Part of understanding Charlie Munger (Trades, Portfolio)'s investment philosophy comes from reflecting on his longstanding dance with the ideas of pioneer value investor Benjamin Graham. While Munger and his partner, Warren Buffett (Trades, Portfolio), remain a part of Graham’s value investing universe, they have developed their own ideas and strategies.
Chapter six of the book, “Charlie Munger: The Complete Investor,” details eight ways in which Munger has taken his own road. Author Tren Griffin wrote this, in introducing the chapter:
“Now that the fundamental principles of the Graham value investing system have been discussed, it is time to discuss how investors can differ in their styles and still remain Graham value investors. You will recall that in this book’s Principles, Right Stuff, and Variables framework, aspects of a Graham value investor’s style that differ are called variables.”
Graham’s four 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.
First variable: Figure out the appropriate intrinsic value of a business. Griffin wrote the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) definition of intrinsic value is “the discounted value of the cash that can be taken out of a business during its remaining life.”
That value is an estimate, or a range, rather than a specific figure because interest rates may change or future cash flow forecasts may change. Coming up with an estimate or range is obviously simpler than calculating a precise number, and in keeping with Munger’s emphasis on simplicity. According to Griffin, Munger initially determines if a valuation will be easy or hard—and promptly throws out everything in the hard category. Buffett has said that intrinsic value is impossible to pinpoint, but must be estimated.
Second variable: Identifying the appropriate margin of safety. Like intrinsic value, the margin of safety is a subjective number and different investors have their own targets, whether 25%, 40% or something else.
Griffin argued that Munger and Buffett want an amount large enough that they can do the calculations in their heads, and the margin should be “overpoweringly clear.”
Third variable: Staying within their circle of competence. In addition to knowing what they’re good at and what they’re not, Munger also sees the circle of competence approach as a form of opportunity cost analysis. Griffin adds that specialization is another factor.
And Munger also inverts this circle of competence concept into its opposite: “And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.”
Fourth variable: Knowing how much of individual securities to buy. Munger does not believe in diversification, he prefers concentration. This he learned from another legendary investor, Phil Fisher, who argued it was hard to find good investments and so he concentrated on only a few stocks.
Munger refers to this as “focus investing." It is based on the idea that a person can only follow—and understand—a limited number of stocks at a time. That number, according to Griffin, is fewer than 20. Graham put the number between 10 and 30 securities.
Fifth variable: When to sell securities. Generally, Munger prefers to buy and hold forever because it allows him to avoid tax costs, transaction fees and other costs. In turn, that means higher compounding benefits.
Of course, other value investors hold other opinions, one of the most popular being to sell their stocks (or securities) when the market is offering something near their intrinsic value. Griffin puts this variable into the context of temperament and compounding.
Sixth variable: How much to bet when you find a mispriced asset. For Munger, you bet big when the opportunity arises. “The wise ones bet heavily when the world offers them that opportunity," he said. "They bet big when they have the odds. And the rest of the time, they don’t bet. It’s just that simple.” He has also said if his and Buffett’s predictions have been better than those of other people, it’s because they’ve made fewer of them.
Griffin quoted statistician Nassim Taleb (“The Black Swan”), who explained what smart investors are looking for: “Payoffs [that] follow a power law type of statistical distribution, with big, near unlimited upside but because of optionality, limited downside.”
Seventh variable: Should the quality of a business be considered? Munger followed Fisher in taking a strong interest in the quality of companies. That’s in contrast to Graham, who was more inclined to make a bargain price the key, what’s known as “cigar-butt” investing. Buffett originally followed Graham, but Munger convinced him to follow the quality strategy.
A couple of other factors also pushed Buffett away from the cigar-butts. Graham had developed his seminal theory in the mid-1930s, when real bargains were everywhere; that changed in the latter half of the 20th century as bargains became rarer. Second, because of their success, Munger and Buffett had vast amounts of money to invest and buying reasonably priced quality stocks was the only solution to that enviable problem.
Eighth variable: Which businesses to own (in whole or part): The big issue for Munger is a competitive advantage, or barriers to entry that protect an existing business, “We buy barriers. Building them is tough. … Our great brands aren’t anything we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it’s hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins.”
And then there is the issue of making decisions, “The difference between a good business and a bad business is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.” By owning quality companies, rather than cigar-butts, Munger and Buffett are also more likely to find the sustainable moats they demand.
Note, for those who read the book, there is a discrepancy between the title that promised seven variables, while the body provides eight of them.
(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.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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