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.
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.
