Charlie Munger has developed a powerful system that is useful in making any type of decision. One notable application of this system by Munger relates to investing and involves another system developed by Benjamin Graham. It is useful to understand what is known as “value investing” not just for its own sake, but to understand how Munger thinks and makes decisions. Even if you find value investing boring or have no intention to follow its principles, you can learn from understanding how it works and has evolved from its original nature based on the ideas of a few people including Munger. For this reason, it is important to understand a little about Graham himself.
“Benjamin Graham was salutatorian of the class of 1914 and, weeks before graduation, was offered teaching positions in three different faculties: Greek and Latin philosophy, English, and mathematics. He was all of 20 years old. Needing to support his siblings and widowed mother, he went to work on Wall Street. In 1934, he wrote Security Analysis, the first book ever to put the study of investments on a systematically logical footing. In 1949, he published The Intelligent Investor, which Warren Buffett has called “the best book about investing ever written.” Warren Buffett….has said that he was struck by the force of Graham’s teachings ‘like Paul on the road to Damascus.’”
What follows are the usual “dozen things” quotations from Charlie Munger stitched together from his writing and statements made at different times and places (in this case over many over decades).
1. “Graham didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn’t feel that the man in the street could run around and talk to managements and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Therefore, it was very difficult. And that is still true, of course human nature being what it is.” “Warren trained under Ben Graham, who said, ‘Just look at the facts. You might lose an occasional valuable insight, but you won’t get misled.’” The most important word in these quotations from Charlie Munger is “system,” which can be defined as a set of processes or elements that interact in ways that can achieve an objective not obtainable from the processes or elements alone. A second important point made by Charlie Munger is about Ben Graham’s desire to create something an “ordinary person” can potentially use successfully. It is important to note that Charlie Munger believes that only a tiny number of people can actually outperform a market using the value investing system because they lack factors like the necessary work ethic and the right emotional and psychological temperament. It is possible that an ordinary investor can us the value investing systems to outperform that market but it is far from the usual case. If an investor does try to outperform a markets Charlie Munger is also saying that it is easy to be misled by promoters and business managers about the value of a business or other assets. Ben Graham believed that by focusing on a rational appraisal of objective facts fewer investing mistakes will be made than by relying on subjective opinions.
2. “Ben 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.” Ben Graham’s system involves four bedrock principles, two of which Charlie Munger introduces here: 1) a share of stock is a proportional ownership of a business and 2) buy at a significant discount to intrinsic value to create a margin of safety. On the first principle, if a security is not a proportional interest in a business then what exactly is it? It certainly isn’t a piece of paper to be traded like a baseball card or a painting. In terms of the second principle on “margin of safety,” the fundamental idea is to buy an asset at a significant enough bargain price that the result will be good even if a mistakes was made in evaluating the asset. Since risk is always relative to the price paid, buying with a margin of safety is a risk-averse approach. A range of future outcomes can still produce a satisfactory result if you buy an asset at a significant bargain.
3. “Ben Graham [had] his 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 its 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. That was a very significant mental construct.” Charlie Munger is introducing the Mr. Market metaphor in making these statements. Mr. Market shows up every day willing to quote you a price. Unfortunately, Mr. Market is, in the words of Warren Buffett, a drunk bipolar psycho. For this reason and others, Mr. Market should always be treated as your servant rather than your master. Why would anyone ever treat someone like this as wise? Mr. Market, in the short term, is a voting machine driven by highly volatile and fickle public opinion instead of a weighing machine measuring return on investment. When Mr. Market offers you a price for an asset you have the option to do nothing. In other words, there are no “called strikes” in investing. There is no premium given in investing for activity and in fact there is a penalty since it results in fees and taxes. For a value investor, it is Mr. Market’s irrationality that creates the opportunity for value investors. As Charlie Munger points out: “For a security to be mispriced, someone else must be a damn fool. It may be bad for world, but not bad for Berkshire.” The best returns accrue to investors who are patient and yet aggressive when they are offered a price for an asset that meets the requirements of value investing.
4. “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. Warren worshiped Graham. He got rich, starting essentially from zero, following in the footsteps of Graham.” Charlie Munger introduces final bedrock principle of value investing here: be objective and dispassionate. In other words, be as rational as you can when making investing decisions. Despite this objective, an investor will always make some emotional and psychological mistakes, but if you can do things like learn from your mistakes, use techniques like checklists, have the right emotional temperament, exhibit a strong work ethic and are a “learning machine,” he believes some investors can outperform the market. Only a very small number of “know something” investors can do this. Charlie Munger believes that most everyone is a “know nothing” investor and should instead invest in a diversified portfolio of index funds and ETFs.
5. “The supply of cigar butts was running out. And the tax code gives you an enormous advantage if you can find some things you can just sit with.” “Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. The classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn’t click. Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they 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.” The beauty of some systems is that they have the ability to evolve so as to adapt to new conditions. And that is precisely what happened in the case of value investing. After the Great Depression many people simply gave up on owning stocks. Loss aversion was so strong among potential buyers that they were simply not rational when it came to the stock market. During this period it was possible for businesses to be bought at less than liquidation value. This was a boon for investors like Ben Graham. Unfortunately for them, that period of time only lasted for so long as memories faded and new investors entered the market. Every so often some pundit will drag out one quote from Ben Graham about how it became to do value investing at one point. These pundits not only take the quote out of context buy ignore the fact that the followers of Graham were even before then time taking Graham’s principles and defining a bargain in a new way considering the quality of the business and in some cases considering what are called “catalysts” to the value of a business. Value investing has evolved significantly since the time of Ben Graham and Charlie Munger has played a big part in that evolution.
6. “I don’t love Ben Graham and his ideas the way Warren does. You have to understand, to Warren — who discovered him at such a young age and then went to work for him — Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.” “I liked Graham, and he always interested and amused me. But I never had the worship for buying the stocks he did. So I don’t have the worship for that Warren does. I picked up the ideas, but discarded the practices that didn’t suit me. I don’t want to own bad businesses run by people I don’t like and say, ‘no matter how horrible this is to watch, it will bounce by 25%.’ I’m not temperamentally attracted to it.” Charlie Munger is always looking for ways to evolve, adopt and even reverse his views. He is a learning machine. Charlie Munger is also excited by great managers running great businesses. And he gets positively ecstatic when every once in a while these managers are running businesses that are available for purchase in whole or in part at bargain prices. This does not happen very often so most of the time he patiently does nothing. But Charlie is prepared to act very aggressively in a big way when the time is right.
7. “I think Ben Graham wasn’t nearly as good an investor as Warren is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals – probably the only intellectual — in the investing business at the time.” Charlie Munger is in this set of quotations is discussing another reason why the value investing system had to evolve for Berkshire. The amount of money that Berkshire must put to work each year is way too big to hope that enough so-called “cigar butt” businesses with a few remaining puffs left in them can be found to compose a full portfolio. When buying a business anything remotely as big as Heinz or Precision Cast Parts it is very unlikely that they will be buying any cigar butts. Berkshire must find assets that represent a bargain defined in terms of quality. As an example Warren Buffett used $23 billion of Berkshire’s $66.6 billion in cash to buy Precision Castparts. Buffet has said that “We will always have $20 billion in cash on hand.” So they won’t be buying a business as big as Precision Castparts for a while.
8. “Having started out as Grahamites which, by the way, worked fine we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.” Charlie Munger makes two key points here: 1) some bargains are only visible if you understand qualitative factors and 2) there sometimes are catalysts that can boost the value of the stock even further based on factors like scale advantages, favorable regulatory changes, improving secular phenomenon and better systems or business momentum. Charlie Munger likes to “find a few great companies and then sit on your ass.” When he finds a great business with excellent management like Costco he is like “a pig in slop” and does not want to leave the pig pen.
9. “The great bulk of the money has come from the great businesses. And even some of the early money was made by being temporarily present in great businesses. Buffett Partnership, for example, owned American Express and Disney when they got pounded down. However, if we’d stayed with classic Graham the way Ben Graham did it, we would never have had the record we have.” “Iscar is not a Ben Graham stock – in fact, it would be the ultimate non-Ben Graham stock. It’s located a few miles from the Lebanese border in Israel. It has a high ROE, doing business all over the earth, using a certain technology to produce carbide cutting tools. The reason I got so high on it so fast was that the people are so outstandingly talented.” Charlie Munger has made the point many times that only a few great decisions delivered most of Berkshire’s financial returns. Warren Buffett has said that as few as 20 bets in a lifetime can make you very rich. Charlie Munger has also said repeatedly that a high quality business selling a bargain price is not a common event and that if you are not prepared to act aggressively when that happens the opportunity will be lost. In thinking about the value of a business, Munger also strayed far from a view that looking at the quality of management is not something that should be considered because it is too easy to be misled. When Berkshire buys a business they want the moat and the management (the two M’s) to be in place already. Berkshire does not build moats itself and it does not want to supply management.
10. “We bought [the Washington Post] at about 20% of the value to a private owner. So we bought it on a Ben Graham-style basis – at one-fifth of obvious value – and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They’re very high class people – the Katharine Graham family. That’s why it was a dream – an absolute, damn dream.” These quotations list many of the elements that Charlie Munger looks for in a business. At the time it was first bought the business known as the Washington Post had both a strong management team and a moat. A significant partial ownership stake was also available for purchase at a bargain price. Of course, the moat of the Washington Post has significantly atrophied as the Internet has enabled competitors to avoid the need for big printing process and physical distribution systems. All moats are under attack by competitors and change in strength and value over time. It is perhaps not surprising that the Washington Post was purchased by an expert moat builder like Jeff Bezos. The task of the new owner is to rebuild the moat of the Washington Post which is not easy given that the news is non-rival and non-excludable.
11. “Ben Graham said it’s not the bad ideas that do you in. It’s the good ideas that get you. You can’t ignore it and it’s easy to overdo it.” Almost everything can be taken to a point where what is wonderful eventually becomes toxic. The great humorist Mark Twain said once that: “Water, taken in moderation, cannot hurt anybody.” Even water in sufficient quantity is not good for you. The same phenomenon applies to investing. What a wise person does at first, the fool does at the end. This particular quotations was made in the context of the Internet bubble which was an extreme example of good ideas taken way too far.
12. “Warren Buffett came to investing at the knee of Ben Graham, who ran a Geiger counter over the detritus of the 1930s. Stocks were ridiculously cheap. Graham bought companies that were quite mediocre on average, but made 20% when their stock bounced.” “Warren trained under this system and made money, so he was slower to come to the idea I learned that the best way to make money is to buy great businesses that earn high returns on capital over long periods of time. We’re applying Graham’s basic ideas, but now we’re trying to find undervalued GREAT companies. That concept was foreign to Ben Graham. Warren would have morphed into a great investor without Ben Graham. He is a greater investor than Graham was. Warren would have been great had he never met anyone else. He would have excelled at any field that required a high IQ, quantitative skills and risk taking. He wouldn’t have done well at ballet though.” The point about Warren Buffett being an unlikely ballet star is important since it raises the idea of “circle of competence.” Risk comes from not knowing what you are doing, so it is wise to know what you are doing (i.e., stay within your circle of competence). The skill of every human being has limits. Knowing in which situations you are skilled or not is very valuable in life. An important point in all of this is: you are not Charlie Munger and you are not going to be Charlie Munger. Having said that, you can learn from Charlie Munger and make better decisions than you would otherwise. Those decisions may be limited to things like choosing a mutual fund or allocating assets between categories. They also might include selecting a college or a spouse. Charlie Munger is trying to convey the idea that in making decisions in life it is wise to be rational, try to filter out sources psychological dysfunction and apply a range of mental models and worldly wisdom.