Charlie Munger

The Complete Investor

Tren Griffin

• Publisher: Columbia University Press
• Year: 2015
• ISBN:
  9780231540414
• Topic: Business
• Subtopic: Decision Making
• Index: Business

Charlie Munger, Berkshire Hathaway's visionary vice chairman and Warren Buffett's indispensable financial partner, has outperformed market indexes again and again, and he believes any investor can do the same. His notion of "elementary, worldly wisdom"—a set of interdisciplinary mental models involving economics, business, psychology, ethics, and management—allows him to keep his emotions out of his investments and avoid the common pitfalls of bad judgment.

Munger's system has steered his investments for forty years and has guided generations of successful investors. This book presents the essential steps of Munger's investing strategy, condensed here for the first time from interviews, speeches, writings, and shareholder letters, and paired with commentary from fund managers, value investors, and business-case historians. Derived from Ben Graham's value-investing system, Munger's approach is straightforward enough that ordinary investors can apply it to their portfolios. This book is not simply about investing. It is about cultivating mental models for your whole life, but especially for your investments.

1

THE BASICS OF THE GRAHAM VALUE INVESTING SYSTEM

LET’S GET STARTED with the most fundamental questions: what is the Graham value investing system, and who can benefit from it?

[Ben Graham] was trying to invent a system anybody could use.

—CHARLIE MUNGER, UNIVERSITY OF SOUTHERN CALIFORNIA (USC) BUSINESS SCHOOL, 1994

The critical point about Graham’s system is that it is simple. Too many people take a situation and create complexity where none is needed. Take, for example, the old joke about unnecessary complexity at the National Aeronautics and Space Administration (NASA). The storyteller starts by saying that early in the space program NASA discovered that ballpoint pens would not work in zero gravity. NASA scientists spent a decade and huge amounts of money developing a pen that wrote not only in zero gravity but on almost any surface, at extremely low temperatures, and in any position of the astronaut. The punch line is: the Russians instead used a pencil. Graham value investing has the inherent simplicity of the pencil.

Munger believes that Ben Graham developed his value investing system to be relatively simple to understand and implement and thus valuable to an ordinary person. Graham value investing is not the only way to actively invest or speculate. For example, venture capital and private equity are very different approaches to investing from value investing, but Munger believes that these alternative active investing systems are not as accessible to the ordinary investor as Graham value investing is. So-called index-based (or passive) approaches to investing will be discussed shortly.

Warren Buffett says that investing is simple but not easy. When Graham value investors make mistakes, it is usually because they have done things that are hard for humans to avoid, like forgetting the inherent simplicity of the Graham value investing system, deviating from the fundamentals of the system, or making psychological or emotional mistakes related to implementation of the system.

Because investing is a probabilistic activity, decisions made in ways that are fundamentally sound may sometimes produce bad results. Sometimes a person will produce an unfavorable result even when his or her process is well constructed and executed. However, in the long run, it is always wise to focus on following the right process over any specific, intermediate outcome. Munger believes that when creating a successful investing process, complexity is not the investor’s friend.

We have a passion for keeping things simple.

—CHARLIE MUNGER, WESCO ANNUAL MEETING, 2002

Peter Bevelin’s book Seeking Wisdom: From Darwin to Munger has a section on the importance of simplicity. Bevelin advised: “Turn complicated problems into simple ones. Break down a problem into its components, but look at the problem holistically.”¹ Keeping things as simple as possible, but no more so, is a constant theme in Munger’s public statements. In a joint letter to shareholders, Munger and Buffett once wrote: “Simplicity has a way of improving performance through enabling us to better understand what we are doing.”²

By focusing on finding decisions and bets that are easy, avoiding what is hard, and stripping away anything that is extraneous, Munger believes that an investor can make better decisions. By “tuning out folly” and swatting away unimportant things “so your mind isn’t cluttered with them … you’re better able to pick up a few sensible things to do,” said Munger.³ Focus enables both simplicity and clarity of thought, which in Munger’s view leads to a more positive investing result.

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

—CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 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.

—CHARLIE MUNGER, WESCO ANNUAL MEETING, 2002

The Graham value investing system is designed to remove from the process any decisions that may lead an investor to make mistakes. The “yes” basket is tiny compared to the other two baskets because an investing decision that results in a “yes” will happen rarely.

Not all companies can be accurately valued using a Graham value investing process. It is perfectly natural for a person who follows the Graham system to acknowledge that fact and move on to other easy decisions. It is often disorienting to some people that a Graham value investor would admit to not knowing how to accurately value a company. Munger made this point with an analogy:

Confucius said that real knowledge is knowing the extent of one’s ignorance. Aristotle and Socrates said the same thing. Is it a skill that can be taught or learned? It probably can, if you have enough of a stake riding on the outcome. Some people are extraordinarily good at knowing the limits of their knowledge, because they have to be. Think of somebody who’s been a professional tightrope walker for 20 years—and has survived. He couldn’t survive as a tightrope walker for 20 years unless he knows exactly what he knows and what he doesn’t know. He’s worked so hard at it, because he knows if he gets it wrong he won’t survive. The survivors know.

—CHARLIE MUNGER, JASON ZWEIG INTERVIEW, 2014

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.

The successful Graham value investor also works diligently to reduce the downside risk of any investment. For this reason, the Graham value investing system tends to shine most brightly during a flat or falling stock market. The Graham value investing system is intentionally designed to underperform an index in a bull market; this is confusing to many people. The underperformance of the Graham value investing system during a bull market is an essential part of this style of investing. 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. Consider what Seth Klarman wrote in Margin of Safety: “Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”⁴ He added, “The payoff from a risk-averse, long-term orientation is—just that—long term.”⁵

Here is a story to further illustrate this point. An investor was walking in a park one day when she saw a frog sitting on a log at the edge of a pond. The frog looked right at her and said, “Excuse me, would you happen to be an investor?”

The investor replied, “Yes, I am. Why do you ask?”

“Well,” replied the frog, “I am a stock speculator. My best client did not like my investing results so he put a spell on me and now I am a frog. The spell can be broken if an investor will kiss me.”

The investor immediately reached over and picked up the frog, put him in her purse, and then started to walk home. The frog was concerned that he was not receiving a kiss and asked, “What are you doing? When do I get my kiss?”

The investor replied, “I’m not kissing you ever. You’re worth a lot more to me as a talking frog than as a stock speculator.”

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. This is not a tragedy, since the Graham value investing system is not the only way to invest successfully. It is important to note that the goal of the Graham value investor is superior absolute performance, not just relative performance. An investor cannot spend the output of relative performance, only actual performance.

Failing conventionally is not the goal of the Graham value investor. Munger’s approach is to invert the methods of most people:

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.”

—CHARLIE MUNGER, WESCO ANNUAL REPORT, 1989

What’s the flip side, what can go wrong that I haven’t seen?

—CHARLIE MUNGER, FORBES, 1969

Munger’s inclination to invert the usual approach to solving a problem is clearly evident when it comes to investing. In his view, investors will do better financially simply by being less stupid. One core idea Munger has borrowed from algebra is that many problems are best addressed backward. For example, by avoiding stupidity, a person can often discover what he or she wants through subtraction. By eliminating the stupid paths that one can take in life, a person can find the best way forward, even given inevitable risk, uncertainty, and ignorance. Not only does one often know a lot more about what is wrong than what is right, but disproving something may also require only one observation. In short, Munger’s view is that being smart is often best achieved by not being stupid. Once, in an interview with Jason Zweig, Munger said it simply: “Knowing what you don’t know is more useful than being brilliant.”

Munger strives to find investments for which a significantly positive outcome is obvious. Because this type of investment is identified only rarely, Munger suggests that one be very patient but also very ready to aggressively invest when the time is right. To use a baseball analogy, Munger knows there are no called strikes in investing, so there is no need to swing at every pitch. When you find an obvious bet with a big upside, Munger’s advice is simple: bet big!

All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers’ costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers’ take, which median result may well be somewhere between unexciting and lousy.

—CHARLIE MUNGER, PHILANTHROPY, APRIL 1999

The point Munger makes immediately above about investing as a less-than-zero sum game after fees and expenses is mathematically irrefutable. John Bogle, the founder of the nonprofit mutual fund provider Vanguard, is perhaps the most successful person to ever evangelize this simple idea. Bogle wrote, “In many areas of the market, there will be a loser for every winner, so, on average, investors will get the return of that market less fees.”⁶ Columbia Business School professor, investor, and author Bruce Greenwald had his own take on this point, which I find compelling:

Only in Woebegone can people out-invest the market. The average performance of all investors has to be the average performance of all assets. It’s a zero-sum game if you judge it relative to the market. There are two sides to every trade. The best way to think about it is that every time you buy a stock, someone is selling … So you always have to ask the question, “Why am I on the right side of this trade?”

—BRUCE GREENWALD, BETTERMENT INTERVIEW, 2013

Graham value investing would not work if markets were perfectly efficient. For this reason, the market’s folly is the fundamental source of the Graham value investor’s opportunity.

Munger’s take on why investing is hard is simple:

The idea that everyone can have wonderful results from stocks is inherently crazy. Nobody expects everyone to succeed at poker.

—CHARLIE MUNGER, DAILY JOURNAL MEETING, 2013

If [investing] weren’t a little difficult, everybody would be rich.

—CHARLIE MUNGER, DAMN RIGHT, 2000

For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.

—CHARLIE MUNGER, WESCO ANNUAL MEETING, 2008

Because the degree to which investors may collectively act like “damn fools” varies over time, opportunities to generate investment gains will inevitably arrive in a lumpy fashion. Successful Graham value investors spend most of their time reading and thinking, waiting for significant folly to inevitably raise its head. Although Graham value investors are bullish about the market in the long term, they do not make investing decisions based on short-term predictions about stocks or markets. When confronted with this idea, people will often ask, “Do you mean Graham value investors wait for mispriced assets to appear rather than predict...