I recently read a book called "The Art of Thinking," written by a Chinese entrepreneur named Cheng Jia. The book is about how to apply Charlie Munger (Trades, Portfolio)'s thinking models in real life.
Cheng is a practitioner of Munger’s multidisciplinary approach in China. As a Munger groupie myself, I thoroughly enjoyed his book. Unfortunately, the book is only published in Chinese, so I’ll share some of the most important takeaways from the book for non-Chinese readers.
One of the most interesting insights from the book is about what Cheng calls “hidden messages.” This concept is similar to Howard Marks' second-level thinking. According to Cheng, there are two types of messages: “explicit messages” and “hidden messages.” Explicit messages are messages explicitly conveyed by somebody without the “why” explanations. Hidden messages are messages that are implied by the explicit messages. Cheng argues that it is the hidden messages that carry more weight in practice.
This might sound a little vague, so let me use some real life value investing-related examples.
In February of this year, Warren Buffett (Trades, Portfolio) spoke to Becky Quick about the Kraft Heinz (KHC) investments. When asked about why Berkshire didn’t add to its Kraft Heinz position when it was down 30%, Buffett said the following explicit messages:
BECKY QUICK: If you’re sticking with the business and it’s 30% cheaper today, why wouldn’t you buy more?
WARREN BUFFETT: Because it isn’t worth as much.
BECKY QUICK: So you think it was a fair write-down that the market gave it?
WARREN BUFFETT: Well, at 35, you’ve got a billion, 200 million shares out. So that’s $42 billion for the equity. And we own $30 or $31 billion. So the whole company is selling for $71 or $72 billion. And as I mentioned, it has about $6 billion of operating income. Now, for $6 billion, would you pay a lot more than $72 billion where it doesn’t look like it’s going to be going up for a while? They said it was gonna go down in 2019. There are other things I think where you get more for your money and better prospects. Not that I regard the prospects for Kraft-Heinz as terrible.
BECKY QUICK: But if you see better places to deploy money, why don’t you sell?
WARREN BUFFETT: We can’t as a practical matter move around tens of billions of dollars that easily. But beyond that I mean, if we’re working with a million dollars or $10 million, would I have a position in it? No. You can move around with a million or $10 million. And Ted and Todd can move around reasonably well with $13 billion. But that can be difficult. $173 billion, I mean, you dance like an elephant. Not like some guy on "Dancing With the Stars."
Let’s take a look at one explicit message: Warren Buffett wouldn’t pay $72 billion for Kraft Heinz when it’s generating $6 billion in operating income.
The first thing we should ask when exploring hidden messages is the question of "why?" Why isn’t Buffett willing to pay $72 billion for Kraft Heinz when it’s generating $6 billion in operating income?
In a previous article, I wrote about Buffett’s 10% hurdle rate. In Kraft Heinz's case, the pretax return was only 8.3% at the time, so it didn’t meet Buffett’s hurdle.
That begs the question: Why was Buffett willing to pay a much higher amount ($107 billion) for the same business a while ago, when the pretax return was even lower? When Buffett paid $107 billion for Kraft Heinz, he was forecasting the business would generate at least $10.7 billion operating income annually in the next few years. In reality, Kraft Heinz only delivered $6 billion, and that is not likely to go up substantially anytime soon. Thus, Buffett only got 5.6% of the 10% he has forecasted. He made the wrong prediction.
Then the next question then becomes: Why is Kraft Heinz earning much less than Buffett expected?
Again, what Buffett explicitly said was, “packaged goods brands [are] losing some ground against the retailers.” But he didn’t say why packaged goods brands are losing some ground against the retailers, or why 3G and Berkshire thought Kraft Heinz had the bargaining power with the retailers when they bought it.
As you can see, the information and insight gets more and more valuable as we explore different layers of the hidden messages, and with each layer, we get closer and closer to the core of the issue. That’s the real power of the model.
Conclusion
If I may use an analogy, explicit messages are like the raw materials in an analysis, whlie hidden messages are the finished products. For us to fully enjoy the benefits of the wisdom imparted by Buffett and Munger, we have to process those raw materials to convert them into finished products. The best way is to keep asking "why?" Sometimes we may not find the exact answer, but whatever we find, it’s deeper and better than the raw materials alone.
Read more here:
- Buttet's 10% Hurdle
- Profound Lessons From Arnold Van Den Berg - Part 2
- Profound Lessons From Arnold Van Den Berg - Part 1
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