Wednesday, 7 September 2016

Charlie Munger: Investment Philosophy

Charlie Munger Resource Page

Charlie Munger, value investor, lawyer, philanthropist, Vice-Chairman of Berkshire Hathaway Corporationand Warren Buffett’s right-hand man. He is also chairman of the Daily Journal Corporation and a director of Costco Wholesale Corporation.

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Systematically you get ahead, but not necessarily in fast spurts. Nevertheless, you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day – if you live long enough – most people get what they deserve.” — Charlie Munger

Charlie Munger: Investment partnership

Charlie Munger moved back to Omaha during 1959 and was soon introduced to Warren Buffett. The two immediately became friends. The two friends began speaking for hours every week discussing potential investment ideas and eventually in 1962, Buffett convinced Munger to quit his law job and start his own investment partnership.

“Warren talked me into leaving the law business, and that was a very significant influence on me. I was already thinking about becoming a full-time investor, and Warren told me I was far better suited to that. He was right. I would probably have done it myself, but he pushed me to it. I have to say, it isn’t an easy thing to work very hard for many years to build up a significant career, as I had done, and then to destroy that career on purpose. That would have been a lot harder to do if not for Warren’s influence on me.

It wasn’t a mistake. It worked out remarkably well for both of us and for a lot of other people…” --Charlie Munger The Wall Street Journal September 2014.

Charlie Munger’s investment partnership opened for business during 1962 and immediately started to outperform. Over its life, from 1962 to 1975, the partnership returned an average of 24.3% per annum for partners, compared to the DJIA, which returned 6.4% over the same period.

Charlie Munger quit the money management business during 1978 and moved to join forces with Buffett full-time, by becoming Berkshire Hathaway Inc.’s vice chairman.

Charlie Munger: Investment philosophy

Charlie Munger had no such attachment to Benjamin Graham, or his cigar butt style of investing.

“I don’t love Ben Graham and his ideas the way Warren does. You have to understand, to Warren -- who discovered him at such a young age and then went to work for him -- Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.

I think Ben Graham wasn’t nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals -- probably the only intellectual -- in the investing business at the time.” -- Charlie Munger The Wall Street Journal September 2014.

Rather than seeking out deep value, Munger looked for quality and during 1965 he convinced Warren Buffett to adopt the same style.

Indeed, that year he encouraged Buffett to make one of his more famous bolt-on acquisitions for Berkshire; See's Candies.

See’s was a legendary West Coast manufacturer and retailer of boxed chocolates, then annually earning about $4 million pre-tax while utilizing only $8 million of net tangible assets. Alongside the tangible asset balance, See’s had one huge asset that did not appear on its balance sheet: a broad and durable competitive advantage that gave it significant pricing power:

“…The family controlling See’s wanted $30 million for the business, and Charlie rightly said it was worth that much. But I didn’t want to pay more than $25 million and wasn’t all that enthusiastic even at that figure. (A price that was three times net tangible assets made me gulp.) My misguided caution could have scuttled a terrific purchase. But, luckily, the sellers decided to take our $25 million bid. To date, See’s has earned $1.9 billion pre-tax, with its growth having required added investment of only $40 million. See’s has thus been able to distribute huge sums that have helped Berkshire buy other businesses that, in turn, have themselves produced large distributable profits. (Envision rabbits breeding.) Additionally, through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments.”– Warren Buffett Berkshire 2014 letter.

At first, Buffett was reluctant to pay more than book value because he was schooled in value investing. However, Munger was adamant that he do the deal.

As it turns out the deal has been wildly successful, producing more than $1bn in pretax earnings since, a return of more than 4,000%.

Even though Munger was influencing Buffett’s investment decision early on, he continued to manage his own partnership until the late 70s. His style at the time was to seek out arbitrage opportunities and look for cigar butts.

“Munger bought cigar butts, did arbitrage, even acquired small businesses...he said to Ed Anderson, “I just like the great businesses.” He told Anderson to write up companies like Allergan, the contact-lens-solution maker. Anderson misunderstood and wrote a Grahamian report emphasizing the company’s balance sheet. Munger dressed him down for it; he wanted to hear about the intangible qualities of Allergan: the strength of its management, the durability of its brand, what it would take for someone else to compete with it.

Munger had invested in a Caterpillar tractor dealership and saw how it gobbled up money, which sat in the yard in the form of slow-selling tractors...Munger wanted to own a business that did not require continual investment, and spat out more cash than it consumed...Munger was always asking people, “What’s the best business you’ve ever heard of?”

He wanted to get really rich, really fast. He and Roy Tolles made bets on whose portfolio would be up more than one hundred percent in a year. And he was willing to borrow money to make money, whereas Buffett had never borrowed a significant sum in his life…

Munger did enormous trades [with borrowed money] like British Columbia Power, which was selling at around $19 and being taken over by the Canadian government at a little more than $22. Munger put not just his whole partnership, but all the money he had, and all that he could borrow into an arbitrage on this single stock—but only because there was almost no chance that this deal would fall apart.” -- The Snowball: Warren Buffett and the Business of Life.

In the late 1990’s/early 2000’s Charlie Munger’s quality over value slant started to really shine through in both his and Warren’s writings. For example, in Charlie’s speech “A Lesson on Elementary, Worldly Wisdom As It Relates to Investment Management & Business.” given in 1995 he stated that:

“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.

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.

So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.

How do you get into these great companies? One method is what I'd call the method of finding them small get 'em when they're little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it's a very beguiling idea. If I were a young man, I might actually go into it.”

Then during 2003, Warren Buffett made the following statement regarding Coca-Cola, See's Candies, and Buffalo News at the 2003 Berkshire Hathaway meeting:

“The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It's an enormous advantage.”

This mentality had a dramatic effect on Berkshire Hathaway’s performance over the years. All you need to do is to look at Buffett’s acquisition of See’s Candies in the late 1960’s, to realize that without Charlie Munger’s quality over value influence on Buffett, Berkshire wouldn’t have become the American corporate giant it is today.

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