What you'll learn:
➤ The Art of Stock Picking
Welcome to the fascinating world of stocks, where we’ll explore the wisdom of Charlie Munger as found in the art of stock picking. In this article, you’ll discover invaluable insights that will help you become a better stock picker.
Charlie Munger firmly believes that our education often neglects this essential skill, akin to the wisdom passed down by our grandparents, where we must consume our carrots before indulging in dessert.
The broader landscape of worldly wisdom is our equivalent of carrots, and it’s fundamental for excelling in the realm of stock picking.
➤ The Power of Models
You might wonder, what is the essence of worldly wisdom? Well, it all starts with a fundamental concept: Facts alone are insufficient. Mere memorization of isolated facts, recited without a deeper understanding, won’t make you a successful stock picker.
To truly excel, you need something more profound. You need models in your mental toolkit. Think of it as assembling a puzzle – individual experiences make sense when they are interconnected.
Why is this so critical? Consider the students who cram for exams and regurgitate facts without understanding the underlying principles. They often struggle, both in academia and in life, because they lack the framework of mental models.
Now, imagine a crucial aspect: a single model won’t cut it. Human psychology tends to simplify reality by fitting it into a single model. This approach is a recipe for disaster; it’s like using a hammer to fix everything, making every problem look like a nail.
To succeed, you need a diverse array of models from various fields. Wisdom isn’t confined to one area of expertise. You don’t need an overwhelming number of models, but a select few, around 80-90%, can handle most of the heavy lifting.
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➤ The Role of Mathematics
Let’s start with mathematics – don’t fret; it’s not as daunting as it may seem. You don’t need to be a mathematical genius, but you should be comfortable with numbers and basic arithmetic.
Remember those permutations and combinations from your school days? They aren’t just abstract math concepts; they hold real-world significance.
Pascal and Fermat casually unveiled these mathematical principles, and they are indispensable for comprehending the world around you. Learning these concepts is akin to refining a golf swing – it might feel awkward initially, but it’s crucial for your success.
Failing to grasp these fundamental probabilities leaves you at a disadvantage, much like a one-legged man in a kicking contest. Warren Buffett, a legendary figure in the stock market, has these mathematical tools ingrained in his thinking, giving him a significant edge.
➤ Understanding Accounting
Accounting is the language of business life, and its intricacies are less complicated than they may appear. But, here’s the catch: accounting is an imperfect approximation of reality, and recognizing its limitations is vital.
For instance, pinpointing the exact useful life of a jet airplane, even if it appears neatly in numerical form, is a challenging task. Carl Braun, a skilled businessman, understood this limitation and crafted his own accounting system, emphasizing the importance of explaining the ‘why.’
This concept isn’t just common sense; it’s rooted in psychology. People are more likely to comprehend and follow instructions when they understand the ‘why’ behind them.
➤ The Power of Reliable Models
The most dependable models stem from the hard sciences and engineering. These models are robust because they are built on high school-level mathematics.
They center on cost-benefit analysis, whether they originate from the mathematics of Fermat and Pascal or Deming’s quality control concepts.
You don’t need to become a statistics expert, but you should grasp the basics, like the Gaussian distribution. Additionally, concepts from engineering, such as backup systems, breakpoints, and critical mass, can enhance your ability to understand and navigate the world more effectively.
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➤ The Psychology of Misjudgment
Now, we delve into psychology, a field that’s a bit more complex. Our minds possess shortcuts that can lead us astray, and magicians cleverly exploit these shortcuts to make us perceive things that aren’t there.
The psychology of misjudgment, as Charlie Munger likes to call it, holds immense significance. There are approximately 20 key principles in this field, and they all interact. Even highly intelligent individuals can make irrational decisions if they neglect these principles.
Here’s the takeaway: When you’re acquiring worldly wisdom, always begin by asking “why.” When you communicate with others, remember to include the “why,” even if it seems self-evident.
Understanding these fundamental psychological principles doesn’t require a lifetime of study – you can grasp the basics in about a week. Although it may seem elementary, this knowledge can save you from costly errors.
➤ The Mind of Man
In the words of Blaise Pascal, “The mind of man at one and the same time is both the glory and the shame of the universe.” This profound observation highlights the extraordinary power of our minds, yet it also underscores the vulnerabilities and cognitive biases that often lead us astray.
Consider the unsettling fact that nearly half of Adolf Hitler’s army consisted of devout Catholics. Clever psychological manipulation can lead individuals to engage in unexpected behaviors. So, how do you make sense of it all?
I’ve devised a two-pronged approach. First, you must assess the rational, genuine interests at play – think of it as solving a complex bridge problem.
But there’s another layer to this puzzle – subconscious influences. Our brains often work behind the scenes, shaping outcomes that aren’t always reliable.
➤ Microeconomics and the Ecosystem
Now, let’s shift our focus to microeconomics, a realm that’s less predictable but equally essential. Picture a free market economy as an ecosystem. While this analogy may not be in vogue, it holds a great deal of truth.
Just as in a natural ecosystem, where specialization leads to thriving niches, businesses that specialize and excel in the economic world often find success that wouldn’t be attainable otherwise.
In microeconomics, economies of scale play a significant role. One such advantage is the concept of cost reduction as a business gains experience.
The more you do something, the more efficient you become, thanks to the incentives of capitalism. It’s akin to basic high school algebra that yields real-world benefits.
➤ The Geometry of Scale
Think about simple geometry, like constructing a massive spherical tank. As you increase its dimensions, you can hold more volume per unit area of steel. It’s a straightforward benefit of scale.
Or consider TV advertising. When television advertising was first introduced, it revolutionized marketing.
However, it was too expensive for small businesses. So, large companies with substantial sales were able to leverage this new advertising medium, expanding their influence and market share.
➤ The Power of Information
Informational advantage is another dimension of scale. Well-known brands like Coca-Cola hold a significant advantage because they are trusted and recognized. People tend to choose familiar brands over unfamiliar ones when presented with choices.
There’s also the psychological concept of “social proof” – we often follow the crowd to avoid standing out. This provides a considerable advantage to businesses with extensive distribution networks, like Coca-Cola.
Scale advantages come in various forms, from basic geometry to information and psychology.
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➤ The Bureaucratic Trap
However, there’s a downside to scale: bureaucracy. As organizations expand, they frequently become burdened by bureaucratic processes.
It’s a natural tendency, as employees become more focused on passing on the work rather than achieving the end result. Decisions take longer, and more agile competitors outpace them.
Furthermore, bureaucracy tends to breed corruption, as individuals in various departments often make unwritten deals to maintain their status quo. The problem is even more pronounced in government structures.
Despite these challenges, large organizations remain a necessity. Yet, efficiently managing large bureaucracies remains a significant issue. Businesses employ strategies to tackle bureaucracy, such as creating decentralized units and innovative motivation and training programs.
General Electric, under the leadership of Jack Welch, has excelled in managing bureaucracy. Nevertheless, it remains a significant challenge in sizable organizations.
In conclusion, while the drawbacks of scale are evident, they coexist with the advantages that size can offer. It’s a complex, ever-evolving balance.
➤ The Perils of Unwanted Truth
Human psychology often resists unwelcome truths. This aversion is visible across various domains, including business. An intriguing example is CBS, a network dominated by William Paley in its early days.
Paley had an aversion to hearing what he didn’t like, and those around him learned this quickly. They began telling him only what he wanted to hear, creating a bubble of unreality. The consequences were detrimental, even though CBS remained a profitable business.
This illustrates how reluctance to face uncomfortable truths can lead to dysfunction at the highest levels of a company.
➤ Microeconomics and Scales of Competition
In the realm of microeconomics, we encounter the curious phenomenon of competition within different markets.
Some markets, even with a small number of major competitors, fail to generate substantial profits. However, in others, profits are abundant. Understanding this dichotomy is a complex puzzle.
Consider the airline industry as an example. Despite providing safe travel and enhanced experiences to consumers, the industry has often yielded negative returns for shareholders due to intense, destructive competition, particularly after deregulation.
In contrast, the cereal industry remains highly profitable, even with aggressive competition and promotions. The factor setting cereals apart is brand identity, and this plays a significant role.
Another factor contributing to this profitability is the willingness of companies to avoid relentless battles for market share. Some businesses tend to be like “demented Kelloggs,” determined to capture the lion’s share of the market and willing to go to great lengths to achieve this.
➤ The Importance of Technology and Ownership
Microeconomics teaches a crucial lesson about distinguishing between technology that enhances your position as an owner and technology that dilutes your benefits. This distinction often eludes people.
For instance, Warren Buffett’s experience in the textile business led him to realize the importance of this principle. When new technology promised increased productivity in their commodity textile production, Buffett saw through the mirage.
He understood that the savings from these improvements would primarily benefit the customers and not the owners of the business. This realization led him to exit the business, saving capital that would have otherwise been invested with little return.
The key takeaway is that investing in improvements that primarily benefit customers rather than owners is not a wise move.
On the other hand, investing in technology that enhances profitability directly for the owners can be a sound strategy. This principle can be applied across various industries, and its understanding is critical for successful investment and business decisions.
➤ The Stock Market and the Efficient Market Theory
Let’s delve into the nature of the stock market and its relationship with the Efficient Market Theory. This theory posits that the stock market is so efficient that it’s impossible for individuals to consistently outperform it.
Charlie Munger acknowledges that the efficient market theory is roughly correct in the sense that markets are indeed quite efficient, making it challenging for most stock pickers to beat the market significantly just by being intelligent and disciplined.
An intriguing paradox arises – one of the world’s greatest economists taught the efficient market theory but invested in Berkshire Hathaway and witnessed substantial wealth creation. In essence, he bet against the very theory he taught.
The efficient market theory asserts that information is instantly incorporated into stock prices, leaving no opportunities for investors to find undervalued or overvalued stocks. Nevertheless,
Charlie Munger suggests that the stock market is both efficient and inefficient. While it’s challenging to consistently outperform the market, opportunities do exist for disciplined individuals who possess an edge and invest wisely.
Munger also humorously labels those who take the efficient market theory to the extreme as “bonkers.”
This sets the stage for my approach to stock picking, indicating that while markets are generally efficient, there are opportunities for those who can identify the market’s inefficiencies and make intelligent investment decisions.
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➤ Pari-Mutuel System and Graham’s Approach
Charlie Munger continues to discuss stock picking strategies. He introduces the concept of the pari-mutuel system, often used in horse racing, to illustrate the difficulty of consistently beating the stock market.
In a pari-mutuel system, odds change based on what’s bet, similar to stock prices that fluctuate with market activity. He emphasizes that outperforming the market is challenging because it’s akin to a betting system, and frictional costs (transaction costs) make it even more challenging.
Munger explain that while the stock market is efficient in rapidly integrating available information into stock prices, some inefficiencies remain, and they can be exploited with shrewdness and discipline.
He also mentions sector rotation, where investors attempt to time the market by shifting between sectors to outperform the market. However, he notes that he knows of no genuinely rich sector rotator.
He then turns to Ben Graham’s value investing approach. Graham’s concept of value to a private owner, which calculates what an entire business could be sold for, was groundbreaking.
His approach focused on identifying stocks trading at a significant discount to this intrinsic value, providing a margin of safety. However, Charlie points out that such opportunities were more abundant in the wake of the 1930s economic downturn.
In a changing market environment, where easily discoverable bargains were disappearing, some value investors began changing their criteria to continue finding investments, adapting to the evolving market conditions.
Charlie highlights the importance of Ben Graham’s concept of “Mr. Market,” where the market is seen as a manic-depressive who offers stocks at varying prices. This concept has been essential for figures like Warren Buffett throughout their lives.
He implies that sticking rigidly to classic Grahamian investing might not have led to the same success that him and Buffett have had. We adapted and refined our approach to changing market conditions.
➤ Value Investing, Management, and Tax Considerations
He discusses the evolution of Berkshire Hathaway‘s investment philosophy, contrasting it with Ben Graham’s approach.
Graham didn’t believe in talking to company managements and aimed to invent a system that anyone could use. As a result, he focused on finding deeply undervalued stocks.
Over time, Berkshire Hathaway moved beyond pure Graham-style investing and realized that a company trading at a higher price-to-book value could still be a great investment due to the quality of the business and its management.
We learned to appreciate the benefits of owning high-quality businesses and their compounding power.
While Berkshire started with a focus on finding small, undervalued companies, we realized that our size made it challenging to replicate this approach and transitioned to investing in larger businesses.
The emphasis shifted to finding high-quality companies with exceptional management. Charlie emphasizes the importance of business quality and management competence.
Munger also touches on the significance of considering tax implications in investment decisions. While it’s essential to consider taxes, Charlie advises against making tax considerations the primary motivation for investment choices.
Being overly focused on tax benefits can lead to suboptimal investment decisions. Instead, we should aim to minimize taxes while adhering to a long-term investment perspective, as this approach can yield significantly better after-tax returns.
In the investment world, it’s crucial to be aware of overpricing and overvaluation. While opportunities exist in undervalued assets, it’s essential to exercise caution and manage risks.
Some businesses have untapped pricing power, like Disney, which can increase prices without losing customers due to their unique value proposition.
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➤ Successful Investment Models
The Washington Post Investment: Munger references an investment made in The Washington Post in 1973-74, which he describes as a once-in-40-years opportunity. The investment appreciated approximately 50 times its original cost.
He cautions that such exceptional opportunities are rare but emphasizes that even a less extraordinary investment can still provide significant returns.
Gillette and Coca-Cola Models: Munger mentions Gillette and Coca-Cola as examples of companies with a global marketing advantage.
These companies offer relatively low-priced consumer goods, and their success is attributed to their strong brands and ability to stay on the cutting edge of product improvements. He highlights their dominant market positions in some regions.
GEICO’s Turnaround Model: Munger discusses the model of turning around a struggling business by cutting away the inefficiencies and returning to its core strengths. He compares this process to cancer surgery, where you eliminate the malignant parts and preserve what’s healthy.
GEICO had initially made mistakes due to overconfidence, but by simplifying the business and focusing on its core strengths, it became a successful model.
Munger acknowledges that successful investment management is challenging, and the investment management industry, as a whole, often struggles to provide value-added services to clients.
He suggests that only a select few investment managers can consistently deliver above-average returns. He believes that it takes more than just brilliance; it requires discipline and the ability to call your shots and load up on the right opportunities.
Munger concludes that the best investment managers are those who can provide above-average real returns to clients over the long term.
However, he acknowledges that this applies mainly to stock picking in American stocks, and different areas of investment management may have their own dynamics and opportunities.
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➤ Final Thoughts
In conclusion, Charlie reflects on Berkshire Hathaway’s success, emphasizing that it’s a result of both value investing and investing in businesses with strong competitive positions and growth potential.
It underscores the significance of price discipline, integrity, and intelligence in business management.
The best investment managers are those who consistently deliver above-average real returns to clients over the long term, and this applies primarily to stock picking in American stocks.
Different areas of investment management may have their own dynamics and opportunities, but it requires more than brilliance; it demands discipline, the ability to call your shots, and capitalizing on the right opportunities.
In summary, remember that stock picking is an art, and like any craft, it requires mastering various tools and principles.
Embrace worldly wisdom, cultivate your mental models, and keep an eye out for the nuances that can lead to successful investment decisions. Your path to becoming a skilled stock picker begins with these fundamental lessons.
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〝The only point in making money is, you can tell some big shot where to go.〞— Humphrey Bogart