Tributes are pouring in for Charlie Munger, Warren Buffett’s lifelong friend, sounding-board and the Vice -Chairman of Berkshire Hathaway, who passed away last week. Many have shared life lessons from the indefatigable 99-year-old who took personal tragedies in his stride and remained an incurable optimist till the end. But what are the enduring lessons that this wise and commonsensical man had for investors? Here are a few.
Don’t pick up cigar butts
When we start out as stock investors, most of us try to practise textbook methods by hunting for stocks trading at a bargain. We define ‘bargains’ as companies trading at a deep discount to their book value or cash per share. Or, we buy up low-priced dud stocks in the hope that they can miraculously turn multi-baggers. But Charlie Munger made Berkshire Hathaway what it is today, by steering Buffett away from such short-term thinking and buying businesses for their ability to deliver a rising cash profit many years into the future.
In his letter on Berkshire Hathaway’s 50th anniversary, Buffett wrote about how Munger cured him of the suicidal practice of cigar-butt investing. In his initial years running Buffett Partnership, Buffett had an affinity for buying companies that were trading at deep discounts to their book value or cash on the books.
His first such mistake, in early 60s, was acquiring a big stake in Berkshire Fine Spinning because it was available at $7.5 per share when its book value was $20.2. The business headed rapidly downhill with New England’s sinking textile industry before it was shuttered 20 years later. Buffett wrote - “Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.”
It was Charlie Munger, a practising lawyer and an architect who met Buffett in 1959, who convinced him to move away from cigar-butt investing and established the blueprint for the compounding machine that is today’s Berkshire Hathaway. Munger’s credo was “Forget what you know about buying fair businesses at wonderful prices and instead buy wonderful businesses at fair prices”.
A good example of this was See’s Candies, a candymaker with $5 million in pre-tax profits and $30 million in sales when Berkshire acquired it. It was not exactly a bargain at the price of $25 million — 3 times its book value. But its subsequent growth made it one. The candymaker had the ability to operate with zero receivables and a high return on capital. By 2007, with hardly any capital infusion, See’s had generated $1.35 billion in cumulative pre-tax earnings for Berkshire. It clocked $82 million pre-tax profits on $383 million in sales in 2007.
Learn to say No
Scepticism is an under-rated attribute for investors. To avoid the big mistakes that decimate wealth, you need to be able to cut through management spin and exaggerated pitches from product sellers and to say a firm no. Charlie Munger had almost a sixth sense for detecting insincerity and fakery. Buffett relied on him to say no to most deals that came their way.
In a speech at Harvard in 1995, Munger shared the secrets to this ability. He described as many as 24 ‘standard causes of human misjudgement’ that make perfectly rational people take silly decisions.
There were a few unusual ones. One was incentive-caused bias, which simply means that before buying anything you need to understand how the seller will make money. This may seem like an obvious thing but Munger cites relatable examples — of real estate brokers exaggerating the attributes of the properties they’re selling to maximise their commission, contractors inflating project costs because they’re paid by the government on a cost-plus basis and even a doctor initiating dozens of gall bladder removals because his incentives were aligned to more surgeries. So, if your stock broker gives you free day-trading tips, you need to be aware that this is not out of altruism but for the commissions he will rake in.
A second is reciprocation tendency, which is the human need to please others — even if it brings personal pain. Wondering how the senior in your neighbourhood got you to sign up for that insurance plan with a steep ₹1 lakh premium? Probably by accosting you often and making you feel guilty for wasting her time.
Then, there’s ‘social proof’ where your decision is heavily influenced by what others are doing. Munger pointed out that it is not just individuals but also companies which get into this copycat behaviour. He cites the example of oil majors lining up to make irrational acquisitions of fertiliser companies, just because others were doing it.
Then there are biases from what Munger describes as ‘contrast’ and ‘deprival super reaction’. If you are made to browse through a bunch of extremely over-priced homes on a realty website, you may end up buying a moderately over-priced one, just because it looked good in contrast. You regret the decision later when you take a more rational view.
Deprival super-reaction is making something desirable to you by exposing you to it for a limited time, or taking it away. Munger recounts how Coca-Cola’s decision to change its formula made consumers scramble for the ‘old Coke.’
Moats that last
Today, the term ‘moat’ is casually thrown around to describe any slight edge that a business may enjoy. But Munger was very particular about recognising that moats can be breached, and new ones created.
To avoid mistaking a temporary advantage for a durable moat, Munger advocated working backwards. He liked to identify companies that delivered fabulous results year after year. Then he tried to work out what made their consistent results possible. He would try to figure out the forces that could interrupt the results. Buffett and Munger found that businesses with moats were often low-cost producers in a sector or commodity, had a natural franchise, enjoyed a very strong brand loyalty or distribution franchise and so on.
Such companies may not be very hard to identify, but the key is to assess whether the moat would last. Munger said that when companies enjoy moats and are highly profitable, they will be continuously under siege from competition. Therefore, their managements needed to work extra-hard at widening that moat every year. Technological moats are more quickly breached than physical ones. Moats can also be easier to lose in some industries than others. Munger quipped- “Just ask Arthur Andersen. That was a very good name in America not very long ago. I think it is harder to lose the good name of Wrigley’s gum than the good name of Arthur Andersen”.