Charlie Munger (Trades, Portfolio) is Warren Buffett (Trades, Portfolio)’s right-hand man, and he’s also a well-respected investor in his own right.
Indeed, just like Buffett, Munger ran his own investment partnership before coming to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) in the late '70s.
Over its life, from 1962 to 1975, Munger’s partnership returned an average of 24.3% per annum, compared to the Dow Jones Industrial Average, which returned 6.4% over the same period.
Rather than seeking out deep value, Munger looked for quality, a style that eventually caught Buffett's attention,Ă‚ and in 1965 Warren adopted this style for good with one of his more famous acquisitions, See's Candies.
As well as quality investing Munger also coined another investing term that most investors use, but it is generally known by a different name.
Sit on your ass
Munger introduced this new concept of investing, a concept he called “sit on your ass investing” at the 2000 Berkshire Hathaway annual meeting. The essence of his new investment theory was find a few outstanding companies, buy them and hold them forever.
Clearly, this isn’t the first time “sit on your ass investing” has been popularized. Generally known as buy-and-hold or buy-and-forget investing, Berkshire Hathaway’s success over the years can be traced to this style of investing. Buffett’s greatest acquisitions, including Geico, See’s Candies, Coca-Cola (KO, Financial) and American Express (AXP, Financial), were all quality businesses bought at an attractive price with the intention of holding them forever.
Just like Buffett, Munger believes you should only buy a stock if you are willing to keep it for 10 years or more, and you are prepared to commit a substantial portion of your wealth to it. In other words, unless you have done rigorous research and believe in a company’s long-term outlook there’s no point investing. And if you have spent time and money conducting rigorous analysis on the prospect, there’s no reason why you can’t devote a significant amount of your portfolio’s assets to it.
For most investors, it is just not possible to do the sort of rigorous analysis on businesses and their prospects that Buffett and Munger can. In fact, for most investors, it is better to buy an index fund or broad basket of companies than pick single-name stocks, as plenty of research has shown. But it’s the “sit on your ass” instruction that is Munger’s most valuable instruction for ordinary investors.
There is plenty of research out there that shows that market timing is a waste of time and effort for most investors, but buy-and-hold investing relies upon an investor's ability to choose those stocks that will be around for the long term.
How do you find the best stocks for this strategy?
The success of a long-term buy-and-hold strategy is driven by a company’s ability to compound shareholder equity at an attractive rate over the long term.
Munger’s speech, "A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business,"Â breaks it down nicely:
“Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result.”
Similarly, here’s what Buffett said about Coca-Cola, See's Candies and Buffalo News at the 2003 Berkshire Hathaway meeting:
“The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. We look for them [areas to wisely reinvest capital], but they don't exist.”
At the same meeting, Munger added the following statement:
“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.”
Once again, it’s finding these businesses that is the hard part, but when you know what you’re looking for in the perfect “sit on your ass” business it’s easier to find those that may conform. Unfortunately, with company lifespans getting shorter and disruption rife, it is becoming harder to find those businesses that can generate a high, sustainable return on equity or return on tangible equity, but there are still opportunities out there for the enterprising investor.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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