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Synthesis of Ideas
When you have a latticework of mental models, you can see how they interact in interesting ways. Here’s one Poor Charlie’s Almanack summary of two competing economic principles.
- “Number one is Ricardo’s principle of comparative advantage in trade, and the other is Adam Smith’s pin factory. And both of these, of course, work to vastly increase economic output per person, and they’re similar in that each somehow directs functions into the hands of people who are very’ good at doing the functions. Yet, they’re radically different examples in that one of them is the ultimate example of central planning—the pin factory—where the whole system was planned by somebody, while the other example, Ricardo’s, happens automatically as a natural consequence of trade.”
- “And, of course, once you get into the joys of synthesis, you immediately think, “Do these things interact?” Of course they interact. Beautifully. And that’s one of the causes of the power of a modern economic system. I saw an example of that kind of interaction years ago. Berkshire had this former savings and loan company, and it had made this loan on a hotel right opposite the Hollywood Park Racetrack. In due time, the neighbourhood changed, and it was full of gangs, pimps, and dope dealers. They tore copper pipe out of the wall for dope fixes, and there were people hanging around the hotel with guns, and nobody would come. We foreclosed on it two or three times, and the loan value went down to nothing. We seemed to have an insolvable economic problem—a microeconomic problem.”
- “Now, we could have gone to McKinsey, or maybe a bunch of professors from Harvard, and we would have gotten a report about ten inches thick about the ways we could approach this failing hotel in this terrible neighbourhood. But instead, we put a sign on the property that said: “For sale or rent.” And in came, in response to that sign, a man who said, “I’ll spend $200,000 fixing up your hotel and buy it at a high price on credit, if you can get zoning so I can turn the parking lot into a putting green.” “You’ve got to have a parking lot in a hotel,” we said. “What do you have in mind?” He said, “No, my business is flying seniors in from Florida, putting them near the airport, and then letting them go out to Disneyland and various places by bus and coming back. And I don’t care how bad the neighbourhood is going to be because my people are self-contained behind walls. All they have to do is get on the bus in the morning and come home in the evening, and they don’t need a parking lot; they need a putting green.” So we made the deal with the guy. The whole thing worked beautifully, and the loan got paid off, and it all worked out.”
- “Obviously, that’s an interaction of Ricardo and the pin factory examples. The odd system that this guy had designed to amuse seniors was pure pin factory, and finding the guy with this system was pure Ricardo. So these things are interacting.”
On Investing and Business
In Poor Charlie’s Almanack, Munger doesn’t talk directly about Berkshire Hathaway’s decisions much, but he does share the general investment philosophies and practices that have made them successful over decades.
- “We’re like the hedgehog that only knows one big thing: If you can generate float [cash from insurance premiums that Berkshire can invest before claims must be paid] at three percent and invest it in businesses that generate thirteen percent, that’s a pretty good business.”
- “The future will be harder for Berkshire Hathaway for two reasons: 1) We’re so big. It limits our investment options to more competitive areas. 2) The current climate offers prospects in common stocks over the next fifteen to twenty years that are way less than we’ve experienced over the past fifteen to twenty years.”
- “It’s a finite and very competitive world. All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return.”
- “Two-thirds of acquisitions don’t work. Ours work because we don’t try to do acquisitions— we wait for no-brainers.”
- “Lumpy results and being willing to write less insurance business if market conditions are unfavorable…that is one of our advantages as an insurer— we don’t give a damn about lumpy results. Everyone else is trying to please Wall Street. This is not a small advantage.”
- “There are two types of mistakes: 1) doing nothing, what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.”
- “The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes— we’ve lost billions.”
- “Intel and its ilk create a coherent culture where teams solve difficult problems on the cutting edge of science. That’s radically different from Berkshire Hathaway. Berkshire is a holding company. We’ve decentralized all the power except for natural headquarters-type capital allocation…It’s not at all clear to me that Warren or I would be that good at doing what Andy Grove does.”
Here’s a Poor Charlie’s Almanack summary of the major concepts to know about investing in companies.
- Remember: “Only twenty percent of the people can be in the top fifth“
- “However, the market was not perfectly efficient. With enough shrewdness and fanaticism, some people will get better results than others.” “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.”
- Bet seldom, but bet hard when you have a deal
- “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’s just that simple.”
- “How many insights do you need? Well, I’d argue that you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it.”
- “It makes sense to load up on the very few good insights you have instead of pretending to know everything about every thing at all times. How many of you have fifty-six brilliant insights in which you have equal confidence? Raise your hands, please. How many of you have two or three insights that you have some confidence in?”
- When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches— representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.” He says, “Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”
- “There are huge advantages for an individual to get into a position where you make a few great investments and just sit on your ass: You’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra one, two, or three percentage points per annum compounded.”
- “We just look for no-brainer decisions. As Buffett and I say over and over again, we don’t leap seven-foot fences. Instead, we look for one-foot fences with big rewards on the other side. So we’ve succeeded by making the world easy for ourselves, not by solving hard problems.”
- Pari Mutuel
- Markets are like betting odds. The best horse is obvious, but it is not obviously a better deal.“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position, etc., etc., is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the damn odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then, it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.”
- “Over many decades, our usual practice is that if [the stock of] something we like goes down, we buy more and more. Sometimes something happens, you realize you’re wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices.”
- “So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of bullshit and craziness with an occasional mispriced something or other. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.”
- Instead of thinking the market was efficient, Graham treated it as a manic-depressive who comes by every day. And some days “Mr. Market” says, “I’ll sell you some of my interest for way less than you think it’s worth.” And other days, he comes by and says, “I’ll buy your interest at a price that’s way higher than you think it’s worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have, or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.”
- Deviating from Graham
- “Graham didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. He also had a concept that management would often couch the information very shrewdly to mislead.”
- “We realized that some company that was selling at two or three times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.”
- “If a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
- How to find deals
- “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 WalMart when Sam Walton first goes public and so forth.”
- “Ideally— and we’ve done a lot of this— you get into a great business which also has a great manager because management matters. For example, it’s made a hell of a difference to General Electric that Jack Welch came in instead of the guy who took over Westinghouse— one hell of a difference.”
- “However, averaged out, betting on the quality of a business is better than betting on the quality of management.”
- “There are actually businesses that you will find a few times in a lifetime where any manager could raise the return enormously just by raising prices— and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot, and the attendance stayed right up…Once you figure that out, it’s like finding money in the street— if you have the courage of your convictions.”
- How do you and Warren evaluate an acquisition candidate? “We’re light on financial yardsticks; we apply lots of subjective criteria: Can we trust management? Can it harm our reputation? What can go wrong? Do we understand the business? Docs it require capital infusions to keep it going? What is the expected cash flow? We don’t expect linear growth; cyclicality is fine with us as long as the price is appropriate.”
- “It doesn’t help us merely for favorable odds to exist. They have to be in a place where we can recognize them. So it takes a mispriced opportunity that we’re smart enough to recognize. And that combination doesn’t occur often.”
- Cancer surgery model
- “They look at this mess. And they figure out if there’s anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn’t work, they liquidate the business. But it frequently does work.”
- “A great business at a fair price is superior to a fair business at a great price.”
- “We’re partial to putting out large amounts of money where we won’t have to make another decision. If you buy something because it’s undervalued’, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But, if you can buy a few great companies, then you can sit on your ass. That’s a good thing. “
- There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested— there’s never any cash. It reminds me of the guy who sells construction equipment— he looks at his used machines, taken in as customers bought new ones, and says, “There’s all of my profit, rusting in my yard.” We hate that kind of business.”
- “As one factor, Graham had this concept of value to a private owner— what the whole enterprise would sell for if it were available. If you could take the stock price and multiply it by the number of shares and get something that was one-third or less of sellout value, you’ve got a lot of edge going for you.”
What Makes Companies Successful?
- “Extreme success is likely to be caused by some combination of the following factors:
- A) Extreme maximization or minimization of one or two variables. Example, Costco or our furniture and appliance store.
- B) Adding success factors so that a bigger combination drives success, often in nonlinear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.
- C) An extreme of good performance over many factors. Example, Toyota or Les Schwab.
- D) Catching and riding some sort of big wave. Example, Oracle.”
- “The effect of taxes. If you’re going to buy something that compounds for thirty years at fifteen percent per annum and you pay one thirty-five percent tax at the very end, the way that works out is that after taxes, you keep 13.3 percent per annum”
- “In contrast, if you bought the same investment but had to pay taxes every year of thirty-five percent out of the fifteen percent that you earned, then your return would be fifteen percent minus thirty-five percent of fifteen percent— or only 9.73 percent per year compounded. So the difference there is over 3.5 percent.”
- “You don’t have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time.”
- Limits thereof
- “We have said that common stocks generally have generated returns of ten to eleven percent after inflation for many years and that those returns can’t continue for a very long period. And they can’t. It’s simply impossible. The wealth of the world will compound at no such rate.”
Moats and Competitive Advantage
- “So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year.That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way— it’s just too risky’. We don’t know how to evaluate that. And, therefore, we leave it alone.” – Warren Buffett
- “I have a clipping from the 1911 Buffalo Evening News that lists the fifty most important stocks then actively traded on the New York Stock Exchange. Today only one, General Electric, remains in business as a large, independent company.That’s how powerful the forces of competitive destruction are. 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 gets extra tough when a fanatical small competitor— like a Rose Blumkin. or a Les Schwab, or a Sam Walton — sets their sights on your particular marketplace. How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.”
- “Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, while in other markets there’s destructive competition that destroys shareholder wealth. If it’s a pure commodity like airline seats, you can understand why no one makes any money. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business. Yet, in other fields —like cereals, for example—almost all the big boys make out. why are cereals so profitable—despite the fact that it looks to me like they’re competing like crazy with promotions, coupons, and everything else? I don’t fully understand it.Obviously, there’s a brand identity factor in cereals that doesn’t exist in airlines. That must be the main factor that accounts for it.”
- “And maybe the cereal makers, by and large, have learned to be less crazy about fighting for market share—because if you get even one person who’s hell-bent on gaining market share…. for example, if I were Kellogg and I decided that I had to have sixty percent of the market, I think I could take most of the profit out of cereals. I’d ruin Kellogg in the process. But I think I could do it.”
- “if you look around at bottler markets, you’ll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you’d have to know the people involved to fully understand what was happening.”
- The Effect of Technology
- [In a competitive market, new technology that is accessible to everyone passes the value down only to the consumer. Everyone adopts the technology and there is no edge. If it’s a lousy business, add new technology and it’s still a lousy business.]
- “Discriminate between when technology is going to help you and when it’s going to kill you.”
- “The huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.”
- “Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new, fancy computers and so forth, all of the savings would come right through to the bottom line”
- “When technology moves as fast as it does in a civilization like ours, you get a phenomenon that I call competitive destruction. You know, you have the finest buggy whip factory, and, all of a sudden, in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead— you’re destroyed. It happens again and again and again”
- “And when these new businesses come in, there are huge advantages for the early birds. And when you’re an early bird, there’s a model that I call “surfing”— when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows.”
- [Hence why Berkshire tends not to invest in technology.]
- [On Harvard needing to change its investment methods to be unconventional again, now that its success is now conventional wisdom] “It is quite counter-intuitive to decrease that part of one’s activity that has recently worked best. But this is often a good idea. And so also with reducing one’s perception of one’s needs, instead of increasing risks in an attempt to satisfy perceived needs.”
- “Reinsurance is not as much of a commodity business as it might appear. There’s such a huge time lag between when the policy is written and when it is paid that the customer has to evaluate the insurer’s future willingness and ability to pay.”
Top of Form
Bottom of Form
Common Investment Myths
- “The reason we avoid the word “synergy” is because people generally claim more synergistic benefits than will come. Yes, it exists, but there are so many false promises. Berkshire is full of synergies— we don’t avoid synergies, just claims of synergies.”
- “Beta and modern portfolio theory and the like— none of it makes any sense to me. We’re trying to buy businesses with sustainable competitive advantages at a low, or even a fair, price. How can professors spread this [nonsense that a stock’s volatility is a measure of risk]?”
- “People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts.”
- “The Greek orator was clearly right about an excess of optimism being the normal human condition, even when pain or the threat of pain is absent. Witness happy people buying lottery tickets or believing that credit-furnishing, delivery-making grocery stores were going to displace a great many superefficient cash-and-carry supermarkets.”
Designing Good Systems with Incentives
- “I have a friend who made an industrial product at a plant in Texas not far from the border. He was in a low-margin, tough business. He got massive fraud in the workers’ compensation system—to the point that his premiums reached double-digit percentages of payroll. And it was not that dangerous to produce his product. It’s not like he was a demolition contractor or something. So he pleaded with the union, “You’ve got to stop this. There’s not enough money in making this product to cover all of this fraud.” But, by then, everyone’s used to it. “It’s extra income. It’s extra money. Everybody does it. It can’t be that wrong. Eminent lawyers, eminent doctors, eminent chiropractors—if there are any such things—are cheating.” So my friend closed his plant and moved the work to Utah among a community of believing Mormons. Well, the Mormons aren’t into workers’ compensation fraud —at least they aren’t in my friend’s plant. And guess what his workers’ compensation expense is today? It’s two percent of payroll —down from double digits. This sort of tragedy is caused by letting the slop run. You must stop slop early. It’s very hard to stop slop and moral failure if you let it run for a while.”
- “If I were running the civilization, compensation for stress in workers’ comp would be zero—not because there’s no work-caused stress, but because I think the net social damage of allowing stress to be compensated at all is worse than what would happen if a few people that had real work-caused stress injuries went uncompensated I like the Navy system. If you’re a captain in the Navy and you’ve been up for twenty-four hours straight and have to go to sleep and you turn the ship over to a competent first mate in tough conditions and he takes the ship aground—clearly through no fault of yours—they don’t court-martial you, but your naval career is over. It doesn’t matter why your ship goes aground, your career is over. Nobody’s interested in your fault. It’s just a rule that we happen to have—for the good of all, all effects considered.”
- “The craving for perfect fairness causes a lot of terrible problems in system function.”
- [Carnation was trying to buy the trademark of Carnation Fish.] “In the end, Carnation came to him sheepfacedly and said, “We’d like to put our quality control inspectors into your fish plants to make sure that your fish are perfect; and we’ll pay all the costs”—which he quickly and smirkily allowed. So he got free quality control in his fish plants- courtesy of the Carnation Company. This history shows the enormous incentive you create if you give a guy a trade¬ mark [he can protect]. And this incentive is very useful to the wider civilization. As you see, Carnation got so that it was protecting products that it didn’t even own.”
Charlie Munger is strongly against active investment managers who take percentage of fees. One speech in Poor Charlie’s Almanack is directed at large charitable foundations and excoriating their reliance on greedy managers.
- “Even when nothing but unleveraged stock picking is involved, the total cost of all the investment management, plus the frictional costs of fairly often getting in and out of many large investment positions, can easily reach three percent of foundation net worth per annum if foundations, urged on by consultants, add new activity, year after year.”
- “And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers’ take, which median result may well be somewhere between unexciting and lousy.”
- “But, you may think, my foundation, at least, will be above average. It is well endowed, hires the best, and considers all investment issues at length and with objective professionalism. And to this I respond that an excess of what seems like professionalism will often hurt you horribly—precisely because the careful procedures themselves often lead to overconfidence in their outcome.”
- “febezzlement” —the functional equivalent of embezzlement—to explain how wealth is stripped away by layers of unnecessary investment managers and consultants
- “The study concluded that the typical mutual fund investor gained at 7.25 percent per year in a fifteen-year period when the average stock fund gained at 12.8 percent per year (presumably after expenses).”
- “Assume that 2006 stock prices rise by 200% while corporate earnings do not rise, at which point all the sensibly distributable earnings of all U.S. corporations combined amount to less than the total of all stockholder investment costs, because such costs rise proportionally with stock prices. Now, so long as this situation continues, no money at all, net of investment costs, is going out of all corporations to all corporate owners combined. Instead, frictional cost imposers get more than all sensibly distributable corporate earnings.”
- [in 2003] “I confidently predict that there are big troubles to come. The system is almost insanely irresponsible. And what people think are fixes aren’t really fixes. It’s so complicated I can’t do it justice here—but you can’t believe the trillions of dollars involved. You can’t believe the complexity. You can’t believe how difficult it is to do the accounting. You can’t believe how big the incentives are to have wishful thinking about values and wishful thinking about ability to clear.”
- “Running off a derivative book is agony and takes time. And you saw what happened when they tried to run off the derivative books at Enron. Its certified net worth vanished. In the derivative books of America, there are a lot of reported profits that were never earned and assets that never existed.”
Wealth Effect and Booms/Busts
This Poor Charlie’s Almanack summary section describes how stock market booms and busts tend to happen, and how investment managers actively contribute to them by exaggerating the gains that are created.
- “First, spending proclivity is influenced in an upward direction when stock prices go up and in a downward direction when stock prices go down…complication that increased spending tends to drive up stock prices while stock prices are concurrently driving up spending. Also, of course, rising stock prices increase corporate earnings even when spending is static, for instance, by reducing pension cost accruals after which stock prices tend to rise more.”
- “The Japanese economy, year after year, stays stalled, as Japanese proclivity to spend stubbornly resists all the tricks of the economists.”
- “A median conclusion of the economics professionals, based mostly on data collected by the Federal Reserve System, would probably be that the “wealth effect” on spending from stock prices is not all that big. After all, even now, real household net worth, excluding pensions, is probably up by less than one hundred percent over the last ten years and remains a pretty modest figure per household, while market value of common stock is probably not yet one-third of aggregate household net worth, excluding pensions.”
- “For one thing, I have been told, probably correctly, that Federal Reserve data collection, due to practical obstacles, doesn’t properly take into account pension effects, including effects from 401 (k) and similar plans.”
- “For another thing, the traditional thinking of economists often does not take into account implications from the idea of “bezzle.” After all, the embezzler spends more because he has more income, and his employer spends as before because he doesn’t know any of his assets are gone.”
- “As Keynes showed, in a native economy relying on earned income, when the seamstress sells a coat to the shoemaker for twenty dollars, the shoemaker has twenty dollars less to spend, and the seamstress has twenty dollars more to spend. There is no lollapalooza effect on aggregate spending. But when the government prints another twenty dollar bill and uses it to buy a pair of shoes, the shoemaker has another twenty dollars, and no one feels poorer. And when the shoemaker next buys a coat, the process goes on and on, not to an infinite increase, but with what is now called the Keynesian multiplier effect, a sort of lollapalooza effect on spending.”
- “You people, I think, have created a lot of “febezzle” through your foolish investment management practices in dealing with your large holdings of common stock.”
- “If a foundation, or other investor, wastes three percent of assets per year in unnecessary, nonproductive investment costs in managing a strongly rising stock portfolio, it still feels richer, despite the waste, while the people getting the wasted three percent, “febezzlers” though they are, think they are virtuously earning income.”
- “Now, toss in with “febezzlement” in investment management about $750 billion in floating, ever-growing, ever-renewing wealth from employee stock options and you get lot more common-stock-related “wealth effect” driving consumption, with some of the “wealth effect” from employee stock options being, in substance, “febezzle” effect, facilitated by the corrupt accounting practice now required by standard practice”
- “Next, consider that each one-hundred-point advance in the S&P adds about $1 trillion in stock market value, and throw in some sort of Keynesian-tvpe multiplier effect related to all “febezzlement.” The related macroeconomic “wealth effects,” I believe, become much larger than is conventionally supposed.”
- “It is an unfortunate fact that great and foolish excess can come into prices of common stocks in the aggregate. They are valued partly like bonds, based on roughly rational projections of use value in producing future cash. But they are also valued partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far.”
- “Suppose all pension funds purchased ancient art, and only ancient art, with all their assets. Wouldn’t we eventually have a terrible mess on our hands, with great and undesirable macroeconomic consequences?”
- “My foregoing acceptance of the possibility that stock value in aggregate can become irrationally high is contrary to the hard-form “efficient market” theory that many of you once learned as gospel from your mistaken professors of yore. Your mistaken professors were too much influenced by “rational man” models of human behavior from economics and too little by “foolish man” models from psychology and real-world experience. “Crowd folly,” the tendency of humans, under some circumstances, to resemble lemmings, explains much foolish thinking of brilliant men and much foolish behavior – like investment management practices of many foundations represented here today. It is sad that today each institutional investor apparently fears most of all that its investment practices will be different from practices of the rest of the crowd.”
- “When stock market advances and declines are regarded as long-lasting, there is more downside force on optional consumption per dollar of stock market decline than there is upside force per dollar of stock market rise.”
- [I don’t quite follow this. Febezzlement would happen if the investor thought she had more gains than she really did (if the money were stolen for example). But because the fees are clear, the absolute returns should be clear to the investor.]
Building a Trillion Dollar Company
In Poor Charlie’s Almanack, Munger poses an interesting challenge – how to grow a trillion dollar company from scratch. He uses this as an example of explaining success from first principles, which can lead to better management and decision making.
- It is 1884 and you are given 2 million dollars. How do you grow it to be a 2 trillion dollar company? Your company name must be Coca-Cola, and you must create a non-alcoholic beverage business. Here is Charlie’s strategy.
- No brainer decisions:
- Trademark Coca-Cola, since you’ll never make enough selling generic beverages.
- This beverage must succeed worldwide to get the scale needed.
- Use math to size the problem:
- By 2034, there will be 8 billion consumers. Each consumer must drink 64oz of water per day. If you capture half the market, and each person drinks 16oz of Coca-Cola a day, we can sell 2.92 trillion eight-ounce servings in 2034.
- Then, if you net 4 cents per serving, you’ll earn $117 billion.
- Major Factors Over Time
- Dollar will depreciate.
- Purchasing power will rise, probably by at least 40x over 150 years.
- Consumers’ desire to improve their drinking experience will rise.
- Technology reduces cost of creating product.
- Working backwards, purchasing power change implies that in 1884, we need just 0.1 cent per serving of earnings.
- Lollapalooza Required
- To create a beverage market overtaking 1/4thof all beverage consumption, and take half the market, you must have a lollapalooza as a combination of multiple factors. Here are the factors that play:
- Conditioned reflexes: Coca-Cola brand triggers purchase response
- Operant conditioning: Maximize rewards of ingestion, and minimize reflexes that are extinguished by competitors.
- Food value in calories
- Flavor, texture, aroma acting as stimuli to consumption under evolutionary neural programming
- Stimulus, by sugar or caffeine
- Cooling effect when man is too hot, or warming effect when man is too cool. Cooling is better, as there aren’t as many options to cool someone as there are to heat. Also, when you are hot, you must consume more liquid.
- To ward off competitors: you must have instantaneous availability. A competing product, if it’s never tried, can’t create a conflicting habit.
- Classical conditioning: Associate positive things with Coca-Cola
- Advertising associates happiness, sex, etc. with the drink
- Color look like wine instead of sugared color
- Carbonate water to seem like champagne
- Social Proof
- The more universal consumption is, the more acceptable it is, and the better the effects of consumption
- Mass advertising
- Logistics and Distribution
- Syrup to fountains and restaurants
- Complete carbonated-water product in containers
- Need many bottling plants around the world
- Must set first-sale price. Any independent bottler should be a subcontractor, not a vendee of syrup
- No perpetual franchises with pricing set forever
- Invert, always invert. What don’t we want?
- Avoid the stop-consumption feelings of aftertaste so people drink liters of our product
- Never lose even half of our trademark
- Don’t cause envy, by deserving our success. Be fanatic about product quality, presentation, reasonableness of prices
- At scale, avoid making huge and sudden changes in flavor. This would eradicate the Pavlovian conditioning, trigger deprival super-reaction, allow competitors to swoop in and replicate the flavor.
- The point to this exercise is that most people, even having observed Coca-Cola for most of their lives, cannot explain the success of Coca-Cola. Furthermore, recent executives could not understand the fundamentals well enough to predict the failure of “New Coke.”
- Similarly: “General Motors recently made just such a mistake, and it was a lollapalooza. Using fancy consumer surveys, its excess of professionalism, it concluded not to put a fourth door in a truck designed to serve also as the equivalent of a comfortable five-passenger car. Its competitors, more basic, had actually seen five people enter and exit cars. Moreover, they had noticed that people were used to four doors in a comfortable five-passenger car and that biological creatures ordinarily prefer effort minimization in routine activities and don’t like removals of long-enjoved benefits. There are only two words that come instantly to mind in reviewing General Motors’ horrible decision, which has blown many hundreds of millions of dollars. And one of those words is “oops.””
- A follow-on point is that in times of duress and need to change, don’t suddenly forget the fundamentals of the situation. Your new strategy may contravene what got you to your position.
- Operant conditioning: Maximize rewards of ingestion, and minimize reflexes that are extinguished by competitors.
Stock Options Expensing
- Munger and Buffett both believe issuing stock options must be accounted for as part of expenses. Avoiding this inflates company earnings (which is why executives like doing it).
- Munger gives the parable of Quant Tech, a stable engineering firm whose founder dies. The new management starts a financial scheme to not report options as part of expenses. They start giving options instead of compensation, which reduces their expenses and increases earnings dramatically.
- Because of Quant Tech’s cash balances from its earlier days, its finances don’t look too suspicious. But it starts practicing active subterfuge, for instance disguising its very low income taxes by prompting foreign government clients to increase company fees while increasing foreign taxes paid.
- Because of boosted earnings and regular earnings growth, the stock prices were naturally inflated, and the holders of stock benefited from the share price. However, eventually suspicion mounts when the earnings don’t quite make sense, the real results are reported, confidence plummets, stock plummets.
- My more general takeaways from the parable are that 1) there is such a thing as true fundamental value, and good companies report this; 2) short-term greedy schemes to profit need continuous lies to perpetuate the scheme, which leads eventually to their unraveling.
Charlie’s Investment Checklist
- MEASURE RISK
All investment evaluations should begin by measuring risk, especially reputational.
- Incorporate an appropriate margin of safety
- Avoid dealing with people of questionable character
- Insist upon proper compensation for risk assumed
- Always beware of inflation and interest rate exposures
- Avoid big mistakes; shun permanent capital loss
- BE INDEPENDENT
Only in fairy tales are emperors told they’re naked.
- Objectivity and rationality require independence of thought
- Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
- Mimicking the herd invites regression to the mean (merely average performance)
- PREPARE AHEAD
The only way to win is to work, work, work, and hope to have a few insights.
- Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
- More important than the will to win is the will to prepare
- Develop fluency in mental models from the major academic disciplines
- If you want to get smart, the question you have to keep asking is “why, why, why?”
- HAVE INTELLECTUAL HUMILITY
Acknowledging what you don’t know is the dawning of wisdom.
- Stay within a well-defined circle of competence
- Identify and reconcile disconfirming evidence
- Resist the craving for false precision, false certainties, etc.
- Above all, never fool yourself, and remember that you are the easiest person to fool
- ANALYZE RIGOROUSLY
Use effective checklists to minimize errors and omissions.
- Determine value apart from price; progress apart from activity; wealth apart from size
- It is better to remember the obvious than to grasp the esoteric
- Be a business analyst, not a market, macroeconomic, or security analyst
- Consider totality of risk and effect; look always at potential second order and higher level impacts
- Think forwards and backwards – Invert, always invert
- ALLOCATE ASSETS WISELY
Proper allocation of capital is an investor’s No. 1 job.
- Remember that highest and best use is always measured by the next best use (opportunity cost)
- Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
- Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven
- HAVE PATIENCE
Resist the natural human bias to act.
- “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
- Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
- Be alert for the arrival of luck
- Enjoy the process along with the proceeds, because the process is where you live
- BE DECISIVE
When proper circumstances present themselves, act with decisiveness and conviction.
- Be fearful when others are greedy, and greedy when others are fearful
- Opportunity doesn’t come often, so seize it when it comes
- Opportunity meeting the prepared mind; that’s the game
- BE READY FOR CHANGE
Live with change and accept unremovable complexity.
- Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
- Continually challenge and willingly amend your “best-loved ideas”
- Recognize reality even when you don’t like it – especially when you don’t like it
- STAY FOCUSED
Keep it simple and remember what you set out to do.
- Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
- Guard against the effects of hubris and boredom
- Don’t overlook the obvious by drowning in minutiae
- Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
- Face your big troubles; don’t sweep them under the rug
Shout out to allencheng.com/ for doing this written summary
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