Charlie Munger (Trades, Portfolio) is Warren Buffett (Trades, Portfolio)’s right-hand man and an extremely accomplished investor in his own right. His experience means that when it comes to investing, there’s not much Munger does not understand or have some insight into. However, there’s one topic he has expressed some lack of understanding of in the past.
The following extract is taken from Charlie Munger (Trades, Portfolio)’s “A Lesson on Elementary Worldly Wisdom as It Relates to Investment Management & Business” from a lecture to the students of Professor Guilford Babcock at the University of Southern California Marshall School of Business as published in the Outstanding Investor Digest's May 5, 1995, Edition.
“Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors - or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.
Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.”
Why do some industries do better than others even though they exhibit the same traits?
This is a curious question. Although it’s easy to see why some commodity businesses can’t continually make fat profit margins, it's harder to understand why other industries do so well, as Munger goes on to explain:
“If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world - safe travel. greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure - a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.
Yet, in other fields - like cereals, for example - almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable - despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.”
It could be argued that there’s a brand identity factor in cereals that does not exist in airlines, but that does not stop manufacturers offering deep discounts on their products. Maybe, there’s less desire to get caught up in a price war:
“Maybe the cereal makers by and large have learned to be less crazy about fighting for market share - because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.”
There’s no real moat for cereals (if Munger believes that he can decimate Kellogg by spending heavily on marketing) so the industry can be easily disrupted, but it hasn’t been. Why this is the case, it’s not possible to tell -- even Munger can’t find a solution:
“In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.
For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening.”
Disclosure: The author owns no stock mentioned.
