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3 Steps to Implement Charlie Munger’s Principle of Inversion
Posted by: GrizzlyRock Capital (IP Logged)
Date: December 21, 2012 10:49AM
Legendary investor Charlie Munger is notable for his investing acumen, willingness to take large positions and memorable quotations. Munger’s partner at Berkshire Hathaway (BRK.A)(BRK.B), Warren Buffett is significantly more press-friendly. While Buffett has 20 or so stories and sound bites that roll off his tongue on cue, Munger takes great care to select impactful words. Munger speaks only when he has something to say.
One of Munger’s more famous quotations comes from the algebraist Jacobi: “Invert, always invert.” In a 1986 speech Munger elaborated, “It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backwards.”
This three-word phrase, “Invert, always invert,” is packed with power and significance but requires a bit of unpacking before we use the principles in daily investing. What does “Invert, always invert” mean for our thinking as investors? How can we practically implement this tool?
At my firm, GrizzlyRock Capital, we triangulate security valuation via a standard discounted cash flow model (DCF), EBITDA multiple and EPS multiple. The DCF is our primary valuation method with the earnings multiples supplementing and corroborating. As is standard on Wall Street, we utilize a base case, stress case, and upside case. Then comes the inversion step!
We take the current security price as stated by Mr. Market and invert. We take our base case scenario and adjust operating & financial metrics until the DCF model suggests the current market price. We can now analyze the probabilities of the company performing better or worse than market expectations.
What company metrics in three to five years are assumed by Mr. Market to justify the share price? Perhaps revenue growth is expected to decelerate or re-accelerate? Perhaps margins are expected to expand? Perhaps unit or store growth is assumed. No matter the metric putting a company on paper in three to five years gives us an advantage over the market by shedding light on what metrics must be to justify current valuation.
The reason is simple – by inverting the share price to specific company metrics and investor gains additional context to assess the current price and an additional tool with which to structure their thinking. Note: His inversion tactic works best with “battleground” stocks such as Netflix, Xerox, Salesforce.com, etc. (Perhaps I’ll do a subsequent post on a specific company.)
Work backwards from current share price to operating results
This works part in parcel with the inversion case DCF model. Many times when creating an inversion case, I end up thinking, “No way company XZY can grow at this rate!” or “This industry is way too competitive for margins to be that high in the future!”
Ok, that’s not a problem. I simple plug in my reasonable expectation for the metric in question and can then assess the viability of other variables (unit growth, margins, capex, cash flow, etc.) The inversion case inherently forces my thinking about a company’s valuation to expand beyond Wall Street’s standard linear thinking.
Once analysis highlights an interesting opportunity and an inversion case supports the thesis of an underpriced security (or overpriced for a short), we as investors tend to get excited. We found a golden nugget!
But wait. What would Munger say? “Invert, always invert.”
In this case, inversion means that we try to prove our thesis incorrect. Let’s leverage the scientific method. Scientists know a powerful principle that investors often forget: Proving something false is inherently easier than “proving” something true.
So, for a value investment, let’s argue the bear case. Why could Mr. Market be correct? Is this security a proverbial value trap?
By forcing ourselves to make a rational argument against our stated position, we invert our analysis. If we fail to convincingly make the bear case for a security that appears inexpensive, we do not prove it undervalued. We prove our original thesis defensible against certain scenarios. In so doing we create a robust, defensible thesis.
As we do this a few times, we increase our probabilistic chance of success by failing to disprove our original thesis incorrect.
By failing, we move forward. Munger would certainly approve – “Invert, always invert.”
Stocks Discussed: BRK.A, XRX, CRM, NFLX,