Charlie Munger (Trades, Portfolio), like his associate Warren Buffett (Trades, Portfolio), owes much of his outstanding investing acumen to the lessons of pioneering value investor Benjamin Graham. Indeed, without Graham, both Munger and Buffett might have been quite ordinary investors.
Author Tren Griffin dug into Munger’s relationship with Graham’s four investment principles in chapter two of “Charlie Munger: The Complete Investor.” Those principles are:
- Think of a share of stock as a proportional ownership of a business.
- Create a margin of safety by only buying shares at a significant discount to intrinsic value.
- Ensure that Mr. Market is your servant and not your master
- Be rational, objective and dispassionate.
Proportional ownership
Munger emphasizes this principle, believing it is the starting point for the valuation of a company. Along with the fundamentals, a would-be investor should know about a company in the way a private investor might know about buying the whole company. The latter might ask questions such as these:
- What does the company sell?
- Who are its customers?
- Who are its competitors?
- What key metrics represent the value the business generates?
In other words, Munger would embark on a bottom-up process when considering a stock. He will want to know the present value of the cash flows over the company’s lifetime and whether the business can produce “high, sustained, and consistent returns on capital.” As Griffin noted, successful Graham value investors resemble great detectives, always looking for bottom-up clues about performance in the past and what that means in the present.
A Graham value investor also skips short-term predictions and where the “emotional herds of human beings” might go next. As the author says, Graham devotees put that in the “too hard” pile and focus on what they can do with much greater ease.
If you do make decisions based on short-term predictions, you are a speculator, not an investor. Munger also said: “Crowd folly, the tendency of humans, under some circumstances, to resemble lemmings, explains much foolish thinking of brilliant men and much foolish behavior.”
The author added a note about another well-known value investing disciple with whom Munger would undoubtedly agree, “Howard Marks advised that Graham value investors focus on what they know now and not where they are going because, rather obviously, your data about the present is extensive while your data about the future will always be zero.”
Griffin also wrote that by sticking to the easy questions and avoiding those that are hard, and making decisions based on data that exists now, the Graham value investor has a higher likelihood of success. Here’s an interesting illustration: Munger refuses to buy gold because he cannot do a bottom-up valuation; gold is not an income-producing asset.
When valuing a stock as a fraction of a whole, ongoing business, Seth Klarman (Trades, Portfolio) refers to the price he would pay as the “private market value.” Griffin added a definition of private market value from GAMCO Investors:
“Private Market Value (PMV) is the value an informed industrialist would pay to purchase assets with similar characteristics. We measure PMV by scrutinizing on- and off-balance-sheet assets and liabilities and free cash flow. As a reference check, we examine valuations and transactions in the public domain. Our investment objective is to achieve an annual return of 10% above inflation for our clients.”
Buy at a significant discount to intrinsic value
At the Wesco Financial annual meeting in 2003, Munger said: “The idea of a margin of safety, a Graham precept, will never be obsolete.”
In “The Intelligent Investor,” Graham wrote, “Confronted with a challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY.”
Graham’s definition of intrinsic value was a positive difference between the share price and its appraised value. The latter is assessed by the present value of future cash flows, and should only be purchased when it is greater than the price offered by the market. Every value investor has his or her on views, even from stock to stock, but many look for a price that is 40% to 60% below the intrinsic value.
According to Griffin, Klarman summed up Graham value investing as buying a bargain, based on the margin of safety, and waiting.
Griffin also used the analogy of adopting a safe following distance while driving on a freeway. Both drivers and Graham value investors are able to avoid having to make predictions. This view of the margin of safety also dovetails with Munger’s goal of avoiding what is hard (short-term predictions).
Munger wrote, “In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon.”
Make Mr. Market your servant
One of Graham’s other accomplishments was making stock markets more understandable by inventing the idea of Mr. Market, the unpredictable man who comes by each day and offers to buy your shares or sell you shares at some random price. In other words, he represents the emotional side of markets, depressed one day and euphoric the next.
He offers discounted prices when depresses and offers overvalued prices when euphoric. Naturally, Graham investors want to buy when Mr. Market is depressed and sell when he is euphoric. As Griffin added, though, as long as the fundamentals remain strong, the market’s short-term gyrations can be safely ignored.
Munger thus has limited faith in the concept of the Efficient Market Hypothesis (EMH), which postulates that investors cannot beat the market because all essential information is known by all investors. He believes the market is mostly efficient, but the difference between somewhat efficient and totally efficient leaves a big opportunity for people like him, the “top 3 or 4 percent” of the investment management community.
Be rational, objective and dispassionate
Munger has often said that the most successful characteristic of a successful investor is the ability to have rational thoughts and make rational decisions. Rationality, he believes, is the best antidote to psychological and emotional errors.
However, being rational is neither simple nor easy, said Griffin. He argued that Graham value investors do not try to predict the behavior of others, but they work hard to keep their behavior from getting in the way of their own rationality.
Investors should have a step-by-step process that helps them put together the simplest building blocks, an approach that can be enhanced with tools such as checklists. The value of such processes and tools comes from avoiding most mistakes.
Griffin promises the much of the remaining book will be devoted to this fourth principle.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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