Charlie Munger: The Complete Investor | Reflections & Notes

Tren Griffin. Charlie Munger: The Complete Investor. Columbia University Press, 2015. (209 pages)

REFLECTIONS

I have always considered money to be a reflection of something more than mere dollars and cents. Add to that Yuval Noah Harari’s description of money as a mere fiction, and we have an insightful sense of what money is, how it has dominated our sense of value, and how we can deconstruct money as a proxy for a variety of human impulses.

I started reading this book for the original purpose of caring for my and my children’s future, making decisions that would maximize my returns for the financial security of my family. Upon finishing the book, what I really got was a crash course in behavioral science, an array of cognitive biases (tendencies) and pitfalls, and a plea towards living virtuously. Munger (and Buffett) ooze a profoundly simple wisdom that is not only applicable to “finance” and “business,” but to life in general. Sure, there are a host of business principles that are really insightful and helpful as well, but even those are reflective of a much deeper modern anthropology.

One popular test in evaluating the merits of moral and ethical principles is to ask, What would happen if everyone behaved this way? With the financial and personal enrichment success of Munger/Buffett, I consider this exercise worthy of consideration. No matter how much money you make by deploying their insights, you are guaranteed to be “rich.”


NOTES

Introduction

…people who can think independently, gain control of their emotions, and avoid psychological errors have an advantage as investors. (1)

The best thing a human being can do is help another human being know more. – Charlie Munger (C.M.), 2010

I observe what works and what doesn’t and why. – C.M.

I created a framework composed of three elements: principles, the right stuff, and variables (6)

I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important. – C.M., 2007

The four fundamental principles of value investing as created by Ben Graham are as follows:

  1. Treat a share of stock as a proportional ownership of the business.
  2. Buy at a significant discount to intrinsic value to create a margin of safety.
  3. Make a bipolar Mr. Market your servant rather than your master.
  4. Be rational, objective, and dispassionate. (7)

In matters related to value investing, many people prefer chewing the menu to actually eating the food. [Zen saying] (8)

1. The Basics of the Graham Value Investing System

The critical point about Graham’s system is that it is simple. (9)

Simplicity has a way of improving performance through enabling us to better understand what we are doing. – C.M.

If something is too hard, we move on to something else. What could be simpler than that? – C.M., 2006

We have three baskets: in, out, and too tough…We have to have a special insight, or we’ll put it in the “too tough” basket. – C.M., 2002

Graham value investing is not about showboating or flouting one’s intelligence. Instead, it is about doing things that are not likely to result in a mistake. (12)

The Graham value investing system is intentionally designed to underperform an index in a bull market; this is confusing to many people. … By giving up some of the upside in a bull market, the Graham value investor is able to outperform when the market is flat or down. (12)

If you cannot accept investing underperformance in the short term in order to achieve long-term investment outperformance, then you are not a candidate for Graham value investing. … It is important to note that the goal of the Graham value investor is superior absolute performance, not just relative performance. (13)

It’s remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying, “It’s the strong swimmers who drown.” – C.M., 1989

What’s the flip side, what can go wrong that I haven’t seen? – C.M., 1969

In his view, investors will do better financially simply by being less stupid. (13)

Knowing what you don’t know is more useful than being brilliant. – C.M.

“Do you mean Graham value investors wait for misplaced assets to appear rather than predict the future in the short term?” The answer is an emphatic yes! The Graham value investor’s job is to recognize misplaced assets when he or she sees them. (15)

I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, “My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.” – C.M., 1994

2. The Principles of the Graham Value Investing System

The number one idea is to view a stock as an ownership of the business. – C.M., 2001

Understanding how to be a good investor makes you a better business manager and vice versa. – C.M., 2005

First Principle: Treat a Share of Stock as a Proportional Ownership of a Business

Put simply: if you do not understand the actual business of the company, you cannot understand the value of assets related to that business, like a share of stock or a bond. (22)

In buying a business, Munger believes the place to start is at the bottom, with business fundamentals, and work up. What does the company sell and who are its customers and competitors? What are the key numbers that represent the value the business generates? (23)

Effective Graham value investors are like great detectives. They are constantly looking for bottom-up clues about what has happened in the past and, more importantly, what is happening now. (23)

…a share of stock cannot e divorced from the fundamentals of the specific business. (23)

Be motivated when you’re buying and selling securities by reference to intrinsic value instead of price momentum. – C.M., 2000

When stocks are a bargain, people are fearful; when stocks are expensive, people are greedy. (25

Crowd folly, the tendency of humans, under some circumstances, to resemble lemmings, explains much foolish thinking of brilliant men and much foolish behavior. – C.M., 2000

In other words, a speculator’s objective is to make predictions about the psychology of large masses of people, which if you are both smart and experienced is a sobering thought. How good are you at predicting what people will do once assembled into a mob? (25)

If you’re an investor, you’re looking on what the asset is going to do; if you’re a spectator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game. – Warren Buffett (W.B.), 1997

Ben Graham told a story forty years ago that illustrates why investment professionals behave as they do. An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence,” said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately, the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.” – W.B., 1985

Once upon a time, a man and his assistant arrived in a very small town and spread the word to the (27) townspeople that the man was willing to buy monkeys for $100 each. The people knew there were many monkeys in the nearby forest and immediately started catching them. Thousands of monkeys were bought at a price of $100 and placed in a large cage. Unfortunately for the townspeople, the supply of monkeys quickly diminished to a point where it took many hours to catch even one.

| When the new man announced he would now buy monkeys at a price of $200 per monkey, the town’s resident’s redoubled their efforts to catch monkeys. But after a few days the monkeys were so hard to find that the townspeople stopped trying to catch any more. The man responded by announcing that he would buy monkeys at $500 after he returned with additional cash from a trip to the big city.

| While the man was gone, his assistant told the villagers one by one: “I will secretly sell you my boss’ monkeys for $350, and when he returns from the city, you can sell them to him for $500 each.”

| The villagers bought every single monkey, and they never saw the man or his assistant ever again. (28)

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. (28)

I have no use whatsoever for projections or forecasts. They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be. We never look at projections but we care very much about, and look very deeply, at track records. If a company has a lousy track record but a very bright future, we will miss the opportunity. – W.B.

[Projections] are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious. They remind me of Mark Twain’s saying, “A mine is a hole in the ground owned by a liar.” Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself. – C.M., 2007

I don’t let others do projections for me, because I don’t like throwing up on the desk. – C.M., 2003

The best way to determine the value of a business is based on the price a private investor would pay for the entire business. …the private market value. (30)

Second Principle: Buy at a Significant Discount to Intrinsic Value to Create a Margin of Safety

The idea of margin of safety, a Graham precept, will never be obsolete. – C.M., 2003

No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life. – C.M., 2009

Confronted with a challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY. – Ben Graham, 1949

Ben Graham’s definition of a margin of safety is “a favorable difference between price on the one hand and indicated or appraised [intrinsic] value on the other.” Intrinsic value is the present value of future cash flows. Margin of safety reflects the difference between the intrinsic value and the current market price. (31)

Simply put, your objective as a Graham value investor is to buy a share of stock at a sufficiently large bargain that you do not need to predict short-term price movements in the stock market. (32)

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. – C.M., 2003

If you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, [Ben Graham] would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety–as he put it–by having this big excess value going for you. – C.M., 1994

“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound tricks across it. And the same idea works in investing.” Munger believes investing should be similar. The first rule of investing is: do not make big financial mistakes. The second rule is the same as the first rule. (33)

The Graham value investor should always remember this admonition: price is what you pay, and value is what you get. (34)

Third Principle: Make “Mr. Market” Your Servant Rather Than Your Master

Ben Graham [had] his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think it is worth. – C.M., 1994

The Graham value investor believes Mr. Market is unpredictably bipolar in the short term; for that reason, when the market is depressed, it will sometimes sell you an asset at a bargain price. Other times, because it is euphoric, the market will pay you more than the asset is worth. Knowing the difference between these two emotional states is of critical importance to the successful use of the Graham value investing system. (36)

…why turn something like a drop in stock prices–which is fundamentally advantageous–into something disadvantageous? As long as the fundamentals of the business itself remain in place, a market’s short-term views on the price of the shares can be ignored and will be corrected in the long term. … There are essentially three steps in the process: analyze the business to determine intrinsic value, buy the assets at a significant bargain, and wait. (37)

I think it’s roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get the unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top 3 or 4 percent of the investment management world will do fine. – C.M., 2009

The investors’ job is to patiently watch rather than predict price movements and be ready to quickly and aggressively buy at a significant discount to intrinsic value and sometimes sell at an attractive price in relation to intrinsic value. For a Graham value investor, reacting quickly and aggressively to favorable prices when they unpredictably appear is essential. (38)

To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. – C.M., 1994

Mr. Market’s bipolar nature is his gift to Graham value investors. Occasionally he will present them with great bargains. At other times he’ll buy your assets at a premium. … Graham value investors price stocks rather than time markets. (38)

Falling in with the crowd will put you under the sway of Mr. Market because Mr. Market is the crowd. If you are the crowd, then you cannot, by definition, beat the crowd. …”Be fearful when others are greedy, and greedy when others are fearful.” (39)

Over many decades, our usual practice is that if [the stock of] something we like goes down, we buy more and more. Sometimes something happens, you realize you’re wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices. – C.M., 2002

Grahm’s value investing system is based on the premise that risk (the possibility of losing) is determined by the price at which you buy an asset. The higher the price you pay for an asset, the greater the risk that you will experience a loss of capital. If the price of a stock drops, risk goes down, not up. For this reason, the Graham value investor will often find that price decrease for a given stock is an opportunity to buy more of that stock. (39)

Fourth Principle: Be Rational, Objective, and Dispassionate

Rationality is not just something you do so that you can make more money; it’s a binding principle. Rationality is a really good idea. You must avoid the nonsense that is conventional in one’s own time. It requires developing systems of thought that improve your batting average over time. – C.M., 2006

[An] increase in rationality is not just something you choose or don’t choose; it’s a moral duty to keep up as much as you reasonably can. It worked so well at Berkshire, not because we were so darned smart to start with–we were massively ignorant. Any of the great successes of Berkshire started with stupidity and failure. – C.M., 2011

The idea of being objective and dispassionate will never be obsolete. – C.M., 2003

While Graham value investors do not try to predict the behavior of other people, they do spend a lot of time trying to keep their own behavior from getting in the way of being rational, objective, and dispassionate. (41)

3. Wordly Wisdom

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a lattice-work of theory, you don’t have them in a usable form. – C.M., 1994

You must know the big ideas in the big disciplines, and use them routinely–all of them, not just a few. Most people are trained in one model–economics, for example–and try to solve all problems in one way. You know the old saying: to the man with a hammer, the world looks like a nail. This is a dumb way of handling problems. – C.M., 2000

All the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. – C.M., 1994

What are the models? Well, the first rule is that you’ve got to have multiple models–because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models. – C.M., 1994

Munger believes that by using a range of different models from many different disciplines–psychology, history, mathematics, physics, philosophy, biology, and so on–a person can use the combined output of the synthesis to produce something that has more value than the sum of its parts. (43)

Simply put, Munger believes that people who think very broadly and understand many different models from many different disciplines make better decisions and are therefore better investors. (45)

In Munger’s view, it is better to be worldly wise than to spend lots of time working with a single model that is precisely wrong. (45)

Munger believes that thinking broadly in many disciplines makes you a better thinker because everything is literally related. (46)

You have to realize the truth of biologist Julian Huxley’s idea that “Life is just one damn relatedness after another.” So you must have the models, and you must see the relatedness and the effects from the relatedness. – C.M., 2005

People calculate too much and think too little. – C.M., 2002

Thinking is a surprisingly underrated activity. Researchers published a study in 2014 that revealed that approximately a quarter of women and two-thirds of men chose electric shocks over spending time alone with their own thoughts. (47)

[cf. Atlantic article; Science Journal]

I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up, and boy, does that help, particularly when you have a long run ahead of you. … So if civilization can progress only with an advanced method of invention, you can progress only when you learn the method of learning. Nothing has served me better in my long life than continuous learning. I went through life constantly practicing (because if you don’t practice it, you lose it) the multi-disciplinary approach and I can’t tell you what that’s done for me. It’s made life more fun, it’s made me more constructive, it’s made me more helpful to others, and it’s made me enormously rich. You name it, that attitude really helps. – C.M., 2007

Munger believes that by going over your decision-making process and carefully using skills, ideas, and models from many disciplines, you can more consistently not be stupid. (49)

I don’t think it’s necessary to be as dumb as we were. – C.M., 2011

I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn. – C.M., 2011

If you cannot understand the business, then you cannot determine what you did wrong. If you cannot determine what you did wrong, then you cannot learn. If you cannot learn, you will not know what you’re doing, which is the real cause of the risk. (52)

Munger has chosen the word wisdom purposefully because he believes that mere knowledge, especially from only one domain, is not enough. To be wise, one must also have experience, common sense, and good judgment. How one actually applies these things in life is what makes a person wise. (53)

4. The Psychology of Human Misjudgment

Humans have developed simple rules of thumb called heuristics, which enable them to efficiently make decisions. Heuristics are essential; without them it would be impossible to make the decisions required to get through a normal day. They allow people to cope with information and computation overload and to deal with risk, uncertainty, and ignorance. Unfortunately, these heuristics can sometimes result in tendencies to do certain things that are dysfunctional. Of course, having a tendency is not destiny. That people will tend to do something does not mean that they will always do so, that they cannot learn to overcome the tendency, or that all people have the same tendency. (54)

The simple truth is that we aren’t adapted to face the world as it is today. We evolved in a very different environment, and it’s that ancestral evolutionary environment that governs the way in which we think and feel. We can learn to push our minds into alternative ways of thinking, but it isn’t easy, as we have to overcome the limits to learning posed by self-deception. In addition, we need to practice the reframing of data into more evolutionary, familiar forms if we are to process it correctly. – James Montier, Darwin’s Mind, 2006

Heuristics conserve scarce mental and physical resources, but the same process, which is sometimes beneficial, can lead people to harmful systematic errors. (55)

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about. – W.B., 1989

1. Reward and Punishment Superresponse Tendency

Upton Sinclair said it best of all. He said, “It’s very hard to get a man to believe non-X when his way of making a living requires him to believe X.” On a subconscious level, your brain plays tricks on you and you think [that] what is good for the true little me is what you should believe. – C.M., 2010

The iron rule of nature is that you get what you reward for. If you want ants to come, put sugar on the floor. – C.M., 2001

Reward and punishment super response tendency relates to what psychologists call reinforcement and what economists call incentives. (58)

An example of a really responsible system is the system the Romans used when they built an arch. The guy who created the arch stood under it as the scaffolding was removed. It’s like packing your own parachute. – C.M., 1993

2. Liking/Loving Tendency

…we are more influenced by people we like, and perhaps more importantly by people who genuinely like us. (61)

Munger likes to say that a year in which you do not change your mind on some big idea that is important to you is a wasted year. (61)

3. Disliking/Hating Tendency

Avoid evil, particularly if they’re attractive members of the opposite sex. – C.M., 2004

4. Doubt-Avoidance Tendency

[It’s] counter productive for a prey animal that is threatened by a predator to take a long time in deciding what to do. – C.M., 2005

…a brain’s processing load can be substantially reduced if a person rejects doubt. (63)

5. Inconsistency-Avoidance Tendency

The brain of man conserves programming spaces by being reluctant to change. – C.M., 1995

…be aware that once you say something in public, you may be blind to disconfirming evidence. (64)

All you need in this life is ignorance and confidence; then success is sure. – Mark Twain

6. Curiosity Tendency

I was born innately curious. If that doesn’t work for you, figure out your own damn system. – C.M., 2010

7. Kantian Fairness Tendency

Humans will often act irrationally to punish people who are not fair. (66)

8. Envy/Jealousy Tendency

…very primal emotions are triggered when humans see someone with something they don’t have, often causing dysfunctional thoughts and actions. Envy is an emotion designed to motivate people to acquire attributes and possessions that increase evolutionary fitness. Now that there is less scarcity in the world, envy has lost much of its value. Instead of motivating people for emotional fitness, envy just makes people unhappy. (68)

9. Reciprocation Tendency

10. Influence-from-Mere-Association Tendency

Liking tendency is more about being blind to the faults of people we like. With association theory, the compliance professional is trying to get you to do something like buy a financial service because it is endorsed or used by a famous actor. (70)

11. Simple, Pain-Avoiding Psychological Denial

One should recognize reality even when one doesn’t like it. – C.M., 2000

12. Excessive Self-regard Tendency

13. Over-Optimism Tendency

14. Deprival Super-Reaction Tendency

I mean people are really crazy about minor decrements down. … Huge insanities can come from just subconsciously overweighing the importance off hat you’re losing or almost getting and not getting. – C.M., 1995

…more commonly called loss aversion,… In other words, people tend to be too conservative in seeking gains and too aggressive in seeking to avoid losses. (75)

One of prospect theory’s most important contributions to finance is loss aversion, the idea that, for most people, losses loom larger than corresponding gains. The empirical evidence suggest we feel losses about two to two-and-a-half times more than we feel gains. – Michael Mauboussin, Aver and Aversion, 2005

15. Social-Proof Tendency

Learning to ignore the crowd and think independently is a trained response. (77)

…a Graham value investor is a marriage between a contrarian and a calculator. (77)

16. Contrast-Misreaction Tendency

Because the nervous system of man does not naturally measure in absolute scientific units, it must instead rely on something simpler. The eyes have a solution that limits their programming needs: the contrast in what is seen is registered. And as in sight, so does it go, largely, in the other senses. Moreover, as perception goes, so goes cognition. The result is man’s Contrast-Misreaction Tendency. Few psychological tendencies do more damage to correct thinking. Small-scale damages involve instances such as man’s buying an overpriced $1,000 leather dashboard merely because the price is so low compared to his concurrent purchase of a $65,000 car. Large-scale damages often ruin lives, as when a wonderful woman having terrible parents marries a man who oddly be judged satisfactory only in comparison to her parents. Or as when a man takes wife number two, who would be appraised as alright only in comparison to wife number one. – C.M., 1995

No one should buy an investment merely because it’s better than the lousy one you just saw or owned. Similarly, when you buy and asset, it should be the best investment of all the investments that are available to you anywhere. (78)

17. Stress-Influence Tendency

18. Availability-Misweighing Tendency

The great algorithm to remember in dealing with this tendency is simple: an idea or a fact is not worth more merely because it’s easily available to you. – C.M., 1995

Investors have a tendency to make decisions based on what they can easily recall. (79)

19. Use-It-or-Lose-It Tendency

…a skill degrades unless it is practiced regularly. … In the context of investing, it is both a (80) fact of life and a shame that so many people spend more time picking out an appliance than picking an investment or investment fund. (81)

20. Drug-Misinfluence Tendency

21. Senescence-Misinfluence Tendency

It is far better to wear out from work than rust out from inactivity. (83)

22. Authority-Misinfluence Tendency

[via: This reminded me of the Asiana Airlines crash at SFO, July 6, 2013]

People tend to follow people who they believe are authorities, especially when they face risk, uncertainty, or ignorance. (83)

When people are uncertain…they don’t look inside themselves for answers–all they see is ambiguity and their own lack of confidence. Instead, they look outside for sources of information that can reduce their uncertainty. The first thing they look to is authority. – Robert Cialdini

23. Twaddle Tendency

The definition of twaddle is simple; it is speech or writing that is silly or not true; nonsense. Prattle has an equally simple definition: to talk in a foolish way. (84)

24. Reason-Respecting Tendency

25. Lollapalooza Tendency

The lollapalooza tendency is the tendency to get extreme confluences of psychological tendencies acting in favor of a particular outcome. Munger believes that all of the tendencies, forces, and phenomena described previously in this book can interact with each other in self-reinforcing ways, which make the output of the whole of what is interacting greater than the sum of the parts. (87)

5. The Right Stuff

1. Patient

Success means being very patient but aggressive when it’s time. – C.M., 2004

Buffett has said that the stock market is designed to transfer money “from the active to the patient.” … You cannot predict when it will happen, but you can certainly wait patiently for the gift to be transferred to you. In this sense, the Graham value investing system is a discovery-based process rather than a prediction-based process. (92)

We get these questions a lot from the enterprising young. It’s a very intelligent question: you look at some old guy who is rich and you ask, “How can I become like you, except faster?” – C.M., 2003

At a fundamental level, investing is just one form of making a bet. It is essential, however, that the bet be made in a way that is investing (net present value positive) rather than gambling (net present value negative). (92)

2. Disciplined

We have this investment discipline of waiting for a fat pitch. If I was offered the chance to go into business where people would measure me against benchmarks, force me to be fully invested, crawl around looking over my shoulder, etc., I would hate it. I would regard it as putting me into shackles. – C.M., 2003

We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business. – C.M., 2005

You need patience, discipline, and an ability to take losses and adversity without going crazy. – C.M., 2005

We’ve got great flexibility and a certain discipline in terms of not doing some foolish thing just to be active–discipline in avoiding just doing any damn thing just because you can’t stand inactivity. – C.M., 2000

I think it’s possible for a great many people to live a life like that where there isn’t much risk of disaster and where they’re virtually sure to get ahead a reasonable amount. It takes a lot of judgment, a lot of discipline, and an absence of hyperactivity. By this method, I think most intelligent people can take a lot of risk out of life. – C.M., 2002

Speculators correlate activity with productivity or success, whereas Graham value investors correlate disciplined inactivity with success. (95)

3. Calm but Courageous and Decisive

I think there’s something to be said for developing the disposition to own stocks without fretting. – C.M., 2003

If you’re not willing to react with equanimity to a market price decline of 50 percent two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations. – C.M., 2010

You will get a few opportunities to profit from finding underpricing. There are actually people out there who don’t price everything as high as the market will easily stand. And once you figure that out, it’s like finding money in the street–if you have the courage of your convictions. – C.M., 1994

It’s amazing how fast Berkshire acts when we find opportunity. You can’t be timid–and that applies to all of life. – C.M., 2011

4. Reasonably Intelligent but Not Misled by Their High IQs

You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don’t have the cast of mind, you’re destined for failure even if you have a high IQ. – C.M., 2002

Very-high IQ people can be completely useless–and many of them are. – C.M., 2010

Einstein passed away and went to heaven, where he was informed that his room was not yet ready. He was told by an angel who was responsible for new arrivals: “I hope you will not mind staying for a while in a dormitory. I am sorry, but it is the best we can do right now.” The angel escorted Einstein to meet his roommates, saying, “This is your first roommate. She has an IQ of 180!” “That’s wonderful!” exclaimed Einstein. “We can discuss mathematics!” The angel then said, “Here is your second roommate. His IQ is 150!” “Why, that’s wonderful,” responded Einstein. “We can discuss physics!” The angel finally said, “Here is your third roommate. His IQ is 100!” “That’s wonderful!” said Einstein. “Where do you think interest rates are headed?” (98-99_

5. Honest

You ought to have an internal compass. So there should be all kinds of things you won’t do even though they’re perfectly legal. That’s the way we try to operate. – C.M., 2004

Character matters greatly in investing and in life. (100)

Walking a tightrope on the razor’s edge of something like honesty is unwise. (101)

6. Confident and Nonideological

Develop correct confidence in your judgment. – C.M., 2002

I have a black belt in chutzpah. I was born with it. – C.M., 2003

The principal problem with ideology is that you stop thinking when it comes to hard issues. Munge believes in regularly taking your best ideas, tearing them down, and looking for flaws as a means of improving yourself, which is hard to do if you are an ideologue. (102)

7. Long-Term Oriented

Almost all good businesses engage in “pain today, gain tomorrow” activities. – C.M., 2001

8. Passionate

…if you do not know about the link between passion and success, you have not been paying attention. People who are passionate tend to work harder and invest more in achieving their goals. Passionate people also read and think more. Passionate people tend to have an informational edge over others who are not as passionate. (104)

9. Studious

Learning from other people’s mistakes is much more pleasant. – C.M., 2012

In my whole life, I have known no wise people (over a brand subject matter area) who didn’t read all the time–none, zero. You’d be amazed at how much Warren reads, at how much I read. – C.M., 2004

Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day. – C.M., 2005

You gotta work where you’re turned on. – C.M., 2013

Carefully learning from the mistakes of others is a way to accelerate the learning process. Nothing vicariously exposes you to more mistakes committed by others than reading. (106)

10. Collegial

Finding colleagues who can help you in life is not something that happens naturally without effort. (107)

11. Sound Temperament

Having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. – C.M., 2005

How a person responds emotionally to events and other aspects of life is more important than intelligence for a Graham value investor. This emotional response to life’s ups and downs, often referred to by Munger as temperament, will vary greatly from investor to investor. (107)

Some people simply do not have a temperament that is suitable for investing. (108)

Unsuccessful investors are dominated by emotion. Rather than responding cooly and rationally to market fluctuations, they respond emotionally with greed and fear. – Seth Karman, Margin of Safety

Reaching the conclusion that you aren to cut out to be a Graham value investor is not a tragedy. In contrast, trying to be an active investor when you have the wrong temperament is almost certain to be a tragedy. (109)

12. Frugal

13. Risk Averse

Using [a stock’s] volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. – C.M., 1997

6. The Seven Variables in the Graham Value Investing System

First Variable: Determining the Appropriate Intrinsic Value of a Business

Intrinsic value can be defined simply: It’s the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it’s additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. – W.B., 2014

…a Graham value investor must remember that the valuation process is inherently imprecise. An imprecise value is perfectly acceptable to a value investor because the Graham value investor is looking for a margin of safety that is so substantial that precise calculation is unnecessary. (115)

When Munger and Buffett value a business, they use what they call owner’s earnings as the starting point. Owner’s earnings can be defined as: Net income + Depreciation + Depletion + Amortization – Capital expenditure – Additional working capital. (116)

Second Variable: Determining the Appropriate Margin of Safety

Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk. – Howard Marks, The most Important Thing, 2011

Valuation is the closest thing to the law of gravity that we have in finance. It’s the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital – James Montier, The Seven Immutable Laws of Investing, 2011

Third Variable: Determining the Scope of an Investor’s Circle of Competence

The idea behind the circle of competence is so simple that it is arguably embarrassing to say it outloud: when you do not know what you’re doing, it is riskier than when you do know what you’re doing. (121)

Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. 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. – C.M., 2009

When Charlie things about things, he starts by inverting. To understand how to be happy in life Charlie will study how to make life miserable; to examine how a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. – Li Lu, China Entrepreneur Magazine, 2010

Too many investors confuse familiarity with competence. … Using Facebook a lot does not make you qualified to invest in a social media startup. If you have not gone beyond simply using a product or service and have not taken a deep dive into the business of a company, you should not invest in that company. (123)

Fourth Variable: Determining How Much of Each Security to Buy

…it is better to know a lot about ten or fifteen companies than to know just a little about many. … Remember the task is not just to pick a quality company, but to find a misplaced bet. (127)

The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun? – C.M., 2005

Fifth Variable: Determining When to Sell a Security

In other words, we’re looking for a mispriced gamble. That’s what investing is. – C.M., 1994

There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: you’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 parentage points per annum compounded. – C.M., 2000

Sixth Variable: Determining How Much to Bet When You Find a Mispriced Asset

It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it’s given to human beings who work hard at it–who look and sift the world for a misplaced bet–that they can occasionally find one. – C.M., 1994

Munger’s bias against what he calls investment hyperactivity is quite strong. When in doubt, his suggestion is that you do nothing. (131)

Around here, I would say that if our predictions have been a little better than other people’s, it’s because we’ve tried to make fewer of them. – C.M., 1998

We try and predict what individual investments will swim well in relation to the tide. And then we tend to accept the effects of the tide as those effects fall. – C.M., 2001

In terms of finance theory, what a smart investor is looking for is optionality. (131)

Seventh Variable: Determining Whether the Quality of a Business Should Be Considered

If I’d never lived, Warren would have morphed into liking the better businesses better and being less interested in deep-value cigar butts. The supply of cigar butts was running out. … The natural drift was going that way without Charlie Munger. But he’d been brainwashed a little by worshiping Ben Graham and making so much money following traditional Graham methods that I may have pushed him along a little faster in the direction that he was already going. – C.M., 2005

More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. – W.B.

The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It’s just that simple. – C.M, 2000

We’ve really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high-quality businesses. And most of the other people who’ve made a lot of money have done so in high-quality businesses. – C.M., 1994

Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite–that is, consistently employ ever-grater amounts of capital at very low rates of return. – W.B., 1992, 1993

Eight Variable: Determining What Businesses to Own (in Whole or in Part)

We need to have a business with some characteristics that give us a durable competitive advantage. – C.M., 2009

We’re partial to putting out large amounts of money where we won’t have to make another decision. – C.M., 2001

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. – C.M., 1997

7. The Right Stuff in a Business

You cannot be a successful Graham value investor if you do not understand the underlying business. (139)

| One major fundamental aspect of any business is management. (139)

1. Capital Allocation Skills

“Can you help me? Sometimes my horse walks just fine and sometimes he limps.” The vet replied: “Not a problem. When he’s walking fine, sell him.” (140)

2. Compensation Systems That Create Alignment with Shareholders

3. Moat-Widening Skills

Munger would rather have a great moat than great managers.

Good jockeys will do well on good horses, but not on broken down nags. – W.B.

So you do get an occasional opportunity to get into a wonderful business that’s being run by a wonderful manager. And, of course, that’s hog heaven day. If you don’t load up when you get those opportunities, it’s a big mistake. … Averaged out, betting on the quality of business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business. – C.M., 1994

Munger wants managers of the business who have an ownership mentality toward the business, not just the attitude of manager. (145)

4. Management Already in Place with Integrity

Working with people who have integrity is its own reward. (146)

We would vastly prefer a management in place with a lot of integrity and talent. – C.M., 2009

Remember that reputation and integrity are your most valuable assets–and can be lost in a heartbeat. – C.M., 2005

When you mix raisins with turds, they are still turds. – C.M., 2000

Munger is not saying that management does not matter. Instead, he is saying that he would prefer to have a business that passes the idiot manager test and for the business to have talented management. (148)

5. The Rare Exceptional Manager

Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. – C.M., 1994

You should invest in a business that even a fool can run, because someday a fool will. – W.B., quoted by Bill Gates, 1996

Berkshire Math

Intelligent people make decisions based on opportunity costs–in other words, it’s your alternatives that matter. – C.M., 2003

Moats

1. Supply-Side Economies of Scale and Scope

2. Demand-Side Economies of Scale (Network Effects)

3. Brand

The psychologists use the term “social proof.” – C.M., 1994

4. Patents and Intellectual Property

Cumulative Impact of Many Factors

1. Berkshire Is Tax Efficient

2. Berkshire Has Low Overheard

3. Berkshire Is the Private Buyer of First Resort

4. Berkshire Has Permanent Capital

5. Berkshire Outperforms in Down Markets

The goal of a value investor is superior absolute performance, not relative performance. … Howard Marks pointed out the following rules for a value investor: “Rule No. 1: Most things will prove to be cyclical. Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” Buffett has his own version of this which states: “Rule No.1 is never lose money. Rule No. 2 is never forget rule number one.” (170)

6. Berkshire Benefits from Float

7. High-Quality Shareholders, Including Buffett and Munger

How long your moat lasts is called your competitive advantage period (CAP),… The rate at which a moat atrophies is similar to what academics call fade… (173)

Frequently, you’ll look at a business having fabulous results. And the question is, “How long can this continue?” Well, there’s only one way I know to answer that. And that’s to think about what could cause those results to stop occurring. – C.M., 2000

 

What happened to Kodak is a natural outcome of competitive capitalism. – C.M., 2012

[via: Or was it?]

What determines whether a company has a moat is qualitative (e.g., supply-side and demand-side economies of scale, brand, regulation, and intellectual property), but how you test to determine the strength of the moat is quantitative (i.e., it’s a mathematical exercise). (175)

cf. Measuring the Moat, Michael Mauboussin

Value Investing vs. Factor Investing

It is important to draw a clear and simple definitional distinction between value as a statistical factor (Fama/French) and value as an analytical style or goal (Ben Graham). (179)

About VIA

www.kevinneuner.com

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