Alibaba - Jack Ma's first letter after the IPO of Alibaba.

Dear Alibaba Group Shareholders,

I would like to take this opportunity, on behalf of everyone at Alibaba Group, to express my deepest appreciation to our customers, employees, investors and partners who have believed in us and supported us over the past year as we embarked on our journey as a public company.

It has been a volatile time for global markets, and we have watched these developments closely. We have a clear vision of where Alibaba is and where it’s headed. Over the past year we have become healthier, stronger and more confident and have made great progress in our strategic development.

What I said on the occasion of our IPO last year when we raised US$25 billion bears repeating. What we earned was not money, but trust. Maintaining that trust means we must listen carefully to the views of others. It also means we must reflect on the challenges we have when communicating with our shareholders and the public. The majority of our products and services are not accessible outside China, which makes it difficult for our overseas shareholders and stakeholders to fully understand the company and what it is like to be an Alibaba customer. As a result, many are trying to understand us through the lens of an outsider and may not have a full or accurate understanding of who we are and what we do.

So, I would like to share some of our thoughts about Alibaba Group here with you:

I. ALIBABA GROUP’S STRATEGY IS TO BUILD THE INFRASTRUCTURE OF COMMERCE FOR THE FUTURE. E‑COMMERCE IS ONLY THE FIRST STEP.

Many people confuse us with other e‑commerce retailers and therefore assess our business model solely on the basis of the growth rate of our gross merchandise volume (GMV). In fact, this narrow definition of e‑commerce is only a fraction of the Alibaba Group strategy. What we are building is an open, transparent and collaborative infrastructure for commerce.

At the end of June 2015, Alibaba Group has 34,000 employees, and fewer than 10,000 of those employees are directly involved in our China retail marketplaces and related GMV. Our platform model is highly efficient as we generate close to RMB3 trillion GMV at an average of nearly RMB300 million per person. We continue to improve our technology and products in order to win market share through innovation and technology — we never rely on the strategy of simply increasing headcount. In the coming years, we will have the opportunity and capability to build the most efficient business organization among the large global companies while creating the most job opportunities through our ecosystem.

Setting aside the employees working on our China retail marketplaces, our B2B business and backroom operations teams, close to half of Alibaba’s workforce is focused on building businesses that have long-term strategic importance. We firmly believe that only by investing in the future and adhering firmly to our long-term strategy will Alibaba have a true future.

It is only through Internet technology and big data that we can establish a truly meaningful innovative infrastructure for commerce that will provide comprehensive support to small and medium-sized enterprises. The less developed business infrastructure in China provides Alibaba a unique opportunity to create the infrastructure of China’s future commerce, not just the infrastructure of e‑commerce. Around half of Alibaba Group’s workforce and our affiliated companies, including Ant Financial and Cainiao, are working on important areas of our ecosystem, including logistics, Internet finance, big data, cloud computing, mobile Internet, advertising and the so-called double H industries — Health and Happiness (the big data-based healthcare and digital entertainment businesses which will take 10 years to become data-driven).

Today, Cainiao, our logistics affiliate, helps handle around 10 billion packages every year; our affiliated Internet financial arm serves more than 400 million active users; our cloud computing business, which is maintaining an annual growth rate of over 100%, is taking a leading role in the world; and our mobile-based products, including search, map and browsers, are providing vital infrastructure services to Chinese users. In the future, we will continue to provide a broad spectrum of services to tens of millions of Chinese companies, spanning e‑commerce, financial services, logistics, cloud computing and big data, marketing, and cross-border trading services.

Our strategy is long-term, so although the above new platforms we are building are still in progress and have yet to yield substantial revenue, their prospects are exciting and we are making headway.

We firmly believe the era of heavy business conglomerates is gone. The economy of today and tomorrow will rely on a platform and ecosystem approach. Sustainable growth can only be achieved when enterprises operate within an ecosystem, participate in collective development and share common interests.

Today, some of our strategic businesses are yielding initial results. Take logistics as an example. In fiscal year 2015, Alibaba generated more than 24 million packages on a daily basis handled by the more than one million delivery personnel employed by our logistics partners. We expect that in 10 years, the number of delivery personnel in China will exceed 10 million. This growth will be driven by social forces rather than by any single company. We also believe that over the next three years, Cainiao’s unique services will bring significant changes to the logistics sector and users will be able to enjoy enhanced and standardized services. Logistics will become a standard offering of e‑commerce companies rather than a core competence. Therefore, Cainiao’s mission is to enable delivery firms to provide standardized and formalized services.

II. CHINA’S ECONOMIC DEVELOPMENT AND ITS RELATIONSHIP WITH ALIBABA GROUP

Recently, signals of China’s economic slowdown have triggered widespread concern and, I believe, overreaction around the world. This reaction illustrates how China’s economy has been fully integrated into the world economy with a considerable degree of influence. However, we believe an economy that continues to experience such rapid growth is neither realistic nor sustainable and China shouldn’t aim for such growth.

For example, the cost of high-speed economic growth has been the destruction of ecological resources. After many government vows to upgrade the economy, the financial crisis in 2008, fatigue in investment and exports and unrealistic expectations of ever-faster growth, China’s economy has reached a point where it must upgrade and update. The current GDP growth pattern is not sustainable. In fact, if China continues to pursue the high growth rates of the past, then China will pay a high price.

I firmly believe that for the future, the advantages of a slowdown in China’s economic prospects far outweigh the disadvantages. China’s economic development is no longer in need of increasing its numbers, but of increasing its quality. China is the world’s second-largest economy, and even with a GDP growth rate of 5%, the growth rate is more than double that of developed economies.

In the past 30 years, the Chinese economy has benefited from the liberalization of thinking and a more open economic policy. However, we have not focused on fostering the creativity and innovation of people, which is the most important factor in stimulating productivity. High GDP growth relies on the capacity of manufacturing, while the improvement in quality of life relies on innovation. I believe there is much more we can do in this regard.

China’s economy is transitioning from an export sales-driven economy to a domestic-consumption economy, and from investing in infrastructure to operating infrastructure. China will use advanced technology and a new market-driven approach to solve the issue of sustainable development. All in all, China’s economy has immense potential. It will not be easy, but China’s future “economic miracle” will lie in its ability to boost productivity and its use of big data and Internet technology to stimulate domestic consumption and generate exponential development opportunities.

Will the economic slowdown have any impact on Alibaba?

At the end of March 2015, the GMV of Alibaba’s China retail marketplaces had already reached RMB2.44 trillion, accounting for 9% of China’s retail consumption. We predict that over 50% of China’s consumption will be conducted online within 10 years, and that means massive potential for the e‑commerce market. On this basis, more than 80% of China’s enterprises will need to use an Internet-based e‑commerce platform, logistics network, financial services, cloud computing and cross-border services. Alibaba’s investments today will make this possible. Our business is no doubt closely related to the Chinese economy, and we believe the services Alibaba Group will provide in the future will be the fourth indispensable resource for enterprises, after water, electricity and land.

I do not agree with the notion that consumption will decline as economic growth slows. It is inaccurate to think that the slowdown of the Chinese economy means that Chinese people are unwilling to spend. The Chinese lifestyle philosophy is different from that of the West. Consumers in developed Western economies are good at spending the money they believe they will earn in the future. To the contrary, Chinese people are constantly saving for the future. The saving rates in China are some of the highest in the world. During economic downturns, Western consumers may have trouble borrowing to maintain their lifestyles, but their Chinese counterparts have savings for retirement or for times of crisis. Therefore, slower economic growth does not mean declining purchasing power. With the convenience and value-for-money merchandise offered by e‑commerce, consumers are becoming more and more willing to shop online.

China’s middle-class population is close to 300 million and in 10 years, that number is going to reach 500 million. Yet the level of consumption among the middle class is still well below their income level. Bearing in mind that consumption is triggered by innovation, it follows that Alibaba’s business model will be a strong driver of domestic consumption in China going forward. This is clearly illustrated by the consumption volume of Alibaba’s 11.11 Global Shopping Festival. China does not lack domestic consumption power. Being thoughtful about how to ignite that power is the key. Whether it is about facilitating imports, driving domestic demand in tier 3 and 4 cities or unleashing the purchasing power of a rural population more than 600 million strong, Alibaba has a great deal to offer.

Great companies are born in challenging times. We believe the transformation of the Chinese economy from a focus on quantity to quality will lead to the formation of some of the world’s most remarkable enterprises. Alibaba hopes it will become one of them.

III. FUTURE DEVELOPMENTS: GLOBALIZATION, RURAL DEVELOPMENT AND BIG DATA CLOUD COMPUTING

Our key priorities for the next decade will be globalization, development of the rural economy and big data.

In terms of globalization, we aim to help small- to medium-sized businesses around the world expand beyond their borders by leveraging the power of e‑commerce, Internet financing, big data, and marketing and logistics platforms. We believe the experience of Alibaba Group in China can be applied globally, giving all SMEs the opportunity to participate and compete in a transparent and fair marketplace. We further believe that future economic globalization will allow consumers everywhere to access a truly global purchasing experience. We have been preparing for a considerable amount of time to make this vision a reality. It may take another one or two decades to complete the mission, but we won’t quit until we live up to our true mission “to make it easy to do business anywhere.”

China has a rural population of more than 600 million, and the business infrastructure in China’s rural areas is poor. However, with the growing popularity of mobile phones, tremendous changes have taken place in these areas. Taobao Marketplace and Tmall, in particular, link farmers directly with urban life. We are now renovating rural infrastructure by leveraging mobile Internet technology, big data, logistics and Internet financing. We do this not only because of the tremendous market potential, but also to close the digital divide, promote information equity and help alleviate poverty through economic opportunity. We are witnessing great changes in China’s countryside, and we encourage our shareholders to visit China’s rural areas to see these changes for themselves. What we are doing today may become a development model for many developing countries in the future. At this historic time, Alibaba Group must embrace change, invest in change and drive change.

Over the past six years, Alibaba Group has made a significant strategic investment in cloud computing and big data services. We believe that mankind is departing the IT era and entering a new era of DT (data technology). In the society of tomorrow, data will be the most important means of production, innovation and social development. People and data will be interwoven. We must continue to invest in the development of data technology. Alibaba is fundamentally a data-driven company. We firmly believe that we will see substantial returns from the investments we have made in data and related technologies over the past six years and will continue to make in years to come. Still in its infancy, we are working to make data and cloud computing the foundation for an inclusive economy. The future potential is massive.

ALIBABA’S CHALLENGE

Alibaba has challenges, but what concerns us may be different from what some may think, and we never shy away from talking about competition or our competitors. Over the past 16 years, we’ve never been short of competitors, nor have we benefited from any form of protection. We’ve blazed our own trail through fierce market competition. We have learned to survive while maintaining our ideals and values. It hasn’t been easy.

We have never been afraid of confronting new challenges. We excel over our competition by engaging in effective strategic planning and flawless execution.

Alibaba seeks to initiate a business revolution. Our future is the infrastructure of commerce. We are in the business of enabling sales transactions — this means we never compete with the businesses on our platforms. Our so-called competitors are also businesses that we want to support and help scale. In other words, it is not appropriate and an oversimplification to view companies that are engaged in e‑commerce as competitors to the Alibaba Group. Comparing us to other e‑commerce companies is not an apples-to-apples comparison. In our case, our relationship with merchants on our platform is more like apples and the apple tree.

Our biggest challenge is not our competition, but our ability to grasp the future and manage ourselves. With our ambitious vision and unique ecosystem, we need professional talents from different fields, a unique culture and an organization that can adapt to future developments. Our colossal business ecosystem and intertwined structure will require not just more corporate managers, but leaders, innovators and trailblazers. This is a tremendous challenge for a 16-year-old company with a workforce with an average age of only 29. There is almost no reference for us when we develop our talents, corporate culture, management model, and the relationship between our business units and government departments. As a young company, we are committed to a mighty challenge, one that’s unprecedented and beyond the imagination. But this is a golden opportunity. We have told ourselves over the past 16 years: If not now, when? If not us, who?

This is the first letter I have published since the IPO on my thoughts about Alibaba’s development strategy to our investors. Thank you again for investing in us and being part of the development of a future business ecosystem. We are grateful for the trust you have placed in us and what we will accomplish in the future.

JACK MA

Executive Chairman

Alibaba Group Holding Limited

http://ar.alibabagroup.com/2015/letter.html


http://ar.alibabagroup.com/2015/index.html

Charlie Munger: Investment advice

1. While carrying out any investment assessment, first calculate risk.
2. Make decisions on your own and be self-determining. After listing risks, you make decisions based on involved risks. Whatever you decide, you should be be self-determining regarding your decisions and actions.
3. Plan to encompass a few imminent, possible complications.
4. Being humble and admitting where you are deficient the first step towards perception. Committing mistakes is human, and admitting your mistakes is part of being humble.
5. In order to reduce errors and mistakes, investigate thoroughly. Accepting mistakes is good but nothing is as good as avoiding mistakes.
6. While making any investment capital is assigned, allocating capital and assets intelligently is a must.
7. Oppose the normal inclination to do something and have patience.
8. In appropriate situations, be determined and confident.
9. Accept change. Change is a common phenomenon of any business and investment so recognize, accept, and acknowledge it instead of fighting it tooth and nail.
10. Pay attention. When you lack attention and concentration, you've taken your first step towards failure.

http://www.valuewalk.com/charlie-munger-page/

Charlie Munger: Quotes

“All intelligent investing is value investing - acquiring more than you are paying for. You must value the business in order to value the stock.”

“The best thing a human being can do is to help another human being know more.”

“Acquire worldly wisdom and adjust your behavior accordingly. If you are new, behavior gives you a little temporary unpopularity with your peer group then to hell with them.”

“In my whole life, I have known no wise people (over a broad subject matter area) who did not read all the time - none, zero.”

“Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. Then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available because of prudence and patience in the past.”

“I find it quite useful to think of a free-Market economy - or partly free Market economy - as sort of the equivalent of an ecosystem. Just as animals flourish in niches, people who specialize in some narrow niche can do very well.”

“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash flow than you are paying for. Move only when you have an advantage.”

“Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company's owners are slim at best.”

“It is not given to human beings to have such talent that they can just know everything about everything all the time. However, it is given to human beings who work hard at it. Who look and sift the world for a mispriced bet - that they can occasionally find one.”

“In addition, the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don't. It is just that simple.”

“Mimicking the herd invites regression to the mean.”

“Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”

“Acknowledging what you do not know is the dawning of wisdom.”

“Above all, never fool yourself, and remember that you are the easiest person to fool.”

“Determine value apart from price; progress apart from activity; wealth apart from size.”

“Recognize reality even when you do not like it - especially when you don't like it.”

“Remember that reputation and integrity are your most valuable assets - and can be lost in a heartbeat.”

“I think records of accomplishment are very important. If you start early trying to have a perfect one in some simple thing like honesty, you are well on your way to success in this world.”

“We try more to profit from always remembering the obvious than from grasping the esoteric.”

“Intelligent people make decisions based on opportunity costs.”

“If all you succeed in doing in life is getting rich by buying little pieces of paper, it is a failed life. Life is more than being shrewd in wealth accumulation.”

“Someone will always be getting richer faster than you. This is not a tragedy.”

“Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you are not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you will end up with one hell of a result.”

“You must have the confidence to override people with more credentials than you whose cognition is impaired by incentive-caused bias or some similar psychological force that is obviously present. Nevertheless, there are also cases where you have to recognize that you have no wisdom to add - and that your best course is to trust some expert.”

“The safest way to try to get what you want is to try to deserve what you want. It is such a simple idea. It is the golden rule. You want to deliver to the world what you would buy if you were on the other end.”

“I am not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I have reached that state.”

“Thinking that what is good for you is good for the wider civilization, and rationalizing foolish or evil conduct, based on your subconscious tendency to serve yourself, is a terrible way to think.”

“If you do not allow for self-serving bias in the conduct of others, you are, again, a fool.”

“Avoid working directly under somebody you do not admire and don't want to be like.”

“Intense interest in any subject is indispensable if you are really going to excel in it.”

“Never, ever, think about something else when you should be thinking about the power of incentives.”

“Fixable but unfixed bad performance is bad character and tends to create more of it, causing more damage to the excuse giver with each tolerated instance.”

“Good businesses are ethical businesses. A business model that relies on trickery is doomed to fail.”

“In my whole life, I have known no wise people who did not read all the time-none, zero. You would be amazed at how much Warren reads-and at how much I read. My children laugh at me, they think I’m a book with a couple of legs sticking out.”

Charlie Munger's investments as Chairman of Daily Journal Corporation

Charlie Munger: Daily Journal Corporation

Charlie Munger is best known for his career as Vice-Chairman of Berkshire Hathaway Corporation and for being Warren Buffett’s right hand man. He is also chairman of the Daily Journal Corporation and has been instrumental in the Journal’s growth over the past six years.

The Daily Journal is a publisher specializing in legal text. The Daily Journal provides news of interest to members of the legal profession, specializes in public notice advertising, publishing state-mandated notices of death, fictitious business names, and sells software used to administer court cases. Charlie Munger started his working life as a lawyer, so the Daily Journal is a natural fit for him.

The Daily Journal was a strong business up until the financial crisis. Return on equity averaged 25% to 30% per annum; cash conversion was 70% per annum on average, and book value doubled between 2005 and 2008. However, since 2010 revenue growth has slowed to around 2.6% per annum and net income has fallen by 75%. EBITDA has more than halved.

Luckily, during the first quarter of 2009, Charlie Munger used $15.5 million of the Daily Journal’s cash to purchase a number of securities for the company. At first, neither Charlie Munger nor the Journal disclosed these positions, (although with both Munger and Rick Gurin working at the Journal, these positions we certain to value orientated and low-risk). This post from The Value Investors Club blog post, written only a few months after Munger started buying shows the secrecy surround the transactions:

“During the first quarter of 2009, Charlie Munger, Chairman of Daily Journal Corp. (DJCO), made a significant redeployment of the company’s excess cash into an investment in common equities. Based on circumstantial evidence, we believe (but cannot be 100% certain since the Company has not disclosed what its invested in) that Munger purchased shares of Wells Fargo & Co (NYSE:WFC) and/or possibly U.S. Bancorp (NYSE:USB) at their recent early-March lows.”

“As such, DJCO now contains a hidden asset that may not be fully reflected in its current share price.”

“Based on circumstantial evidence, it appears possible that Munger plunked $15.5mm of DJCO cash to buy WFC (or USB or both). If this speculation on DJCO's equity purchase(s) is correct, then that $15.5 million investment which rose to $24.7mm at the end of March would now be up to $33-42 million at today's prices for USB/WFC. Thus in summary, DJCO looks cheap at a market cap of $64.5 million...we believe there is good value in DJCO based on the strength of Munger's legendary capital allocation skills.” -- Value Investors Club July 2009.

Charlie Munger started buying securities with the Journal’s cash for two reasons. Firstly, value:

“We bought Wells Fargo & Co (NYSE:WFC) stock when it was at $8, and I don’t think we will have another opportunity like that.” --Charlie Munger Daily Journal 2015 Meeting [FULL NOTES]
Secondly, the Journal’s board believed that jumping into stocks was the safest move during the financial crisis:

“The board recognized that this decision would be contrary to the conventional (but questionable) notion that the least risky way to preserve corporate capital for the long-term benefit of stockholders is to invest it in government bonds at interest rates approximating zero,” Source.

From a starting point of just under $16 million, the Daily Journal’s portfolio had grown to $135.3 million as of 31 December 2014. The portfolio’s holding were revealed for the first time during 2014, and they are typical Buffett/Munger style investments. Four main companies account for the bulk of the portfolio; Wells Fargo (by far the largest position around 70% of portfolio), Bank of America, U.S. Bancorp and Korean steel producer Posco.

“Posco is the most efficient steel company in the world. It had a pretty close to a local monopoly position in its country for a long time. It is very hard to avoid being commoditized in the modern world. In the places like The The Dow Chemical Company (NYSE:DOW) Company (NYSE:DOW) with complex chemical process, with 1000 PhDs, it is still hard to not be commoditized. Posco was able to do so.” -- Charlie Munger Daily Journal 2015 Meeting [FULL NOTES]

And Charlie Munger’s investments have put a rocket under the Daily Journal’s book value growth. Here’s the Journal’s book value per share from year-end 2008 to year-end 2014.

Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 CAGR
Book Value Per Share $9.69 $11.31 $14.85 $19.66 $38.23 $43.94 $46.99 $63.17 $82.09 $98.77 29.43%
Data from Morningstar


http://www.valuewalk.com/charlie-munger-page/

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.




http://www.valuewalk.com/charlie-munger-page/

Lessons from Charlie Munger-XIX

Mar 20, 2013

In the previous article, we discussed how investors often make wrong investing decisions due to misguided influence from authority figures. Today we shall discuss yet another human tendency that often leads us into unproductive behaviour.

Twaddle tendency

All creatures survive in groups. And the one factor that connects creatures of a species is communication. It goes without saying then that communication has been one of the most critical tools in the evolution and survival of all species. Broadly, communication facilitates sharing of information about food, attracting a mate, signaling danger and so on. 

One of the things that differentiate human beings from other animals is our ability to think. The relatively larger size of our cerebral cortex is the reason for our creativity, language and logical deduction. As such, we have a highly advanced and complex language at our disposal.

But do we always make the most rational and productive use of words? The answer seems to be no. And this is where the 'twaddle tendency' fits in. An online dictionary defines 'twaddle' as silly, trivial or pretentious talk or writing. Being a social animal, man often indulges in petty small talks and chatter. No wonder the celebrity rumour and gossip pages are often the most widely viewed amongst all other news and editorial content!

Twaddle or nonsense talks are not such a bad thing by themselves. They only become a nuisance when they come in the way of some serious work that is in progress. And this is what we need to keep a check on. Charlie Munger relates an interesting experiment on honeybees which can be used as an analogy to show how the twaddle tendency can lead to unproductive results. For those not very well-read in biology, honeybees have a peculiar dance language that they use to indicate to their fellow mates where the food is. After returning to the honey comb with pollen or nectar, the worker bee performs a dance with particular movements. Through this, it communicates to the other bees both the distance and the location of the food. The other worker bees then follow the directions suggested and set out to gather pollen and nectar.

A certain scientist was curious to know how the honeybees would respond if the nectar was placed in an unusual position. So he placed the nectar in a straight-up position at a significant height. As you would have guessed, no nectar exists in such a position in a natural setting. So, this baffles the honeybee. It does not have a genetic program that is capable of communicating this new position. 

According to you, what should the honeybee ideally do in such a situation? It should just go back to the hive and pick a quiet corner, shouldn't it? But the honeybee does not do that. Instead, it comes back and attempts a dance. But the dance turns out to be incoherent. Just like twaddle! 

Can this behavioural tendency of the honeybee also apply to human beings? In our next article of this series, we will analyse the twaddle tendency in human beings, particularly in the context of the stock markets and the economy. We will also discuss ways that could help investors to filter away all the useless twaddle. 

https://www.equitymaster.com/detail.asp?date=03/20/2013&story=3&title=Lessons-from-Charlie-Munger-XIX

Lessons from Charlie Munger-XVIII

Mar 14, 2013

In the previous article, we discussed how humans have a natural tendency to submissively follow authority and how in some cases it can have tragic consequences. Today, we shall discuss this psychological tendency in the context of stock markets and how investors can wean themselves off this thinking error.


Authority-Misinfluence tendency in stock markets

Uncertainty and risk have a big influence on how independently people take their decisions. The greater the risk and uncertainty, the greater is the tendency to seek guidance and conformation from an authority figure. This makes the stock market a place that is incurably afflicted by the authority-misinfluence tendency. 

Just spare a moment and ponder about how exactly you decide when to buy or sell a stock. Do you invest based on 'hot tips' shared by 'influential' friends? Do you avidly track the portfolio of successful investors/ fund managers and try to mimic them? Do you invest based on the advice given by stock experts who appear on television? Do you blindly follow the advice of your broker or any other advisor? 

If your answer is a 'yes' to any one of these, then here are some more questions. What makes you follow these experts? Do you ever question or challenge their opinions? Do you trust them simply because they are in a position of authority? Is it convenient for you to follow them blindly so that you can escape the blame in case things go wrong? 
If you honestly reflect over these questions you will see that your decisions are seldom your own. In fact, it is not just small investors who fall prey to the wrong influence of authority. Even experts do, a lot of times.

You will recall that just prior to the stock market crash of 2008 most analysts had given a thumbs-up to an unreasonably expensive big ticket IPO of a famous corporate house. The IPO was oversubscribed a whopping 73 times! And then, not very surprisingly, the stock tanked after listing. In fact, it's been over five years since the stock listed and it is still down nearly 68% from its listing day closing price. This is what happens when one indiscriminately gives in to follow-the-leader tendency.

Of course, we are by no means suggesting that you should switch yourself off from all external help. This would be a stupid thing to do. Listening to views and opinions from experts is quite valuable. But there is difference between listening to experts with discretion and blindly following them. It is important that you exercise your own independent judgment to the opinions of others. 


'Mr Market' is there to serve you, not to guide you 

In an abstract sense, 'Mr Market' (as referred to the stock market by value investing genius Benjamin Graham) is a representation of an authority figure. People pay excessive attention to where the markets are going. But you must remember that 'Mr Market' is a fickle leader and often deviates away from the rational path. 

The greatest investors in the world are those who do not give in to the moods of 'Mr Market'. In fact, in his Letter to Shareholders in 1987, legendary investorWarren Buffett put down some very important lessons that he had learned from his Columbia Business School professor. Ben Graham had taught him to look at the market quotations as if they were coming from an emotionally troubled fellow called 'Mr Market'. The poor guy often goes through periods of euphoria followed by periods of gloom. But the good thing is that 'Mr Market' does not mind if you ignore him. His only job is to come up with a new quote every day, every few seconds.

So if you learn to command this peculiar gentleman, you can take advantage when he is gloomy and rack up great businesses at depressed prices. On the other hand, when 'Mr Market' is euphoric, you can simply ignore him. The most important thing to remember is to let the 'Mr Market' serve you, not to influence your investing decisions. 

https://www.equitymaster.com/detail.asp?date=03/14/2013&story=5&title=Lessons-from-Charlie-Munger-XVIII

Lessons from Charlie Munger-XVII

Mar 7, 2013

In the previous article, we discussed how the ageing process could weaken your thinking capacity and ways that could help you to retain your mental prowess in old age. Today we shall discuss a psychological tendency that is very dominant in all spheres of our lives and often misleads investors into making poor decisions.


Authority-misinfluence tendency

In his bestselling psychology book Influence, renowned author Robert Cialdini tells an interesting and funny story. A man complaining of earache goes to visit the doctor. The doctor diagnoses an ear infection and prescribes ear drops for him. On the prescription, he writes, "Place drops in R ear." Given that doctors are usually in a rush, he abbreviated "Right" with R. 

What do you think the trained nurse must have done? She followed the instructions obediently and interpreted it as 'rear' instead of 'right ear'. Very dutifully, the nurse asked the patient to turn over and placed the prescribed number of drops in the patient's anus. Yes, what you just read is true!

Now, you don't have to be a trained medical practitioner to realise that an ear infection is unlikely to be cured by placing the drops in your rear. It is interesting to note here that neither the nurse nor the patient doubted the sanity of the prescription. Why? Simply because it came from an authority! 

Errors owing to the misinfluence of authority are found across all spheres of human life. In some cases, the results tend to be very tragic. A classic case that shows the powerful influence of an authority figure is the Holocaust. What else do you think could have motivated Nazis to ruthlessly slaughter millions of innocent Jews?

Charlie Munger recalls an incidence from World War II wherein a new pilot was very eager to please the general. Sitting besides the general in the copilot's seat, he misinterpreted a minor shift in the general's position as a direction to do something absolutely foolish. Without a moment's doubt, he did it and this resulted in a plane crash.

Why is man innately wired to follow authority? What causes man to submissively bow down to authority even if it may seem wrong and unreasonable? 

The answer probably lies in the way we have evolved over the ages. All our ancestors lived in dominance hierarchies. Dominance hierarchy is a social living group with a ranking system based on power. Owing to competition over limited resources and mating opportunities, relative relationships are developed between members of the same gender. This results in the creation of a social order. The social order undergoes changes only when a dominant animal is overpowered by a subordinate one.

Human societies have followed a similar path. History has been largely shaped by few men at the helm, while the majority of humanity has simply followed orders. This explains why following authority is a very automatic tendency of man. 

Following authority is not a flaw in itself. In several cases, it is quite crucial. For instance, think about the fate of a military operation where each member refuses to take orders without questioning. On the other hand, follow-the-leader tendency can be very dangerous at times as the examples above suggest.

In our next article of this series, we will analyse how the authority-misinfluence tendency could be causing you to make investment mistakes in the stock markets. We will also discuss ways that could help investors minimise the ill-effects of this tendency. 

https://www.equitymaster.com/detail.asp?date=03/07/2013&story=6&title=Lessons-from-Charlie-Munger-XVII

Lessons from Charlie Munger-XVI

Jan 18, 2013

In the previous article, we discussed the importance of use-it-or-lose-it tendency for investors. Today we shall discuss another psychological tendency which is pertinent to investors of all age groups.


Senescence-misinfluence tendency

The word 'senescence' may not seem familiar. It derives its roots from the Latin word 'senescere' which means 'to grow old'. So effectively, senescence-misinfluence refers to the cognitive decay and mental limitations on account of biological aging. Of course, the aging process may differ from person to person in terms of the time it commences and the pace at which it progresses. But, by and large, old people have difficulty acquiring new skills. As such, the probability of learning complex new skills is practically zilch. 

But here is an interesting twist. Though acquiring new skills may be challenging, the good news is that some people very well manage to retain old skills that they have practiced intensely over the years. In fact, there is a long list of people who have achieved great feats despite their old age. Benjamin Franklin, who has been Charlie Munger's personal hero, helped frame the US Constitution at the age of 81 years. At the age of 76 years and 340 days, a Nepalese gentleman by the name of Min Bahadur Sherchan became the oldest person to climb Mount Everest, the world's tallest mountain. Age did not hinder the famous deafblind American author and political activist from writing a book called 'Teacher' at the age of 73 years. Across the world and across fields there is long list of such achievers who have seldom let old age get in their way.

What does senescence-misinfluence tendency have to do with investing?

You may be wondering why we are discussing old age in the context of investing. Let us explain a bit and you will see the connection.

Our financial needs change with the various phases of our life. Given that the topic under discussion concerns old age, let us focus on a person's financial needs post retirement. At this age, you may not have the burden of educating and marrying your kids. You may also not have to worry about buying a home. With all major investments and expenses behind you, you may be relatively relieved.

But you may have several other expenses. For instance, your healthcare expenses could be significantly higher. You may also want to fulfil all the dreams that you may have sacrificed in your youth. And so on. The point is that you are going to need a good deal of money irrespective of your age. 
But would your pension income be enough to take care of your post-retirement needs? And wouldn't you want to avoid depending on your kids for money? At an age when you may not be in the best physical frame to travel distances and perform demanding tasks, what could you do for an alternative source of income? The answer is investing. 

Some may counter with the usual argument that investing in stocks is risky. Of course, there is no denying that there is an inherent risk. But the real risk of significant losses lies in speculative short-term trading. If you choose the path of long term value investing, you will not only live with minimal risk, but the chances of immense profits will be significantly high. Remember, in the long run, equities tend to outperform all major asset classes. 

But it would be a big mistake if you wait until retirement to start investing actively. The preparation has to start much earlier. When you are relatively young, invest time regularly to educate yourself about value investing. Let this be a life-long process of learning and investing. In this way, you will be very well-equipped to deal with your investments in your latter years.

But wouldn't old age hinder your thinking abilities and decision making? Your greatest inspirations could be Warren Buffett (82 years) and his so-called Siamese twin Charlie Munger (89 years). What is the secret behind their outstanding thinking prowess and investing acumen even at this age? The answer is simple. If you develop useful skills early in your life and practice them rigorously over the years, you could manage to retain those skills for a much longer period, despite the aging process. 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=01/18/2013&story=5&title=Lessons-from-Charlie-Munger-XVI

Lessons from Charlie Munger-XV

Dec 14, 2012

In the previous article, we discussed how investors can avoid falling prey to the availability-misweighing tendency. Today we shall discuss another important tendency which is not just crucial to investing but almost everything you do in your life.


Use-it-or-lose-it tendency

The name is quite self-explanatory. If you don't use a certain skill, you tend to lose it gradually. The most common example that we all grow up hearing is about our tail bone. Human beings, in their evolution from apes, lost their tails as they stopped using it over time. The same holds true for the various mental and physical skills that we possess. 

You may recollect that when you were younger, there were many things you could do very well. But as time passed and you lost touch with those things, the skills have either diminished or have been forgotten completely.

Often, you may not immediately notice that a skill is attenuating. For instance, say a person excelled in Science and Sanskrit when he was in school or college. But on account of a marketing job, he made little use of his knowledge in those subjects. Slowly, over time these skills shimmered away. Each of us can name several such instances.

What can one do to avoid such loss of useful skills? The only way to keep such skills alive is to use them regularly. The importance of regular practice is especially very vital in skills of a very higher order. For example, a Polish pianist called Paderewski once admitted that if he did not practice even a single day, he could notice some deterioration in his performance. And if he did not practice for as long as one week, the audience would also be able to notice the difference.

Similar is the case with aircraft pilots. It is crucial that they remember all the necessary skills that are required while flying, though all of them may not be frequently used. Any deterioration in vital skills can result in destruction of people and property.

Charlie Munger suggests using something that is a functional equivalent of the aircraft simulator employed in pilot training. While investing is not a rocket science, there is no reason to take it too casually. Many people take investing as a side business which can be done without putting in too much time and effort. And that is one of the biggest fallacies. Legendary investors such as Warren Buffett, Charlie Munger and Peter Lynch did not create great fortunes out of thin air. They are known to be rigorous practitioners of their art. They all read extensively and spend a huge amount of their daily routine analysing companies. In other words, by using their mental skills meticulously, they have become successful pilots of the investing world. 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=12/14/2012&story=3&title=Lessons-from-Charlie-Munger-XV

Lessons from Charlie Munger-XIV

Oct 12, 2012

In the previous article, we discussed the availability-misweighing tendency and elaborated how it has an adverse effect on investments. Today we shall discuss what investors can do to avoid falling prey to this thinking error. 

Playing Charles Darwin

The theory of evolution proposed by Charles Darwin, a 19th century British scientist, revolutionised the way many thought about the natural world. It is worth noting that around the time, a majority Europeans subscribed to the biblical description that the world was created by God in seven days.

Given the vulnerability of the human mind to thinking errors and psychological shortcuts, what led Darwin to think so radically different? As it turns out, the man operated through a mental model that helped steer past several psychological biases. Charlie Munger suggests that taking Darwin's approach could be an effective antidote for availability-misweighing tendency. 

What did Darwin do to eliminate biases? It is said that Darwin was a very strong proponent of objectivity. He was known for playing the devil's advocate to his own ideas and hypotheses. So much so that as soon as he would have an idea, he would try to gather evidence to disconfirm it. In fact, he tended to be even more rigorous in his approach with ideas that were particularly compelling.

Let's try and apply this approach to investing in stock markets. Say for instance, there is a certain stock that your friend has strongly recommended you to consider buying. Suddenly, the stock price goes up following a positive piece of news. What would be your reaction? Your friend is optimistic about the stock. The news is positive. The markets too have cheered the news. Isn't there enough reason to run and call your broker to buy the shares? If you would have done that, you would have quite likely fallen prey to the availability-misweighing tendency. 

A wiser response would have been to do what Darwin always did: Challenge the merit of the idea. Look for potential risks and concerns that could adversely affect the company. Arrive at your independent view only after thoroughly evaluating the potential of the stock. The ultimate investing decision should be based solely on your understanding and insight and not from borrowed optimism. In short, if you come across a stock that appears to be the market's darling with a lot of media attention on it, play the devil's advocate and consider all possible risks and concerns that can derail the investment. If the idea still holds, it is certainly worth investing.

It is observed that a vital quality that is common amongst all great investors is discipline. It is this discipline that helps them overcome the various thinking errors and biases, availability-misweighing tendency being one of them. A practical way to ensure discipline and to avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner. 

In conclusion, remember what Charlie Munger has said, "An idea or a fact is not worth more merely because it is easily available to you." 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=10/12/2012&story=3&title=Lessons-from-Charlie-Munger-XIV

Lessons from Charlie Munger-XIII

Oct 5, 2012

In the previous article, we discussed the contrast misreaction tendency and elaborated how it has an adverse effect on investments. Today we shall discuss yet another erroneous psychological tendency that causes investors to misinterpret information, resulting in wrong investing decisions.


Availability-misweighing tendency

The first thing many people do after they wake up in the morning is grab the newspaper. Reading the paper gives us a sense of what's going around in the real world. The same is true for television news channels. Based on what is served to us by the news media, we build our mental model of what the real world outside is like.

But does this mean that the news stories presented by the media are the most important and legitimate issues concerning us? What about issues that don't make it to the newspaper or the TV but still could be very relevant and vital? This discrepancy often leads us into a distorted view of reality. What appears more often and more prominently around us assumes a lot more importance than it may deserve. On the other hand, issues that may not be discussed could be disregarded as trivial. 

This brings us to availability-misweighing tendency. What does it mean? Charlie Munger explains it very aptly quoting a song: "When I'm not near the girl I love, I love the girl I'm near." The human mind has a tendency to focus on what's easily available. And in doing so, often tends to give undue importance to it. On the other hand, the significance of things and events that are not easily accessible could be undermined.


Availability-misweighing tendency in the stock markets

Business fundamentals and earnings drive stock prices over the long term. However, on a day-to-day basis, it is the relentless flow of news and information that sends markets up and down. Owing to this intricate relationship with news, the stock market is one place that most easily falls prey to the availability-misweighing tendency. Isn't it often observed that news items that are prominently projected in the media elicit substantial response from the stock markets? In other words, the markets are ready to react to any information that is made available to them. This also means that important matters that are not covered by the news media may be ignored by the stock markets. 
Take for instance, the recent slew of economic reforms announced by the government. The initiative has been covered extensively by the media. Though most of these reforms are not very significant and are unlikely to have any major positive impact on India's economic growth in the near future, the sentiment on the Indian bourses has suddenly turned optimistic.

The case of individual investors is also very similar. Stocks that are most widely talked about in the media often make an easy entry into the stock portfolio. Many companies tend to use this tendency to prop up their share prices. Using their PR machinery, companies bombard the media with press releases, interviews and news reports about every trivial development and achievement, many of which may not have any major impact on earnings. But in the absence of other relevant information, investors often end up giving undue importance to such insignificant matters. 

In the next article, we will discuss what investors can do to avoid falling prey to this think error. 

https://www.equitymaster.com/detail.asp?date=10/05/2012&story=6&title=Lessons-from-Charlie-Munger-XIII

Lessons from Charlie Munger-XII

Mar 30, 2012

In the previous article, we discussed the social proof tendency and explained how often company managements and investors get bitten by the bug of' institutional imperative'. Today we shall discuss another important psychological tendency that often causes massive misjudgments and bad investment decisions.


Contrast Misreaction tendency

How do we really perceive things? For instance, how does our brain figure that an elephant is a big fat creature? Or, how do we know that a tortoise is very slow? The answer to both these questions is relative comparison. We perceive everything in relative terms. That is, an elephant seems big in comparison to our own selves and most other creatures. A tortoise seems to be moving slower when compared to a hare. Of course, this mode of perception is not just restricted to how we look at animals. But it extends to all things in life, and very evidently in investments and stock markets. It influences how we think about economic news and information, corporate performance, stock prices, and so on. 

The reason why we tend to perceive things in relative terms is that it is impossible for the human nervous system to measure everything in absolute scientific units. So we use our senses to identify things by comparing them with other things. It is the relative contrast that gives things their specific characteristics. This is a simple program that the human mind follows. But like all psychological processes, if a mental program is allowed to run without due diligence, it can cause thinking errors and misjudgements. In this specific case, it can lead to contrast misreaction tendency. 

What is contrast misreaction tendency? Contrast misreaction causes people to make wrong judgments based on misleading contrasts between two or more things and situations. Charlie Munger cites an interesting example where this tendency is often misused- A person is shifting to another city and looking for a new house for his family. To get some quick help, he goes to a real estate broker. First, the salesman takes him around and shows him some really terrible homes for insanely high prices. Then, he takes the person to a merely bad house at a slightly lower price. Need we mention what happens next! What exactly went amiss in this case? How did the home buyer fall into the saleman's psychological trap? Blame it on the contrast misreaction tendency. When the person was shown the last property, he compared the house and its price to the horrible ones he saw before. Because of this comparison, he was ready to buy the not-so-good-house at a pretty high price. 


Contrast misreaction tendency in the stock markets 

Do investors also make wrong investment decisions because of the contrast misreaction tendency? The answer is yes, very often. The following instance will explain how investors enter this psychological trap.


Expensive at 140, attractive at 300!

Mr Chandra was an active investor. He was suggested by a friend to buy shares of XYZ Ltd when the stock price was Rs 90 per share. Instead of buying immediately, he decided to wait for some time. But in just a matter of few weeks the stock price mounted to Rs 140 per share. That was a whopping rise of nearly 56%. Obviously, Mr Chandra was very distressed. He cursed himself for not buying when the stock was trading at Rs 90. But now, he couldn't get himself to invest in the stock. It's way too expensive, he thought.

In the meanwhile, the stock continued to rally. In just a few months, the stock price was hovering around Rs 400. Mr Chandra had never felt so miserable. He had missed such a big opportunity. But then the stock price faced some selling pressure and corrected by about 25%. At Rs 300, what do you think Mr Chandra must have done? He invested heavily into the stock. 

Why did he not buy the stock at Rs 140? What forced him to buy the same stock at Rs 300? The answer in both cases is contrast misreaction tendency. Rs 140 seemed very expensive in contrast to Rs 90, the price at which his friend had suggested. However, Rs 300 seemed cheaper relative to the high of Rs 400 that the stock had witnessed.

A similar mistake also occurs with valuation multiples. For instance, if a stock has commanded a price to earnings (P/E) multiple of 50 times in the past, it doesn't mean that a P/E of 30 times is a lucrative buying opportunity. 

How can investors avoid such thinking errors? We believe the principles of value investing are a perfect antidote for the contrast misreaction tendency. Never judge the value of a company based on its past stock price performance or P/E multiples. Look at the company's business fundamentals and its past financial track record. How are the future growth prospects? What are the risks and opportunities to the business? Do the company's managers behave like owners? Valuing the company based on such important parameters will help you avoid false comparisons.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=03/30/2012&story=8&title=Lessons-from-Charlie-Munger-XII&utm_source=archive-page&utm_medium=website&utm_campaign=sector-info&utm_content=story

Lessons from Charlie Munger-XI

Mar 1, 2012

In the previous article, we discussed the social proof tendency in day-to-day life and also explained why corruption in India is so deeply rooted. Today, we shall discuss the social proof tendency in the context of business and finance. 


The Institutional Imperative

Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions. Even the legendary investor Warren Buffett had the same notion when he entered the world of business. But through time and experience, he realised that more often than not, despite all the qualifications and experience, it was not the case. A deadly force which he calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses. 

What does institutional imperative mean? The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. A simpler term that comes to mind is peer pressure. However surprising it may seem, even CEOs are subject to this pressure which forces them to make stupid mistakes. 

The evidence is almost everywhere. Say for instance, if some companies in a certain sector go on a capacity expansion spree, others are quite likely to follow, even though the overall economic situation may be hinting otherwise. What is the excuse such companies provide when the initiative goes for a toss? It's not difficult to guess- 'Everybody was doing that'. 

From his own mistakes, Buffett realised how important it was to not fall victim to this force. As an antidote to this problem, he introduced a technique at Berkshire Hathaway that has been quite effective in dealing with institutional imperative. To idea is simple- Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake. 

The tendency to fall prey to the social proof tendency is also seen among investors. Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. What should investors do to avoid such mistakes? Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency. 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=03/01/2012&story=8&title=Lessons-from-Charlie-Munger-XI

Lessons from Charlie Munger-X

Jan 5, 2012

In the previous article, we had discussed how our tendency to be over-optimistic distorts our view of reality and as a result, we often end up making wrong investment decisions. Today, we shall discuss a very important human tendency which is prevalent in all walks of our social life and has a tremendous influence on how we think and behave. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.


Social proof tendency 

We would like you to contemplate a bit about the below questions before we share our views on them:

• Have you ever commuted on Mumbai's local trains? If you have, you will most certainly agree about how a harmless looking gentleman can so quickly transform into a savage beast to plough his way into the train and onto a seat.
  
  
• What causes riots? How are terrorists created? What do you think prompts an otherwise normal person to pick up weapons and brutalise unarmed strangers?
• What was the reason for the success of Anna Hazare's movement against corruption? Why did an otherwise indifferent middle class go all out in support of Team Anna, sometimes even referring to the episode as India's second freedom struggle?
• Why are Indians cleaner and more disciplined abroad than at home?

Though there may be other reasons as well, but the one important common thread among all these is the social proof tendency. What is social proof tendency? Well, it is an automatic tendency to think and act the way people around you are thinking and acting. 

In the first instance, an otherwise gentleman turns rash in a Mumbai local train. Since everyone is doing the same, it seems socially acceptable to him. While he may not display that kind of behaviour in most other places, pushing and suffocating others in a local train appears pardonable to him. At least that is what it seems to him from the behaviour of others. Meaning, there is social proof. 

The social proof tendency works in both positive and negative situations. Be it riots and terrorists. Or be it the massive support that came in for Anna Hazare. This tendency most readily occurs in the presence of puzzlement or stress, or both. 


Social proof tendency and corruption in India

Charlie Munger points out one interesting aspect of the social proof tendency which very well explains why corruption in India is so deeply rooted. The "Serpico Syndrome" is named in the memory of Frank Serpico who once entered a highly corrupt New York police division. Unlike others, he resisted to be consumed by the contagion of corruption. And for that resistance, he was almost about to lose his life. Isn't this reminiscent of the many Indian films wherein the protagonist is the honest police officer who challenges the corrupt system? In the film, of course, the good cop reigns over his adversaries. In real life, however, that is seldom the case. As it is evident, the evil of corruption continues to persist in our country because of this very Serpico Syndrome, which is created by the social proof tendency and the power of incentives. 

Akin to the other spheres of life, social proof tendency is present in overwhelming proportions in the world of business and finance. It dominates how investors behave in stock markets, how company managements do business and so on. We will discuss this is more detail in the next article of this series. 


https://www.equitymaster.com/detail.asp?date=01/05/2012&story=4&title=Lessons-from-Charlie-Munger-X