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Robert Abbott
Robert Abbott
Articles (383)  | Author's Website |

Charlie Munger: How Munger and Buffett Get to Go, No-Go

The gurus have their own pathway leading to investment decisions

November 27, 2018 | About:

In a brief but insightful appendix to “Charlie Munger: The Complete Investor,” author Tren Griffin looks into what he calls “Berkshire Math.”

He pointed out that Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) have some distinct ideas when they are valuing or evaluating a company. That begins with their use of the long-term (30-year) U.S. Treasury rate as their discount rate (the rate of return used in a discounted cash flow analysis; for example, the Treasury rate was 3.19% at the end of the third quarter of 2018).

The Treasury rate allows them to compare apples to apples when assessing securities. As a result, their analyses always begin with this number. Buffett has said, “In order to estimate the present value of anything, we’re going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate … to simply compare all kinds of investment opportunities across the spectrum.”

From Munger’s perspective, this is a case of opportunity costs, or what you need to give up to get something else. He put it this way: “Intelligent people make decisions based on opportunity costs—in other words, it’s your alternatives that matter. That’s how we make all of our decisions.”

So, for example, if they were to buy more shares of Coca-Cola (NYSE:KO), they would ask themselves what they would be giving up by committing their capital. All alternatives could then be assessed relative to the nearly risk-free returns they would receive from a Treasury bond. The additional shares of Coca-Cola could then be compared, on an objective basis, against other stocks, bonds and other securities.

For the gurus, this sensibly focuses their attention on the top 2% of their opportunities. Griffin added that this focus meant they ended up with a concentrated portfolio, which is fine with Munger. He believes risk is the result of not knowing what you are doing, and so he has a “focused Investing” style, allowing him to specialize in companies whose businesses he understands.

Continuing with the concept of risk, Griffin wrote that Munger only invests when he strongly believes that current earnings are nearly certain to continue. Griffin contrasts this with other investors who adjust their discount rates to adjust for risks. Munger and Buffett want to start with essentially no risk (in keeping with the Treasury rate).

This approach leads them to search for companies that combine “conservatively determined” fundamentals with a stable business history. Companies that measure up on these two criteria are mostly likely to deliver similar returns in the future.

Still, even they make mistakes occasionally and so they add one more guard rail: They will not buy a company or its shares unless they can get them at a discount of at least 25% to intrinsic value. This is the margin of safety that protects them and their shareholders at Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B).

As you will likely recall, Munger disregards volatility as risk and defines it instead as a loss of capital. In addition, he has separated opportunities into hard decisions and easy decisions. If a business has inherent risks, then Munger throws it onto the hard pile and forgets it.

Griffin then turns to what he calls the simple “mathematical process” used by the gurus. But before starting on the process, we need a basic understanding of “owner’s earnings.” Buffett explained what he meant by owner’s earnings in the 1986 Letter to Shareholders.

First, it refers to the total net cash flows that are expected over the life of the business, less any reinvestment of earnings. He wrote, “These represent (a) reported earnings plus (b) depreciation, depletion, amortization and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume”

Buffett contrasts this with what he calls “the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c).”

Getting back to the process:

  1. They calculate the past and present owner’s earnings.
  2. A reasonable and conservative growth rate is added to owner’s earning.
  3. The present value of the owner’s earnings are calculated by discounting with the 30-year Treasure rate.

As Griffin observed, this puts the focus on return on equity and not on earnings per share. Further, they do not use price-earnings ratios in calculating valuations.

Munger, said Griffin, likes genuine free cash flow and has no interest in EBITDA (earnings before Interest taxes, depreciation and amortization) or non-GAAP (generally accepted accounting principles) earnings.

The Berkshire Math, then, adds up to a unique set of metrics and a process that allows the company to avoid many risks while still pursuing above-average returns.

(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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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

Visit Robert Abbott's Website


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