Free 7-day Trial
All Articles and Columns »

Applying Munger’s Latticework

November 06, 2006
insider

Peter Lindmark

0 followers

Charles Munger’s speech to the University of Southern California’s Business School in 1994 is one of the most enlightening pieces of work I have read. The topic, “a lesson on elementary worldly wisdom” at first glance seems to fall outside the realm of investing, but this is far from the truth.

Mr. Munger’s advice is to build a latticework of mental models, which combine the one hundred or so basic topics from freshman level courses in college across all fields of study. Just as investors use ratios and discounted cash flows to build spreadsheets, they also should be able to analyze business models and identify reasoning for under or overvaluation using Mr. Munger’s idea of a latticework of mental models.

I am often asked how to apply these models in real life. Initially one must fill his or her latticework with models, sub-divided with checklists that can be applied everyday. Then, one has to use this latticework until it becomes second nature.

A current example: one can apply psychology, behavioral finance, and statistics models to today’s phenomenon of large capitalization equities selling at a discounted P/E multiple relative to small capitalization equities. Small company’s earnings are more erratic and vulnerable to recessions. Which models can one use to explain this mispricing, or offer contrary evidence why small capitalization stocks sell at a premium versus their historical discount to large capitalization stocks?

One such model from the psychology sub-set is mere association. Investors lost a great deal of money on Microsoft, Coca-Cola, and Intel in the bubble of 2000. Therefore, people associate these names with the losses they endured. Recent vivid evidence and anchoring bias lead people to anchor such companies to said losses or attach the recent vivid evidence of such losses to the companies at present. Microsoft is at $27, down from nearly $80. Coca-Cola is at $45, down from nearly $90. General Electric is down to $35 from $60. These stocks are now mispriced relative to interest rates, and everyone who lost money has recent vivid evidence which they are subsequently anchoring to the bubble prices and how much money was lost.

In addition, status quo, envy, and jealousy are more reasons investors are avoiding these large capitalization companies. Everyone is jealous or envious of small capitalization stocks and commodities which outperformed large capitalization stocks over the past decade. Consequently, everyone wants to be part of the status quo, i.e. own these current winners. One wants money where the winners will be in five years, not in the successes of the past five years. Even though the past helps steer us, in investing, it is the future of the business that counts.

Impatience may perhaps be the greatest reason why these discounts exist in the large capitalization companies. Investors who did not sell their shares after the bubble have held these stocks, which have gone nowhere but down or sideways for the past six years. Social proof can also be applied when explaining why large capitalization companies are selling at a discount: investors move in herds. Growth investors do not want to own Intel or Microsoft because there is not enough growth left in the companies. Most value investors do not want to own them because the price to earnings ratio does not provide a large enough margin of safety, as well as being technology companies.

These reasons from the psychology, behavioral finance, and statistics sub section have helped me understand the mispricing of large capitalization U.S. Companies relative to both small capitalization companies and current interest rates. It is not surprising a savvy group of value investors have been buying these big capitalization companies for the past few years: they are aware of Charles Munger’s models and behavioral finance. If one can apply his or her models, whatever they may be, in life one will find bargains which will not arise from traditional low P/E, or low price to book screens.

About the author:

Peter Lindmark
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.8/5 (8 votes)

Comments

vooch
Vooch - 7 years ago
I prefer Munger's "The Psychology of Misjudgement" speech, and I would like to work with somebody to dissect all of his possible errs of misjudgement and see how they relate to stocks.

- Vooch


plindmark
Plindmark - 7 years ago
Vooch, I agree "The Psychology of Misjudgement" speech and the last chapter of Poor Charlie's Almanack provide excellent blueprint of the subdivision of psychology. If you haven't already look at Peter Bevelin's book Seeking Wisdom from Darwin to Munger as there is an extensive psychology checklist. --Peter Lindmark
vooch
Vooch - 7 years ago
It took me 2 or 3 times to get what Munger was trying to convey in his Latticework speech, but now it is crystal clear. The speech covers the prerequisite knowlege necessary to buy stocks like they do.

I also think it's one of the best pieces I've ever read on the subject of investing.

- Vooch

vooch
Vooch - 7 years ago
That speech is so chock-full of information it's incredible.

Here's my first attempt at it:

http://www.quantinetics.com/images/latticework-20061204.jpg

- Vooch

plindmark
Plindmark - 7 years ago
Is that your latticework or did you pull model's from Munger's speech?
vooch
Vooch - 7 years ago
I took Munger's speech and turned it into that, and then I added some stuff. I'm working on it for my book.

As for that Peter Bevelin book, I've had difficulty finding it, so I imagine I'm gonna wait and get it on amazon.com eventually.

Thanks,

Vooch

plindmark
Plindmark - 7 years ago
Vooch,

Call the Omaha Book Worm for Bevelin's book. It is interetsing the connectedness of your latticework .jpg. I look forward to your book!
vooch
Vooch - 7 years ago
By the way, here's a link to Munger's speech:

http://www.vinvesting.com/docs/munger/art_stockpicking.html

- Vooch

vooch
Vooch - 7 years ago
To elaborate further because of some questions I received, here is Munger's "Psychology of Misjudgement" speech:

http://www.vinvesting.com/docs/munger/human_misjudgement.html

- Vooch

vooch
Vooch - 7 years ago
I just came across this page:

http://www.poorcharliesalmanack.com/pdf/page390.pdf

which states that Munger has modified his original "Psychology of Misjudgement" speech.

I'll be looking forward to reading that book also.

- Vooch

vooch
Vooch - 7 years ago
Finally, I found and ordered the Peter Bevelin book "Seeking Wisdom: From Darwin to Munger", which I've learned is only available at Hudson Booksellers in Omaha at (402) 345-8676. The lady on the phone knew the book title before I even told her - they must sell a bunch of 'em there.

Also, I ordered Poor Charlie's Almanack, Hagstrom's Latticework, and about 10 other books. I'm getting down to the last few I want to buy finally.

- Vooch


vooch
Vooch - 7 years ago
In "The Psychology of Misjudgement" speech, does anyone know more about the 'Misjudgement #3: incentive-cause bias' Munger is talking about. He gives a few examples, but the explanation is a little lacking for me.

I'm trying to figure out where the investor could have made the mistake. Any ideas?

By the way, I'm still working on my latticework idea:

http://www.quantinetics.com/images/latticework-2006-12-17.jpg

- Vooch

vooch
Vooch - 7 years ago
ahhhh.... I found the explanation later in the speech:

"Now let's get back to B.F. Skinner, man-with-a-hammer syndrome revisited. Why is man-with-a-hammer syndrome always present? Well if you stop to think about it, it's incentive-caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he's expressed them to other people -- consistency and commitment tendency. I mean you've got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome."

> I'm trying to figure out where the investor could have made the mistake. Any ideas?

To answer my own question, it is from overconfidence because someone is steadfast in their means to an end.

- Vooch

P.S. Both of these speeches seem like candy to me - I cannot get enough! hehehe

vooch
Vooch - 7 years ago
Here's my newest version of modified-Munger latticework stuff printed off on paper:

http://www.quantinetics.com/images/latticework-2006-12-17c.jpg

It's huge!

- Vooch


vooch
Vooch - 7 years ago
plindmark,

I was reading your "Investor Presentation" (on your website) this weekend, and I was curious to learn of your source for this sentence:

"A 15 stock portfolio has a 25% chance of beating the market. A 250 stock portfolio has a 2% chance of beating the market."

Was that from something you've read or do you know the formula behind that? If you know the source from that line, I would appreciate it. I don't know the source, nor the formula, but it's very interesting.

Thanks,

Vooch

plindmark
Plindmark - 7 years ago
Vooch, It is from Robert Hagstrom's The Warren Buffett Portfolio. There is a study in the first part of the book.

vooch
Vooch - 7 years ago
plindmark,

> It is from Robert Hagstrom's The Warren Buffett Portfolio.

> There is a study in the first part of the book.

OK Thanks ! I haven't read that one yet, but I may have it at home.

I've got 3 other Hagstrom books (Latticework, New Liberal Art, and Detectives) on order right now.

I received Bevelin's book and Munger's Wit and Wisdom. I've flipped through both books and they both look interesting.

I think I've bought about two dozen books recently, so I'll have plenty to read and absorb in 2007.

- Vooch

vooch
Vooch - 7 years ago
plindmark,

I got a chance to read that section tonight in Hagstrom's The Warren Buffett Portfolio. Thanks for telling me your source for that quote - it was an interesting read.

- Vooch

plindmark
Plindmark - 7 years ago
Looks like you have some excellent books for '07. Let me know how your latticework goes. It is getting huge, I prefer simplification so I can use it readily and everyday.

Best wishes,

Peter
JosephY
JosephY - 7 years ago
Hi Vooch,

The mindmap at http://www.quantinetics.com/images/latticework-20061204.jpg

comes out all blurred for some reason. Is there any way you can send me the jpeg file offline? Thks.

vooch
Vooch - 7 years ago
JosephY,

It's blurry by design because it's still under development and will become part of my upcoming book.

- Vooch

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Hide