a recent example of a company that is in trouble due to excessive curiosity related to airlines. Richard Branson may have a very fine airline in Virgin in terms of quality, but profitability is elusive. Buffett himself jokes that he has a 1-800 number he calls which will talk him out of investing in airlines whenever he gets the urge.
7. Kantian Fairness Tendency
“modern acculturated man displays and expects from others a lot of fairness” Munger”
All in all, this tendency seems a very good thing. In terms of generating dysfunction, perhaps Charlie is referring to how humans will act irrationally to punish those who are not fair. A leading blogger on the psychology of investing writes:
“Economists for a long time took the view that people would accept any offer made to them as long as they were better off, yet many studies have shown that this isn’t true and that people will reject offers they view as unfair.” http://www.psyfitec.com/2011/09/robert-cialdini-and-weapons-of.html
8. Envy/Jealousy Tendency
The dangers of envy are a frequent Munger topic. How can I improve on the master?
“The idea of caring that someone is making money faster [than you are] is one of the deadly sins. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?” http://www.fool.com/news/commentary/2003/commentary030509wt.htm
“…Missing out on some opportunity never bothers us. What’s wrong with someone getting a little richer than you? It’s crazy to worry about this….” http://www.tilsonfunds.com/wscmtg05notes.pdf
“Here’s one truth that perhaps your typical investment counselor would disagree with: if you’re comfortably rich and someone else is getting richer faster than you by, for example, investing in risky stocks, so what?! Someone will always be getting richer faster than you. This is not a tragedy. http://www.fool.com/BoringPort/2000/boringport00051501.htm
“We have a higher percentage of the intelligentsia engaged in buying and selling pieces of paper and promoting trading activity than in any past era. A lot of what I see now reminds me of Sodom and Gomorrah. You get activity feeding on itself, envy and imitation. It has happened in the past that there came bad consequences.” http://money.cnn.com/2005/05/01/news/fortune500/buffett_talks/index.htm
“Well envy/jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I’ve heard Warren say a half a dozen times, “It’s not greed that drives the world, but envy.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
9. Reciprocation Tendency
People behave irrationally when they feel the need to reciprocate. That’s why the Hare Krishna fundraiser gives away a flower when he or she approaches. A professor writes:
“When we are given a gift, we feel indebted to the giver, often feel uncomfortable with this indebtedness, and feel compelled to cancel the debt…often against our better judgment. The rule of reciprocation is widespread across human cultures, suggesting that it is fundamental to creating interdependencies on which societies, cultures, and civilizations are built. In effect, the rule of reciprocation assures that someone can give something away first, with the relative assurance that this initial gift will eventually be repaid–nothing is lost.” http://www.media-studies.ca/articles/influence.htm
As one example, Munger notes:
“…people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htmv
10. Influence-from-Mere Association Tendency
Humans can easily be misled by mere association. Munger writes in Poor Charlie’s Almanack: responsive behavior, creating a new habit, is directly triggered by reward previously bestowed.” He goes on to write about a range of phenomena that arise from this tendency like Persian Messenger Syndrome (AKA “shoot the messenger”).
“Think how association, pure association, works. Take Coca-Cola company (we’re the biggest share-holder). They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with presidents’ funerals and so-forth.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
“At most corporations if you make an acquisition and it turns out to be a disaster, all the paperwork and presentations that caused the dumb acquisition to be made are quickly forgotten. You’ve got denial, you’ve got everything in the world. You’ve got Pavlovian association tendency. Nobody even wants to even be associated with the damned thing or even mention it. At Johnson & Johnson, they make everybody revisit their old acquisitions and wade through the presentations. That is a very smart thing to do. And by the way, I do the same thing routinely.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
This is a continuation of my previous blog posts on “the Psychology of Human Misjudgment,” which is Charlie Munger’s description of dysfunctional decision making heuristics. Munger writes:
“…tendencies are probably much more good than bad. Otherwise, they wouldn’t be there, working pretty well for man, given his condition and his limited brain capacity. So the tendencies can’t be simply washed out automatically, and shouldn’t be. Nevertheless, the psychological thought system described, when properly understood and used, enables the spread of wisdom and good conduct and facilitates the avoidance of disaster. Tendency is not always destiny, and knowing the tendencies and their antidotes can often help prevent trouble that would otherwise occur.” Poor Charlie’s Almanack
Here is a personal example of potentially dysfunctional heuristics at work. For a few months I had been having slight pain in my biceps near my elbows. My doctor said it was probably an injury from lifting weights. One night about four weeks ago I was sleeping soundly when I was jolted awaked by much more significant bilateral pain in both of my biceps. I immediately thought: “I am having a heart attack; I need to get to an emergency room.” I woke my wife and asked her to get dressed quickly and to get in the car. As we were driving to the hospital the painful sensations in my biceps started to go away. It was at that point that I believe I started telling myself a story about the pain in my arms not really being from a heart attack. I am sure I was subconsciously thinking: “I have a busy schedule next week. I can’t afford to have a heart attack right now. This pain is probably nothing. I probably just hurt myself in the gym. Who gets bicep pain with a heart attack and no chest pain?” I then said to my wife: “Maybe we should go home.” My wife insisted we go to the emergency room. I might have argued with her, but at that moment I reminded myself about Munger and Buffett’s approach to risk:
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” http://beta.fool.com/danielsparks/2012/12/14/berkshire-hathaways-downside-protection/18950/
Going to the emergency room emergency room for tests on my heart function was clearly wise since the amount of possible loss was so massive even if the probability was small (which it was not given the symptoms). After thinking about this formula I no longer argued with my wife about going to the emergency room. In this case rationality (and my wife) overcame psychological denial, over-optimism and other negative decision making heuristics. It turned out that my pain was from a small heart attack and three days later I was in the operating room for a triple bypass.
You might say: “Well that was stupid.” Yes it was very stupid. But the reality is that we all do things like this every single day by telling ourselves false stories to avoid the truth. Even if you spend a lot of time with behavioral economics you can only improve your skills on the margin. You will always make mistakes. Nobel Prize winner Daniel Kahneman, who has spent his life researching behavioral economics, has said: “Except for some effects that I attribute mostly to age, my intuitive thinking is just as prone to overconfidence, extreme predictions, and the planning fallacy.” http://chronicle.com/article/The-Anatomy-of-Influence/129688/ Just because you can’t be perfect does not mean you can’t get marginally better at avoiding mistakes and have an edge in the market over people who do not understand Munger’s tendencies and other aspects of behavioral economics.
Here are the remaining 15 of Munger’s tendencies not covered in the previous blog post:
11. Simple, Pain-Avoiding Psychological Denial
As I drove to the hospital I was in significant danger of falling prey to “psychological denial” that night I had the heart attack. Munger has his own example of psychological denial:
“This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems. http://www.rbcpa.com/Mungerspeech_june_95.pdf
Was I avoiding psychological denial whenever I ordered a bacon cheeseburger in the years leading up to my heart problem given I am genetically predisposed to the condition? You decide. We all need friends and colleagues who can help us find the truth. Sometimes we all need a cold rhetorical slap in the face from a friend or significant other. By definition you don’t have perspective on yourself.
In an investing context, smart investors should have known that Bernard Madoff generating consistent positive returns was not possible month after month. But the investor liked the result so much that they went into psychological denial mode.
“Failure to handle psychological denial is a common way for people to go broke.” http://boundedrationality.wordpress.com/quotes/charlie-munger/
12. Excessive Self-Regard Tendency
Munger likes to talk about the fact that way more than half of Swedish drivers think they are above average drivers. Thinking your IQ is higher than it is potentially a big problem. Thinking that your IQ is a bit lower than it actually is can be a good thing says Munger.
“We don’t like complexity and we distrust other systems and think it many times leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something that is false. We’re so afraid of that process so we don’t do it.” http://www.valueinvestingworld.com/2012/05/charlie-munger-quote-complexity-and.html
Unfortunately, some people think that only others are overconfident:
“… the trouble is that if even 90% are no good, everyone looks around and says, “I’m the 10%.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
Companies are not immune from this excessive self-regard tendency, including Berkshire portfolio companies:
“[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
13. Overoptimism Tendency
In driving to the hospital I surely did not want to find I had heart disease. I suspect that I was thinking too optimistically that I had merely injured my biceps. I wanted to not have a medical problem, so I told myself a story that was contrary to the evidence I possessed. Munger describes the phenomenon:
“..in the 5th century B. C. Demosthenes noted that: “What a man wishes, he will believe.” And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.” http://22.214.171.124/search?q=cache:mgSaxC3O1IoJ:www.philanthropyroundtable.org/magazines/1999/march/munger.html+Berkshire+Hathaway%27s+vice+chairman+shreds+the+conventional+wisdom+on+foundation+investing&hl=en&gl=us&ct=clnk&cd=1
As I said above, even experts who spend their lives studying behavioral economics can prey to this problem. Daniel Khaneman writes:
“One of our biases is that we can ignore the lessons of experience. A group of people compiling a report will estimate they can do it in a year, even though every other similar report has taken comparable groups five years. … “When I started the book I told Richard Thaler (the author of Nudge) that I had 18 months to finish it. He laughed hysterically and said, ‘You have written about that, haven’t you? It’s not going to work the way you expect’.” How long did it take you, I ask. “Four years, and it was very painful.” http://forums.udacity.com/questions/10006251/no-fooling-nobel-winning-economist-daniel-kahneman
14. Deprival Superreaction Tendency
In the language of behavioral economics, this tendency is called loss aversion. Mauboussin writes:
“One of prospect theory’s most important contributions to finance is loss aversion, the idea that for most people, losses loom larger than corresponding gains. 7 The empirical evidence suggests we feel losses about two to two-and-a-half times more than we feel gains. Loss aversion is a clear-cut deviation from expected utility theory.” http://www.capatcolumbia.com/MM%20LMCM%20reports/Aver%20and%20Aversion.pdf
A good example of loss aversion at work can be found in the world of golf. A blogger writes:
“Research shows that even professional golfers display loss aversion. They do significantly better when putting to save par than when putting to make a birdie. Indeed, neuroscientists have found that loss aversion is wired into the human brain. And not just the human brain — monkeys are averse to losses, as well.” http://www.bloomberg.com/news/2012-12-24/people-hate-losses-and-that-affects-u-s-budget-talks.html
Football coaches punt too often in games for the same reason.
Munger advocates that people try to train their minds so as to overcome the tendency to the extent possible:
“Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. ‘For example’, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
Investors sell their stocks too early and hold on to their losers to long for the same reason. Selling a stock that is way down and taking the loss is really hard for people who have not trained themselves to avoid this tendency. Do venture capitalists to often put more money into companies that they have invested in already even though they would no do so it it was a new investment?
People too often would rather fail conventionally than succeed unconventionally. Munger:
“I mean people are really crazy about minor decrements down. … huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
15. Social-Proof Tendency
Humans have a natural tendency to herd. Bernard Madoff was a master at using social-proof tendency to get investors to give him their money. He worked hard to make sure that only successful people were a part of his Ponzi scheme. Professor Cialdini has an essay on how Madoff used social proof here: http://www.influenceatwork.com/wp-content/uploads/2012/02/Madoff_by_Cialdini.pdf
Social proof is a bedrock cause of bubbles that occur in the investing world as well as the path dependence which creates power laws. Using a classic Munger inversion apprapoch: if you see a power law, there is very likely social proof lurking behind it somewhere.
Munger has his own example from the corporate world:
“Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster” http://www.rbcpa.com/Mungerspeech_june_95.pdf
16. Contrast-Mis-reaction Tendency
“Because the nervous system of man does not naturally measure in absolute scientific units, it must instead rely on something simpler. The eyes have a solution that limits their programming needs: the contrast in what is seen is registered. And as in sight, so does it go, largely, in the other senses. Moreover, as perception goes, so goes cognition. The result is man’s Contrast-Mis-reaction Tendency. Few psychological tendencies do more damage to correct thinking. Small-scale damages involve instances such as man’s buying an overpriced $1,000 leather dashboard merely because the price is so low compared to his concurrent purchase of a $65,000 car. Large-scale damages often ruin lives, as when a wonderful woman having terrible parents marries a man who would be judged satisfactory only in comparison to her parents. Or as when a man takes wife number two who would be appraised as all right only in comparison to wife number one.” Poor Charlie’s Almanack
Here is a blogger’s interpretation of this tendency:
“‘Contract-Misreaction’ causes people to take actions which are potentially detrimental, because they appear insignificant or appear positive when compared to other actions. Munger uses an analogy of the human eyes to illustrate how this tendency works: humans only see items which contrast with their environment. In the same way, humans find it difficult to differentiate perceptions where there is little in the way of contrast. For example, a man may buy a $1,000 leather dashboard, even if overpriced, when considered in combination with the fact that the vehicle cost is a much larger $65,000.
While the above example is a relatively minor one, Munger points to some examples where this tendency can have detrimental and long-lasting effects. In business, Munger has seen marketers use this practice to their advantage. Real-estate brokers may show clients awful properties at inflated prices for the purpose of closing a sale on merely a bad property at a merely partially inflated price. This practice is also seen frequently in mainstream advertising, with service/product providers asserting a phony price for a product and then promptly offering a ‘discount’ to a lower price. Munger argues that even though consumers recognize this practice, it still works! Therefore, being aware of psychological ploys does not prove to be a perfect defense!” http://www.barelkarsan.com/2009/07/psychology-of-human-misjudgement_12.html
17. Stress-Influence Tendency
Munger thinks people under stress can make big mistakes as well as have life altering experiences:
“Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog is in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
18. Availability-Misweighing Tendency
“The great algorithm to remember in dealing with this tendency is simple: An idea or a fact is not worth more merely because it is easily available to you.” http://markettorrent.com/topic/8171?page=9
A blogger describes the problem here:
“When making decisions, people tend to be influenced by what can be readily remembered. Vivid, much-publicized events are easily recalled. Stock market crashes are vivid, highly publicized events. Long periods of steady market advance are less vivid and less publicized. The result is that people over-emphasize crashes and exaggerate risk. An adviser can provide more balanced information in order to overcome negative perceptions arising from the availability bias.” http://www.fpanet.org/journal/BetweentheIssues/LastMonth/Articles/ABehavioralViewofHowPeopleMakeFinancialDecisions/
19. Use-It-or-Lose-It Tendency
“All skills attenuate with disuse. I was a whiz at calculus until age twenty, after which the skill was soon obliterated by total nonuse.” Poor Charlie’s Almanack
This one is pretty simple. Skill degrades unless it is practiced. For example, flying an airplane is not something you want to do once in a while. If you are not flying often or sting in a simulator often, you should not be flying.
20. Drug-Misinfluence Tendency
This tendency is self-explanatory. Everyone makes mistakes, but Munger has said often that staying away from the really big mistakes like cocaine is vital.
“We’ve all seen so much [drug abuse], but it’s interesting how it’ll always cause this moral breakdown if there’s any need, and it always involves massive denial.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
21. Senescence-Misinfluence Tendency
This is another self-explanatory tendency. Senility happens, but you can slow it with activity. Munger:
“some people remain pretty good in maintaining intensely practiced old skills until late in life, as one can notice in many a bridge tournament…. Continuous thinking and learning, done with joy, can somewhat help delay what is inevitable.” Poor Charlie’s Almanack
22. Authority-Misinfluence Tendency
People tend to follow people who they believe are authorities. Munger cites the Nazi madness as an example. Then there are the Milgram experiments in which people are told to shock others and they comply since they person giving the command is wearing a lab coat and looks official.
Munger gives this example of the tendency :
“You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who’s been trained in simulators a long time — he knows he’s not to allow the plane to crash — they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes. I mean this is a very powerful psychological tendency.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
23. Twaddle Tendency
The definition of “twaddle” is: “speech or writing which is silly or not true; nonsense.” What Charlie is saying here is that people tend to spend a lot of time on meaningless activities that accomplish little or nothing. In Munger’s view people too often confuse twaddle with importance and value. Here’s one example from Munger:
“The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But, to me, all intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock.” http://www.ticonline.com/archives_quotes.html
Most of the talking heads on financial TV are dishing out twaddle. Of course, the hardest thing is to spot when you are telling yourself twaddle since the easiest person to fool is yourself.
24. Reason-Respecting Tendency
What Munger calls “compliance professionals” know that it is possible to get people to act against their interest as long as they are given a reason even if it is silly. Munger:
“Unfortunately, Reason-Respecting Tendency is so strong that even a person’s giving of meaningless or incorrect reasons will increase compliance with his orders and requests. This has been demonstrated in psychology experiments wherein “compliance practitioners” successfully jump to the head of the lines in front of copying machines by explaining their reason: “I have to make some copies.” This sort of unfortunate byproduct of Reason-Respecting Tendency is a conditioned reflex, based on a widespread appreciation of the importance of reasons. And, naturally, the practice of laying out various claptrap reasons is much used by commercial and cult “compliance practitioners” to help them get what they don’t deserve.” Poor Charlie’s Almanack
25. Lollapalooza Tendency – The Tendency to Get Extreme Confluences of Psychological Tendencies Acting in Favor of a Particular Outcome
All of the tendencies described above interact with each other in ways that can make the whole of the effect greater than the sum of the parts. This is a classic signature of complex adaptive systems. What asked what caused “the current economic mess” Munger replied:
“It was a lollapalooza event – a confluence of causes that is how complex systems work.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Sometimes this lollapalooza tendency can be used for good purposes. As Munger points out:
“The system of Alcoholics Anonymous: a 50% no-drinking rate outcome when everything else fails? It’s a very clever system that uses four or five psychological systems at once toward, I might say, a very good end.” http://www.tilsonfunds.com/mungerpsych
But of course an evil cult can use the same techniques.
Another example Munger cites of a lollapalooza tendency involves open outcry auctions:
“Well the open-outcry auction is just made to the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away… I mean it just absolutely is designed to manipulate people into idiotic behavior.” http://www.valueinvestingworld.com/2010/02/psychology-at-home-auction.html
Buffett’s advice for these open outcry auctions is simple: “Don’t go”.
Charlie believes that this lollapalooza tendency is often encountered in investing:
“An investment decision in the common stock of a company frequently involves a whole lot of factors interacting … the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
In the book Poor Charie’s Almanack Munger describes an airline manufacturer that ran tests that resulted in numerous injuries which were a classic example of lollapalooza tendency. Munger:
“… it’s a combination: authorities told you to do it. He told you to make it realistic. You’ve decided to do it. You’d decided to do it twice. Incentive-caused bias. If you pass you save a lot of money. You’ve got to jump this hurdle before you can sell your new airliner. Again, three, four, five of these things work together and it turns human brains into mush. And maybe you think this doesn’t happen in picking investments? If so, you’re living in a different world than I am.” http://www.tilsonfunds.com/mungerpsych
Perhaps the best way to sum up Munger’s view of these tendencies, is to just quote Charlie responding to people who think that economists can assume that people are rational:
“How could economics not be behavioral? If it isn’t behavioral, what the hell is it?” https://twitter.com/mungerisms/status/154735076549201920