In 1996, Charlie Munger (Trades, Portfolio) gave an informal speech to a group. This speech is named “Practical Thought About Practical Thought?” in the book "Poor Charlie’s Almanac." Munger warned that most people don’t understand the speech. He said that it was an extreme communication failure when made, and people have since found it difficult to understand even when read slowly, twice.
This speech is by far the best case study that I have ever read or heard. While Charlie Munger (Trades, Portfolio) arguably popularized the idea of solving problems using a diverse set of mental models, unfortunately he has not given many examples of how he applies this multi-disciplinary approach in investment. It is the rarity of real life examples that makes this speech especially valuable. As I read the speech over and over again, I thought it may be helpful to step back, contemplate and extract some information on how Munger (Trades, Portfolio) uses mental models to solve practical problems.
You were in the year 1884 and to be chosen as the other partner in Coca-Cola's business, you must demonstrate, in 15 minutes, that your business plan will make Coca-Cola worth $2 trillion 150 years later, in the money of that time, despite paying out a large part of its earnings each year as a dividend.
This is a daunting challenge, and here is how Charlie Munger solved this problem:
Munger’s first step is to simplify the problem as much as possible. Munger is a big believer of Einstein’s simplicity philosophy (“everything should be as simple as it can be, but not simpler”). Another helpful idea is from Richard Reynman: "But the game is to try to figure a thing out, with what we know is possible." This simplification step should be your automatic first step in your problem solving process. In Coca-Cola’s case, Munger simplified the problem by identifying the two most important decisions - "making Coca-Cola into a strong, legally protected trademark and developing a product having universal appeal because it harnesses powerful elemental forces." Note here we have a multi-disciplinary action that combines the big thinking model and the business model.
Next, Munger proposed that we use numerical fluency to ascertain what our target implies.
"We can guess reasonably that by 2034 there will be about eight billion beverage consumers around the world. On average, each of these consumers will be much more prosperous in real terms than the average consumer of 1884. Each consumer is composed mostly of water and must ingest about 64 ounces of water per day. This is eight eight-ounce servings. Thus, if our new beverage, and other imitative beverages in our new market, can flavor and otherwise improve only 25 percent of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight-ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth two trillion dollars."
In essence, this step is doing the big picture math. Here we need to make some assumptions that involve profit per serving, servings per capita and total population by 2034 with reasonable confidence.
Naturally this will lead us to evaluate the assumptions we made earlier and see if they are reasonable. To test our assumptions with regards to the profit per serving, Munger again simplified it to the most important factors that will make our assumptions reasonable. These factors again involve interactions among multiple disciplines -
1. The creation of a beverage with a strong universal appeal - this is the application of herding and social proof from psychology.
2. The depreciation of dollar over time - this is application of money supply and demand, and monetary policy in macroeconomics.
3. "The consumers’ proclivity to inexpensively improve their experience while ingesting water will go up considerably faster" - this is the application of utility maximization concept in behavioral finance.
4. As technology improves, the cost of production will go down - in my opinion, this falls under the business model framework and specifically, the evaluation of technological improvement on a business.
Among the above factors, creating a universal appeal is the most important one and it is something we can exert some influences on. Therefore, Munger once again, simplified the problem by defining the two intertwined challenges of large scale, which if solved, would invent universal appeal. The key to attack these two challenges is to cause every favorable factor we can think of to work for us. Out of sheer brilliance, Munger proposed that we use a combination of elementary psychology concepts:
- Pavlovian conditioning.
- Social proof.
- Operant conditioning caused by the "wonderful-tasting, energy-giving, stimulating and desirably cold beverage."
If we can apply those psychology concepts successfully, Munger points out that "we are going to start something like an autocatalytic reaction in chemistry, precisely the sort of multi-factor-triggered lollapalooza effect we need."
Now we have solved the problem of creating a universal appeal, the next step is to figure out the logistics and distribution strategy. Munger, not surprising, proposed another multi-disciplinary solution that involves the following concepts:
- Spending heavily on advertising and sales promotion to create huge Pavlovian and social proof effects across all distribution channels (psychology).
- Maximize profit by making independent bottlers subcontractors, not vendees (supply chain management - business model).
- "Avoid needless shipping cost and have many bottling plants scattered over the world" (product production and distribution - business model).
All the above efforts will help Coca Cola maintain a powerful profit-maximization distribution channel that will be crucial to the success of the business.
Munger then moved on to how to defend and solidify the business moat (business model). He proposed that we need to work obsessively to keep our formula secret (scarcity concept from psychology) and to ride the wave of technological advance that will help Coca-Cola with better transportation and expand product offering.
The final step in Munger's thinking involves inversion (big thinking model). Invert, always invert. In this case, Munger listed the things we want to avoid in executing the business plan. Even at this stage, he applies the multi-disciplinary approach. Let's take a closer look:
- Coca-Cola must "avoid the protective, cloying, stop-consumption effects of aftertaste that are standard part of physiology, developed through Darwinian evolution to enhance the replication of man's genes by forcing a generally helpful moderation on the gene carrier."
- Coca-Cola must "avoid losing even half of the powerful trademark." This is the application of business model framework.
- Coca-Cola must avoid "bad effects from envy and focus on product quality, quality of product presentation, and reasonableness of prices." This is a combination of psychology and business model framework.
- Coca-Cola must avoid "huge and sudden change in the flavor, which will trigger the hostile consumer super-reaction to deprival" (psychological biases).
And this completes the exercise.
The Coca-Cola (NYSE:KO) case study is by no means simple, although Munger said it should be a simple exercise because all he used are elementary concepts from a few fields such as psychology and economics.
I think we can cultivate the habit of using multiple mental models in our decision making and problem solving processes. It will involve a 4-step approach:
Step 1: Identify and simplify the problem.
Step 2: Apply the big thinking framework.
Step 3: Apply elementary concepts from multiple disciplines where you see fit and pay special attention to concepts related to human psychology.
Step 4: Invert, always invert.
In order to adopt this approach, we have to make this a routine exercise and progress gradually, not in a fast spurt. To some of us, this means fundamentally change the way we approach problems, which is inherently hard due to the consistency and status quo biases. We also have to relentlessly widen our knowledge base so that we have the tools we need. I encourage the readers to spend some extra time on the big ideas from psychology. As you can probably tell, human psychology is the dominant discipline in his Coca-Cola case study.
And with that, I have nothing to add. Any feedback and comments will be greatly appreciated.