Tuesday, May 23, 2017

Multibagger 2017

Multibagger 2017


  1. Reliance Industries,
  2.  
  3. UltraTech Cement,
  4. ICICI Prudential Life,
  5. Indian Bank,
  6. Wipro
  7. Biocon,
  8. Kotak Mahindra Bank
  9. Maruti Suzuki
  10. TVS Motors,
  11. Ambuja Cement,
  12. Ceat
  13. Federal Bank
  14. IDFC
  15. CanFin Homes
  16. Bajaj Finance
  17. Biocon
  18. Ashok Leyland
  19. JSW Steel
  20. Petronet LNG
Experts in multibagger stocks
PVR
Jagran Prakashan
Emami Ltd
Ultratech Cement
Asian Paints
TATA Motors VDA
HDFC
UPL Ltd
RIL
Bharati Airtel
Ashok Layland
Eicher Motors
TVS Motors
LIC Housing
Repco Home Finance
VST Tillers Tractors
Bharat Electronics
ARO Granite Industries
NCC
Federal Bank
Sydicate Bank
Sinext Industries
Andhra Bank
Idea Cellular
Ruchita Papers Ltd.
Precision Wires India Ltd
Sarda Energy and Minerals Ltd
IG Petrochemical

(i) Rakesh Jhunjhunwala and Radhakishan Damani

(ii) Dolly Khanna/ Rajiv Khanna
  RSWM 0.00 4.13 19
  Nilkamal 0.00 2.73 36
  PPAP Automotive 0.00 1.53 2
  Liberty Shoes 0.00 1.71 2
  Nitin Spinners 0.00 6.04 4
  Emkay Global Financial Services 0.00 3.77 2
  IFB Agro Industries 0.00 1.37 5
  Thirumalai Chemicals 0.00 1.85 15
  Nandan Denim 0.00 6.56 8
  NOCIL 0.00 33.86 23
  Srikalahasthi Pipes 0.00 6.21 17
  Dai-Ichi Karkaria 0.00 0.90 4
  Ruchira Papers 0.00 2.57 3
  Sterling Tools 0.00 1.10 10

(iii) Vijay Kedia
  Apar Industries,
  Sudarshan Chemicals,
  Repro
  Atul Auto,
  Cera Sanitaryware
 
  Amrutanjan Health Care Limited 1.07 156853 6.41
  Apcotex Industries Limited 1.12 231814 6.55
  Aries Agro Limited 4.6 598091 7.38
  Astec LifeSciences Limited 1.03 200000 4.62
  Cera Sanitaryware Limited 1.92 250000 49.94
  Cheviot Co Ltd 1.11 50000 3.54
  Lykis Ltd 16.59 3234383 19.4
  Panasonic Energy India Co Ltd 1.24 93004 2.97
  Repro India Limited 6.18 673416 26.16
  Sibar Software Services India Ltd 1.27 203900 0.01
  Speciality Restaurants Limited 1.06 500000 4.47
  Steward & Lloyds India Ltd 4.73 142014 0.31
  Sudarshan Chemical Industries Limited 3.82 2642479 30.85
  TCPL Packaging 1.38 119961 6.59
(iv) Porinju Veliyath
 
  Porinju Veliyath Portfolio Holdings
  Eastern Treads Limited
  IZMO Limited
  Simran Farms
  Stylam Industries
  Samtex Fashions
  BDH Industries
  Emkay Global
  Flex Foods
  Tara Jewels
  Alpa Labs
  V2 Retail
  ABC India
  Linc Pen
  Harrisons Malayalam
  Palred Technologies
  Sahyadri Industries
  Archies
  Gokaldas Exports
  Arvind Infrastructure
  Globus Spirits
  Tera Software
  KNR Construction
  Jubilant Life Sciences
  Nirvikara Paper Mills
  TATA Coffee
(v) Basant Maheshwari
 CUPID LTD
 Pantalones Retail
 Television 18
 Titan Industries
 Bharti Airtel
 Voltas
 Page Industries and Hawkins

 Repco Home Finance Limited
 Hawkins Cookers Ltd

Repco Home Finance Limited
Hawkins Cookers Ltd
Page Industries Limited
Gruh Finance Limited
Whirlpool of India Limited
Titan Company Limited
HDFC Bank Limited
Kajaria Ceramics Limited
Cera Sanitaryware Limited



(vi) Mudar Pathreya
==========================================================================================

Wealth Creations Streitegies



===========================================================================================
The following five stocks are small-cap stocks with excellent quality of management and high RoEs. They have a huge scale of opportunity ahead of them. These stocks have the potential to give multibagger returns in the future as well.
(i) Caplin Point Laboratories;
 (ii) Shaily Engineering Plastics;
 (iii) Vidhi Dyestuffs;
 (iv) Apcotex Industries;
 (v) Oriental Carbon;
 (vi) Adi Finechem;
 (vii) Astec Life;
 (viii) Prima Plastics;
 (ix) Heritage Foods;
 (x) Capital First.
Multibagger Stocks 2016
The following stocks have already given huge returns in 2015 and 2016. However, they are of such good quality of management and have such a dominant command over the market that they can be expected to give excellent returns in the future as well.
(i) Pricol
 (ii) LIC Housing Finance
 (iii) Repco Home Finance
 (iv) VST Tillers Tractors
 (v) Bharat Electronics
 VRL Logistics

 ==================================================================================================

  Asian Paints, Nestle, Infosys, Marico, Dabur, Eicher Motors, Bajaj Auto,'
 
  Atul
  TVS Motor Company
  J. K. Cement
 
 
  =================================================================================================
  2006 to 2016 90,677% time profit in following
 
  Symphony
  Ajanta Pharma
  DFM Food
 
  Caplin Point Labs
  Relaxo Footware
  Mayur Unicourts
  Tasty Bite
  La Opala RG
  Mannapuram Finance
  Captial Trust
  Eicher Motors
 
  United Spirits - Alcohol Share
  Symphani LTd
  Atul Auto
  Crompton Grevj Consumer
  Orient Paper
  Bajaj Electricals
  Havels
  Phillips
  Amara Raja Battery
 
 
 
  sanjay bhattacharya
  ramdev agrawal
  Porinju Veliyath
 
 
 


Monday, May 22, 2017

Paul Tudor Jones — 21 Trading Rules That Have Stood the Test of Time


Paul Tudor Jones — 21 Trading Rules That Have Stood the Test of Time

On October 1987, the financial markets collapsed.

It’s a devastating month for both traders and investors.

But not for Paul Tudor Jones…

That same month, he made an incredible return of 62 percent.

More importantly, he’s done what many thought was impossible…

…combining five consecutive, triple digit return years, with low equity retracements.

With such legendary track record, it pays to find out what are Paul Tudor Jones trading rules that brought him much success.

21 trading rules that will improve your trading

1. When you are trading size, you have to get out when the  market lets you out, not when you want to get out.

The old high was at 56.80, there are probably going to be a lot of buy stops at 56.85. If the  market is trading 70 bid, 75 offered, the whole trading ring has a vested interest in buying the market, touching off those stops and liquidating into the stops.

If I want to cover a position in that type of situation, I will liquidate half at 75, and the remaining half beyond that point.

2. Never play macho with the market and don’t over trade.

My major problem was not the number of points I lost on the trade, but that I was trading far too many contracts relative to the equity in the accounts that I handled.

3. If I have positions going against me, I get out; if they are going for me, I keep them.

4. I will keep cutting my position size down as I have losing trades.

When I am trading poorly, I keep reducing my position size. That way, I will be trading my smallest position when my trading is worst.

5. Don’t ever average losers.

6. Decrease your trading volume when you are trading poorly; increase  your volume when you are trading well.

7. Never trade in situations you don’t have control.

I don’t risk significant amounts of money in front of key reports, since that is gambling, not trading.

8. If you have a losing position that is making you uncomfortable, get out. Because you can always get back in.

9. Don’t be too concerned about where you got into a position.

The only relevant question is whether you are bullish or bearish on the position that day.

10. The most important rule of trading is to play great defense, not offense.

Everyday I assume every position I have is wrong. I know where my stop risk points are going to be.

I do that so I can define my maximum possible drawdown. if my positions are going against me, then I have a game plan for getting out.

11. Don’t be a hero. Don’t have an ego.

Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.

12. I consider myself a premier market opportunist.

I develop an idea on the market and pursue it from a very low risk standpoint until I have repeatedly been proven wrong, or until I change my view points.

13. I believe the very best money is to be made at market turns.

Everyone says you get killed trying to pick tops and bottoms and you make all the money by catching the trends in the middle.

Well, for twelve years, I have often been missing the meat in the middle, but I have caught a lot of bottoms and tops.

14. Everything gets destroyed a hundred times faster than it is built up.

It takes one day to tear down something that might have taken ten years to build.

15. Markets move sharply when they move.

If there is a sudden range expansion in a market that has been trading narrowly, human nature is to try to fade that price move.

When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion.

16. When I trade, I don’t just use a price stop, I also use a time stop.

If I think a market should break, and it doesn’t, I will often get out even if I’m not losing any money.

17. Don’t focus on making money; focus on protecting what you have.

18. You always want to be with whatever the predominant trend is.

19. My metric for everything I look at is the 200-day moving average of closing prices.

I’ve seen too many things go to zero, stocks and commodities.  The whole trick in investing is: “How do I keep from losing everything?”  If you use the 200-day moving average rule, then you get out.  You play defense, and you get out.

20. At the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?

21. I look for opportunities with tremendously skewed reward-risk opportunities.

You should always be able to find something where you can skew the reward risk relationship so greatly in your favor, that you can take a variety of small investments with great reward risk opportunities, that gives you minimum draw down pain, and maximum upside opportunities.

Conclusion

Do you want to learn more?

Click on the link below to access the Top 100 Trading Rules of all time.

These trading rules are personally handpicked by me, and includes the biggest names in trading, like Jesse Livermore, Paul Tudor Jones and Ed Seykota.

Paul Tudor Jones

Jones has succeeded in every major venture he has tried. He started out in the business as a broker and in his second year grossed over $1 million in commissions. In fall 1980, Jones went to the New York Cotton Exchange as an independent floor trader. Again he was spectacularly successful, making millions during the next few years. His really impressive achievement though was not the magnitude of his winnings, but the consistency of his performance: During his three and a half years as a floor trader, he witnessed only one losing month.

It’s been 25 years since Paul Tudor Jones (PTJ) was featured in the original Market Wizards. He has since maintained his all-star track record. According to the New York Times, as of mid-2014, PTJ’s flagship fund averaged long-term annual returns of around 19.5%. And what’s even more impressive is that he didn’t have a single losing year over those 25 consecutive years — a feat unheard of in the hedge fund industry.

To follow is an examination of this legendary fund manager, whose trading style resembles that of a street fighter and whose gut-instinct for market turns are unparalleled.

Paul Tudor Jones on the most important thing… "Don’t lose money"

“…at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.”

PTJ has an aggressive, cut-throat trading style, which is necessary if you want to string together multiple 100%+ years like he did. But what’s extraordinary about this record is the lack of drawdowns. It’s something only a handful of traders have ever accomplished (ie, Druckenmiller, Soros, Brandt).

He achieved this by mastering risk-management and consistently chopping off that left tail. This is a key trait of ALL top traders and investors… and PTJ stands out as one of the best. He learned the critical importance of managing risk through the painful and indelible experience of trading and making mistakes.

Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great money management tools.

That was when I first decided I had to learn discipline and money management. It was a cathartic experience for me, in the sense that I went to the edge, questioned my very ability as a trader, and decided that I was not going to quit. I was determined to come back and fight. I decided that I was going to become very disciplined and businesslike about my trading.

Author Brian McGill writes, “We are never taught more deeply and more truthfully than by pain.” True words…

Paul Tudor Jones has mentioned that when hiring traders he prefers those who have blown up accounts and suffered the pain of large losses. These traders have had risk management seared into their very being. This is a trait that almost has to be learned through experience and can’t be taught.

Side note: I remember reading the original Market Wizards book over a decade ago when I was as a green-behind-the-ears market punter. It seemed that every interview included a “Market Wizard” recounting their blown account from the early days and physical and emotional anguish that came with it. I thought to myself “wow, that sounds shitty. I’ll just never do that so I don’t have to experience something similar. Luckily, I’m an extremely levelheaded guy who doesn’t get emotional over trading. I’ll just stick to my risk management protocols and be fine.”

Fast forward a couple of years, two blown out accounts and a lot of money up in flames later, and yours truly finally realized how naive (stupid, ignorant, arrogant etc) he’d been. One of the Market Wizards (don’t remember the name) said something along the lines of “experiencing the pain of blowing up an account is a necessary stepping stone to learning how vital risk management is.” I couldn’t agree more. I emerged from the visceral and painful experiences of those big losses humbled and equipped with a maniacal focus on not losing money. Those early losses were important money spent on my trading tuition.  

Like Seykota said, “The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.” For some reason this is a platitude repeated by many, but understood by very few.

I think I am the single most conservative investor on earth in the sense that I absolutely hate losing money.

There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum drawdown pain and maximum upside opportunities.

Don’t ever let them get into your pocket — that means there’s no reason to leverage substantially.

When I am trading poorly, I keep reducing my position size. That way, I will be trading my smallest position size when my trading is worst.

I have very strong views of the long-run direction of all markets. I also have a very short-term horizon for pain.

Everything gets destroyed a hundred times faster than it is built up. It takes one day to tear down something that might have taken ten years to build.

On The Importance of Asymmetry And Macro

So much of successful trading consists of finding the right balance between risk management and betting big on the juiciest opportunities. This is one of the most difficult questions a trader is forced to constantly grapple with. There are no perfect answers.

Markets are fluid and dynamic. There will always be many unknowns. And because of this inherent complexity, a trader should always err on the side of capital preservation over profit maximization. It’s a lot easier to get steam rolled than it is to hit the cover off a fat pitch.

An important tool in rectifying the capital preservation/profit maximization dilemma is the understanding and implementation of asymmetry in trading.

Profitable trading is about finding and creating positive asymmetry. Positive asymmetry is when potential gains are multiples of potential losses. The greater the positive multiple, the greater the asymmetry. A trader should always be thinking in this fashion of potential risk weighted against potential reward (risk/reward).

A trader can find asymmetric opportunities through many approaches (ie, technical, fundamental, macro, sentiment etc) and then create more asymmetry through position sizing and risk/trade management. Finding and creating asymmetry is a central aspect of PTJ’s approach.

[I’m looking for] 5:1 (risk /reward).  Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.

I’d say that my investment philosophy is that I don’t take a lot of risk, I look for opportunities with tremendously skewed reward-risk opportunities.

PTJ is a macro trader. Trading macro means different things to different people. To Paul Tudor Jones, it means he doesn’t adhere to any single approach and is unconstrained in where he goes and what he trades. He also often takes a top-down approach when assessing markets. He simply uses whatever tool that works and makes him money.

I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader.

The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge. Because I think there are certain situations where you can absolutely understand what motivates every buyer and seller and have a pretty good picture of what’s going to happen. And it just requires an enormous amount of grunt work and dedication to finding all possible bits of information.

Market prices are the reflection of two forces: supply and demand. It’s the goal of the trader to use the tools at his disposal to better understand the supply and demand situation of the asset he’s trading. A mental model we use at Macro Ops is the Transaction Approach to determine buying and selling in markets.

I know from studying history that credit eventually kills all great societies. We have essentially taken out our American Express card and said we are going to have a great time.

Maybe there are macroeconomic forces at work that are part of a larger super cycle that we don’t have any control over. Perhaps we are simply responding to the same type of cycles that most advanced civilizations fell prey to, whether it was the Romans, sixteenth century Spain, eighteenth-century France, or nineteenth-century Britain.

You look at every bear market and they’ve always basically occurred because of an uptick in inflation and an uptick in interest rates.

Markets move in cycles. There’s the short-term cycle (aka the business cycle) and the longer-term cycle. These cycles are predominantly driven by credit (debt) and its affects on demand and the balance sheets of countries, companies, and people. Understanding the interaction of these two debt cycles and how they drive bull and bear markets is at the foundation of how our team at Macro Ops approach markets.

And because credit is the largest factor in driving demand, Central Banks, who control the cost of money (credit), are the primary causes of bull and bear markets.

When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500.

When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form.

Certain people have a greater proclivity for [macro trading] because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility, of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.

These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation.

Many market participants — especially the “smart” ones — fail because they think they can understand every move. To them, it’s more important to sound intelligent than it is to make money over the long-term. Academic economists who have a history of sounding smart but being wrong are great examples of this.

As a trader you have to know what you know and know what you don’t know… and never get the two mixed up. Markets will never fail to surprise you. One of the most dangerous things in this game is uniformed conviction. Be humble, embrace your fallibility and know that it’s impossible to really know the why in this game with anything close to absolute certainty.

Why it pays to be a "Slave to the Tape"

Paul Tudor Jones has an uncanny knack for reading the tape (price action) and getting a feel for where markets are going. A product no doubt of the era in which he came up, where information was scarce and the tape was the primary signal and information source. Since the market always knows more than you do, a trader has to respect price above all else.

The inability to read a tape and spot trends is also why so many in the relative value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced ‘100-year events’ every five years.

While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.

…at the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s? If it’s going up you’re supposed to be long it. But there’s no question that it’s just easier for me to leverage with some degree of conviction the short side of some markets.

I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart.

…technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action.

Livermore would say, “Your business with the tape is now — not tomorrow. The reason can wait. Buy you must act instantly or be left.” PTJ understands that truth and pays ultimate respect to price action as a result.

All the trades I have on are interrelated. I look at it in terms of what my equity is each morning. My goal is to finish each day with more than I started.

Everyone says you get killed trying to pick tops and bottoms and you make all the money by catching the trends in the middle… I have often been missing the meat in the middle, but I have caught a lot of bottoms and tops.

It’s not that we had any unfair knowledge that other people didn’t have, it is just that we did our homework. People just don’t want to believe that anyone can break away from the crowd and rise above mediocrity.

Evolution, Staying Frightened, and Emotional Detachment

The evolution of a trader generally follows the progression of moving from simplicity —> complexity —> informed simplicity. The goal is to build up your knowledge base, find what works, and strip yourself of what doesn’t. Da Vinci was right when he said “simplicity is the ultimate sophistication”. Many traders hide their ignorance with complex models, indicators, and theories filled with big words but of little value.

There’s a fundamental information set that you acquire with regard to each particular asset class and then you overlay a whole host of technical indicators and that’s how you make a decision.

Tullis taught me about moving volume. When you are trading size, you have to get out when the market lets you out, not when you want to get out. He taught me that if you want to move a large position, you don’t wait until the market is in new high or low ground because very little volume may trade there if it is a turning point.

I consider myself a premier market opportunist. That means I develop an idea on the market and pursue it from a very low-risk standpoint until I have repeatedly been proven wrong, or until I change my viewpoint.

When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion.

…because of the complexity of defining interacting and changing market patterns, a good trader will usually be able to outperform a good system.

It doesn’t make any difference whether it’s pork bellies or Yahoo. At the end of the day, it’s all the same. You need to understand what factors you need to have at your disposal to develop a core competency to make a legitimate investment decision in that particular asset class.

Now I spend my day trying to make myself as happy and relaxed as I can be. If I have positions going against me, I get right out; if they are going for me, I keep them.

The idea that you can’t beat the markets is a frightening prospect. That is why my guiding trading philosophy is playing great defense. If you make a good trade, don’t think it is because you have some uncanny foresight. Always maintain your sense of confidence, but keep it in check.

I think one of my strengths is that I view anything that has happened up to the present point in time as history. I really don’t care about the mistake I made three seconds ago in the market. What I care about is what I am going to do from the next moment on.

I try to avoid any emotional attachment to a market. I avoid letting my trading opinions be influenced by comments I may have made on the record about a market.

[No loyalty to positions] is important because it gives you a wide open intellectual horizon to figure out what is really happening. It allows you to come in with a completely clean slate in choosing the correct forecast for that particular market.

I know that to be successful, I have to be frightened. My biggest hits have always come after I have had a great period and I started to think that I knew something.

When I think of long/short business, to me there’s 5 ways to make money: 2 of those are you either play mean reversion, which is what a lot of long/short strategies do, or you can play momentum/trend, and that’s typically what I do.  We’ve seen cheap companies get cheaper many, many times.  If something’s going down, I want to be short it, and if something’s going up, I want to be long it.  The sweet spot is when you find something with a compelling valuation that is also just beginning to move up.  That’s every investor’s dream.

Paul Tudor Jones is a legendary trader because he’s great at playing defense and neurotic about protecting his capital. He never pigeonholed himself into a single trading approach but instead uses a multitude of tools; adopting what works and tossing what doesn’t. Through years of studying the tape he developed an instinctual feel for price action which allows him to spot turning points in markets and be aggressive at inflection points.

And above all else, even after obviously becoming one of the greatest, he’s still maintained a deep sense of humility in approaching markets which has allowed him to remain mentally flexible and robust.

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”


 

Paul Tudor Jones Interview

Here is an excerpt from an interview with Paul Tudor Jones:

Q: What sparked your original interest in trading?
A: I went to New York and saw the floor of the commodities exchange and there was such an energy level there and so much excitement that I knew that was the place for me.     I’ve always liked action and the exchange seemed like a perfect home for me.

Q: When did you decide you wanted to run a fund?
A: In 1976 I started working on the floor as a clerk and then I became a broker for E.F. Hutton. In 1980 I went strictly on my own as what they called a local and did that for about two and a half years and had two and a half wonderfully profitable years, but I really got bored. I applied to Harvard Business School, got accepted and was about to go. I literally was packed up to go and then I thought, ‘this is crazy’, because for what I’m doing here, they’re not going to teach me anything. This skill set is not something that they teach in business school. So I didn’t go, I stayed, but I was really bored because there wasn’t the personal interaction that was something that I craved and having colleagues and being in a clean atmosphere and that was when I started my fund. All through growing up I’ve been involved in team sports and fraternities and in school I was involved in a whole variety of activities all of which were team oriented and when I was on my own I was printing money every month, but I wasn’t getting the psychic satisfaction from it.

Q: How would you describe your general investment philosophy?
A: I think I am the single most conservative investor on earth in the sense that I absolutely hate losing money. My grandfather told me at a very early age that you are only worth what you can write a check for tomorrow, so the concept of having my net worth tied up in a stock a la Bill Gates, though God almighty it would be a great problem to have, it would be something that’s just anathema to me and that’s one reason that I’ve always liked the futures market so much, because you can generally get liquid and be in cash in literally the space of a few minutes. So that always appealed to me because I could always be liquid very quickly if I wanted to. I’d say that my investment philosophy is that I don’t take a lot of risk, I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.

A Dozen Things I’ve Learned from Paul Tudor Jones About Investing and Trading

Posted by trengriffin

6

Paul Tudor Jones is the founder of the hedge fund Tudor Investment Corporation. The New York Times reported in March of 2014: Mr. Jones can “claim long-term annual returns of close to 19.5 percent in his $10.3 billion flagship fund, Tudor BVI Global.”

 

1. “Certain people have a greater proclivity for [macro trading] because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility, of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.”

There are many ways to make a profit by trading and investing. For example, venture capitalists buy mispriced optionality and traders buy mispriced assets based on factors like momentum. Comparing value investing with what Paul Tudor Jones does for a living is interesting.  What could be more anti-Ben Graham and value investing than a statement like:  “We learned just to go with the chart. Why work when Mr. Market can do it for you?”

“While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.”

Set out below are some statements by Paul Tudor Jones that reveal a bit about his trading style:

When I think of long/short business, to me there’s 5 ways to make money: 2 of those are you either play mean reversion, which is what a lot of long/short strategies do, or you can play momentum/trend, and that’s typically what I do.  We’ve seen cheap companies get cheaper many, many times.  If something’s going down, I want to be short it, and if something’s going up, I want to be long it.  The sweet spot is when you find something with a compelling valuation that is also just beginning to move up.  That’s every investor’s dream.”

 

“I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader. When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500. When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form. The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced “100-year events” every five years. “

 

“These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action. The pain of gain is just too overwhelming for all of us to bear!”

 

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”

 

“One principle for sure would be: get out of anything that falls below the 200-day moving average.”

 

“I teach an undergrad class at the University of Virginia, and I tell my students, “I’m going to save you from going to business school.  Here, you’re getting a $100k class, and I’m going to give it to you in two thoughts, okay?  You don’t need to go to business school; you’ve only got to remember two things.  The first is, you always want to be with whatever the predominant trend is. My metric for everything I look at is the 200-day moving average of closing prices.  I’ve seen too many things go to zero, stocks and commodities.  The whole trick in investing is: “How do I keep from losing everything?”  If you use the 200-day moving average rule, then you get out.  You play defense, and you get out.”

 

“It’s just the nature of a rip-roaring bull market. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.” 

 

My takeaway: Paul Tudor Jones is timing non-rational human behavior based primarily on his pattern recognition skills. He does things like “spend an entire day watching a projection of his hedge fund’s positions blinking as they change.” What he does is interesting, but I am not interested in trying to replicate it myself. It does not suit my temperament, interests or skills. In other words, I am temperamentally unsuited to adopt his trading approach. I would rather drop a 100 pound stone on my toe than to watch blinking lights on a screen for a living. I put what Paul Tudor Jones does in what Charlie Munger might call the “not interested” pile. Would I put money in a hedge fund Paul Tudor Jones ran?  That is a moot question since he has no need or desire to raise money from people like me just as David Tepper would not invest money for me if I asked him. Would I invest with someone else who said he or she would replicate what they do? I doubt it, and certainly not anyone I know of right now. Whether I would invest in a tweaked index fund that considered a factor like momentum is a different question. I have not done this so far and it would certainly depend on the fees charged by the manager. Outperformance that is less than the manager’s fees is not interesting to me.

Understanding a factor like momentum is a big part of what Paul Tudor Jones does. Ben Carlson gives an excellent summary of the momentum approach to trading here which reads in part:

“The momentum factor is based on buy high, sell higher or alternatively, cut your losses and let your winners run. Value investing is based on a long-term reversion to the mean. Momentum investing is based on that gap in time that exists before mean reversion occurs. Value is a long game, while momentum is usually seen in the short- to intermediate-term… And it is a terrible idea to chase performance if you don’t know what you’re doing or why you’re doing it. Momentum is chasing performance, but in a systematic way, with an entry and exit strategy in place. Momentum tries to take advantage of performance chasers who are making emotional decisions. This is why the best momentum investors use a rules-based approach, to avoid those emotions.”

It is worth noting that momentum has been on a favorable roll lately. That does not mean the performance of momentum as a strategy will continue, but that momentum can work to outperform the market is a fact.

Despite his unique system, Paul Tudor Jones shares many approaches and methods with other great investors who have adopted different systems. I describe some of these commonalities below.

 

2. “I am always thinking about losing money as opposed to making money.”

“Don’t focus on making money; focus on protecting what you have.” 

“At the end of the day, the most important thing is how good are you at risk control.”

“Where you want to be is always in control, never wishing, always trading, and always, first and foremost protecting your butt.”

“I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.”

“[I’m looking for] 5:1 (risk /reward).  Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.”

The focus of great investors on not losing money is universal. Warren Buffett says the same thing, as do Seth Klarman and Howard Marks. This desire not to lose money is another way of saying that great investors and traders want to find bets with a lot more upside than downside. In other words, they are looking for asymmetry of potential outcomes: big upside and small downside. That’s optionality. They want to find bets that are very substantially in their favor. Great investors and traders are not gamblers since they seek positive expected value when making a bet.

 

3. “If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in. There is nothing better than a fresh start.”

Only bet when the odds are substantially in your favor. Don’t bet unless you have a margin of safety. If you are not feeling certain and comfortable with your bet, then don’t bet. Put differently by Charlie Munger: “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.”

 

4. “I think one of my strengths is that I view anything that has happened up to the present point in time as history. I really don’t care about the mistake I made three seconds ago in the market. What I care about is what I am going to do from the next moment on. I try to avoid any emotional attachment to a market.”

Treating past decisions as sunk and looking at each position on that basis is a great skill for an investor to have. Researchers put it this way: “People have trouble cutting their losses: They hold on to losing stocks too long, they stay in bad relationships, and they continue to eat large restaurant meals even when they’re full. This behavior, often described as ‘throwing good money after bad’, is driven by what behavioral scientists call the ‘sunk-cost bias’” What has been spent is spent. Once it is gone it is gone.

 

5. “By watching [my first boss and mentor] Eli [Tullis], I learned that even though markets look their very best when they are setting new highs, that is often the best time to sell. He instilled to me the idea that, to some extent, to be a good trader, you have to be a contrarian.”

That you can’t perform the market if you are doing just the same things as the market is a mathematical fact. You must sometimes be a contrarian and sometimes be right about that view in a way that makes the magnitude of what you do right outperform the crowd.  Paul Tudor Jones said once: “I also said that my contrarian trading was based on the fact that the markets move sideways about 85 percent of the time. But markets trend 15 percent of the time and you need to follow the trend during those times.” How he does this is a mystery to me. It’s pattern recognition, but what’s the pattern?

 

6. “[Eli] was the largest cotton speculator in the world when I went to work for him, and he was a magnificent trader. In my early 20s, I got to watch his financial ups and downs and how he dealt with them. His fortitude and temperament in the face of great adversity were great examples of how to remain cool under fire. I’ll never forget the day the New Orleans Junior League board came to visit him during lunch. He was getting absolutely massacred in the cotton market that day, but he charmed those little old ladies like he was a movie star. It put everything in perspective for me.”

“I want the guy who is not giving to panic, who is not going to be overly emotionally involved, but who is going to hurt when he loses. When he wins, he’s going to have quiet confidence. But when he loses, he’s gotta hurt.”

Having control over your emotions is a very valuable thing since most mistakes are emotional or psychological. I believe this anecdote is making the point that people who can keep emotions and actions in spate buckets have a big advantage. Self-control and self-awareness are very valuable.

 

7. “My guiding philosophy is playing great defense. If you make a good trade, don’t think it is because you have some uncanny foresight. Always maintain your sense of confidence, but keep it in check.”

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”

This is a series of statements about the dangers of hubris. Oscar Lavant put it this way: “What the world needs is more geniuses with humility; there are so few of us left.” The best investors and traders are humble. They know they have made, and will continue to make, some mistakes.

 

8. “I got out of the brokerage business because I felt there was a gross conflict of interest: If you are charging a client commissions and he loses money, you aren’t penalized. I went into the money management business because if I lost money, I wanted to be able to say that I had not gotten compensated for it. In fact, it would probably cost me a bundle because I have an overhead that would knock out the Bronx Zoo. I never apologize to anybody, because I don’t get paid unless I win.”

This is a quote about having “skin in the game.” Advisors with skin in the game perform better and are more accountable. What is good for the advisor or manager is good for you which lowers conflicts of interest. Aligned incentives are a very good thing, not just in investing but in life generally.  The more aligned interests are the more you can base a relationship on trust. The more trust that exists the fewer resources need to be devoted to compliance. The optimal outcome is what Charlie Munger calls “a seamless web of deserved trust.”

 

9. “This skill is not something that they teach in business school.”

That Paul Tudor Jones can do it does not mean that you can do it: “I get very nervous about the retail investor, the average investor, because it’s really, really hard.  If this was easy, if there was one formula, one way to do it, we’d all be zillionaires.” The danger of writing something like this blog post is that many knuckleheads will surely say “Oh, I can be just like Paul Tudor Jones.” No, the chances of that being true are vanishingly small. There is only one Paul Tudor Jones. You are not Paul Tudor Jones. But his record exists. It can’t be ignored.

 

10. “I’ve done really well on the short side.  There’s nothing more exciting than a bear market.  But it’s not a wonderful way for long-term health and happiness.”

“I spent 20 years doing it, it’s not the right way to make a living trading.  It’s simply not.”

Shorting stocks has negative optionality. Mohnish Pabrai says:  “When you are long on a stock, as it goes down in price, the position is going against you and it becomes a smaller portion of your portfolio. In shorting, it is the other way around: if the short goes against you, it is going to become a larger position of your portfolio. When you short a stock, your loss potential is infinite; the maximum you can gain is double your value. So why will you take a bet where the maximum upside is a double and the maximum downside bankruptcy?” Warren Buffett points out: “You’ll see way more stocks that are dramatically overvalued than dramatically undervalued. It’s common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it’s not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it’s worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, “Hey! Look at all that value creation!” and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas.”

 

11. “The single most important things that you can do is diversify your portfolio.  Diversification is key, playing defense is key, and, again, just staying in the game for as long as you can.”

It may seem odd that what some people call a gut trader like Paul Tudor Jones is focused on diversification.  What he and other investors are saying is that if you don’t play defense and you lose, you are out of the game. They know that you can’t win unless you remain in the game.  Diversification also allows you to “practice patience.” Paul Tudor Jones said on one occasion “if you don’t see anything, don’t trade.” He adds: “there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.”

 

12. “The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge.”

Paul Tudor Jones may be a momentum trader but he is also an investor who looks at fundamentals.  You can’t find mispriced assets unless you have an investing edge and that edge can come from better information and knowledge.


 

The 15 Best Things Paul Tudor Jones Has Ever Said About Trading

 

Paul Tudor Jones is one of the greatest traders that's ever lived.

The master macro trader called the 1987 crash perfectly, as depicted in the legendary PBS documentary "Trader" of the same year. (Copies of the VHS once sold for hundreds on eBay.) One of the greatest trades of all time, Jones' shorting of Black Monday reportedly netted him $100 million. $3 billion later, Jones continues to accrue worldbeating annual returns.

We've collected his 15 best pearls of investment insight.

"The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge."

 

"Intellectual capital will always trump financial capital."


 

Nifty under Modi: What investors have learnt so far (Hint: respect earnings)

As Nifty scales new highs and valuation comfort in the market wanes, investors should focus solely on the earnings trajectory to pick the winners for the remainder of Modi's tenure.

 


Krishna Karwa
Moneycontrol Research
Since the NDA’s landslide win in the 2014 polls, the Nifty Index has risen 34 percent in absolute terms, and 10.3 percent annually compounded. That may seem modest at first glance, but the breadth of the rally shows enough stocks that delivered eye-popping returns during the same period.
Earnings for the Nifty as a whole have been flat and that makes the index look expensive. But a closer look at earnings growth and share price performance of individual Nifty companies underscores the fact that stock prices are slaves to earnings in the long run.
The following graphs tell the story.
Exhibit 1 – Nifty stocks with returns greater than 100 percent over the past three years.
image1
For example, an investment of Rs 1 lakh in the stock of Eicher Motors when Modi took office would have given an investor over Rs 4.5 lakh today. The company’s earnings have also grown 3 times over this period. Eicher is not the sole stock where the financial performance was well rewarded by the market. Indiabulls Housing and Maruti Suzuki grabbed the second and third positions, respectively. Discretionary consumption clearly benefited in the first three years of the Modi era. The top ten gainers list also includes other notable discretionary consumption names like Asian Paints. The first lesson learnt was that stock prices follow earnings.
Exhibit 2 – Nifty stocks with returns at least two times higher than the index return over the past three years.
image2
Interestingly, for all these leading discretionary consumption names, while the earnings growth was robust, the stock return far exceeded the earnings growth, thereby indicating multiple re-rating. Smart investors clearly rode on companies where there was earnings visibility, thus rendering them expensive, apparently. However, as long as the earnings story remained intact, valuations did not stand in the way of stock performance. This is the second lesson learnt – do not worry too much about valuation if there is earnings growth.
The winners list includes a couple of stocks that benefitted from policy changes – BPCL and IOC. The deregulation of most of the petroleum products led to sharp earnings improvement and re-rating of the sector. In fact, unlike discretionary consumption, for the downstream oil companies, earnings growth has outpaced stock performance. Hence, even after the sharp rally, the stocks look reasonably valued on a relative basis.
The other pocket which benefitted in the first three years of Modi Sarkar are the savvy private banks that steered clear of the NPA mess that majority of the public banking entities were faced with. The private banking sector will continue to hog the limelight too, albeit the seemingly expensive valuations, as companies aim to grab market share from their comparatively weaker public sector counterparts. The banks that benefitted the most since the past three years were Yes Bank, IndusInd Bank, and Kotak Mahindra Bank.
Exhibit 3 – Nifty stocks with negative returns over the past three years
image3
Turning to the laggards, which mostly included companies affected by international aspects, earnings disappointment had a major role to play. The third lesson to keep in mind is that though companies with strong global linkages (either because of commodity prices or export-oriented businesses) may witness a sharp surge in earnings (which, in turn, remain contingent on numerous global factors) from time to time, subject to a good financial performance, chances of volatile movements and correction of multiples cannot be ignored. Therefore, going forward, strong domestic driven businesses will enjoy a premium over global businesses.
The prominent names in the list of losers included technology majors such as Wipro and Tech Mahindra, in addition to government-controlled resource entities such as Coal India and ONGC.
Interestingly enough, although there have been big winners within the Nifty – both in terms of earnings and price performance -- the same hasn’t impacted blended index earnings as the share of the market capitalization of the winners, at 38 percent, is much less than the losers.
As Nifty scales new highs and valuation comfort in the market wanes, investors should focus solely on the earnings trajectory to pick the winners for the remainder of Modi's tenure.
 

 
A Dozen Things I’ve Learned from Charlie Munger (Distilled to less than 500 Words)
Posted by trengriffin
This is the last post in a 12 part “Dozen Things” series on Charlie Munger.  Collectively the first 11 posts are nearly as large as a book.
The intent with this post is to distill Charlie Munger’s approach to making decisions to less than 500 words.  If you don’t have the patience to read 500 words, I can’t help you.
1. STAY IN YOUR CIRCE OF COMPETENCE: Know the edge of your own competency. It is not a competency if you don’t know the edge of it.
2. MAINTAIN A MARGIN OF SAFETY: Buy assets at a bargain so your investing results can be financially attractive even if you make a mistake. Price is not always the same as value. Avoid big mistakes. Reputation and integrity are your most valuable assets. Reputation earned over a lifetime can be lost in seconds.
3. THINK INDEPENDENTLY AND WITH OPPORTUNITY COST IN MIND: Markets and crowds are not always wise. Allocate your time and other resources to your most attractive opportunities. The highest and best use of a resource is always measured by the next best use.
4. BE INTELLECTUALLY HUMBLE: Recognize that the world is genuinely complex and that what you know is a fraction of what you still don’t know. Wait for what you expect rather try to forecast timing. Think about second order and above impacts of anything.
5. BE SMART BY NOT BEING STUPID: Tune out stupidity. The greatest and most important risk is permanent loss of capital, not just volatility in price. Only accept risk when you are properly compensated for assuming that risk. Activity for its own sake is not intelligent.
6. BE PATIENT, BUT AGGRESSIVE WHEN IT IS TIME: Great opportunities do not appear that often, but when they do appear they won’t last long so you must be aggressive when the time is right. When the odds of success are very substantially in your favor, bet big.
7. BE PREPARED: Great investments are hard to find but by consistently working hard you might find a few of them. You only need to find a few great investments in a lifetime.
8. KEEP IT SIMPLE: Apply organized common sense when solving a problem or when doing an analysis of an opportunity. Think more and calculate less. Avoid false precision and unnecessary transaction costs. Try not to interrupt interest that is compounding. Focus on being a business analyst, not a macroeconomic forecaster. Pay attention to the business cycle, but don’t try to predict it.
9. ACCEPT CHANGE: Avoid master plans since change is the only constant in life. Adapt. Look for evidence that would dis-confirm your own ideas. Understand arguments from all sides. Face your problems.
10. THINK BROADLY: Use multiple models from many disciplines in doing an analysis. Borrow the great ideas of the best thinkers in every discipline. The antidote to man with a hammer syndrome is a full set of tools.
11. AVOID HUBRIS: Try to avoid fooling yourself, which is hard since it is easy to do. Understand that more of success in life is luck than you imagine.
12. KEEP LEARNING: Be a learning machine. Never stop reading. Be curious. Surround yourself with smart people. Set aside time to read and think.
Warren Buffett: “There’s no successor to Charlie Munger. You’re not going to find anyone like him. He’s got a real fan club, but for good reason. I’m a member, too.”
A Dozen Things I’ve Learned from Charlie Munger about Ethics
Posted by trengriffin
3
It is important to consider a post like this in the context of the other posts in this series, like the post on mistakes. No one is perfect. Everyone makes mistakes.
 
“Ben Franklin said: ‘I’m not moral because it’s the right thing to do – but because it’s the best policy.’” “We  knew early how advantageous it would be to get a reputation for doing the right thing and it’s worked out well for us. My friend Peter Kaufman, said ‘if the rascals really knew how well honor worked they would come to it.’ People make contracts with Berkshire all the time because they trust us to behave well where we have the power and they don’t. There is an old expression on this subject, which is really an expression on moral theory: ‘How nice it is to have a tyrant’s strength and how wrong it is to use it like a tyrant.’ It’s such a simple idea, but it’s a correct idea.”  Thinking about this sentence raises the question about difference between ethics and morality. Opinions on the distinction between these two words vary. For purposes of this post I refer to “morality” as relating to shared communal or societal norms about right and wrong.  For the companion term this post will use this definition from US Supreme Court Justice Potter Stewart: “Ethics is knowing the difference between what you have a right to do and what is right to do.” Returning to the ideas in the quotations, what Ben Franklin and Charlie Munger are saying is that not only is unethical and immoral behavior wrong, it is a bad business practice.
 
“You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich–who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich–in money–not just in reputation.” Being ethical is just good business. As an example, I have a close friend who owns and leases commercial office building space and when he walks the streets of Seattle everyone seems to know him and they wave and smile. He is vastly better known than the mayor and certainly more popular. He is ethical to the core and people love to do business with him. The quality of his life is excellent and he is a multi-millionaire. He is wealthy both in terms of assets and friends.  Buffett has said: “You have certain things you want to achieve, but if you don’t have the love and respect of people, you are always a failure. That is the one thing you must earn, it can never be bought. No one that has the love and respect of others is ever a failure.”
 
 “We believe there should be a huge area between everything you should do and everything you can do without getting into legal trouble.  I don’t think you should come anywhere near that line.” This is the application of a margin of safety principle to ethics. Why risk coming anywhere near a legal problem when there are so many other actions to be taken and opportunities to pursue that do not have the same risk? It is truly amazing when someone with massive wealth ends up disgraced over some minor incremental crime, especially when the person involved already has massive wealth. Munger said once: “Last night, referring to some of our modern business tycoons – specifically, Armand Hammer – I said that when they’re talking, they’re lying, and when they’re quiet, they’re stealing. This wasn’t my witticism; it was used [long ago] to describe the robber barons.”
 
 
“Firms should have the ethical gumption to police themselves: Every company ought to have a long list of things that are beneath it even though they are perfectly legal.” “We don’t claim to have perfect morals, but at least we have a huge area of things that, while legal, are beneath us.  We won’t do them.  Currently, there’s a culture in America that says that anything that won’t send you to prison is OK.”  There is a big difference between what is legal and what is ethical.  Knowing the difference is critically important. Character and sound ethics means not doing what is unethical even if it may be legal. There is also the gray area of what business do you avoid. Buffett has said: “Charlie’s favorite company, Costco. They are the #3 distributor in the US of cigarettes, but you wouldn’t avoid buying it because of that. You’ll drive yourself crazy trying to keep track of these things. Our philosophy is … we just won’t be in certain businesses.” Munger puts it this way: “Warren told the story of the opportunity to buy Conwood, the #2 maker of chewing tobacco. I never saw a better deal, and chewing tobacco doesn’t create the same health risks as smoking. All of the managers chewed tobacco – it was admirable of them to eat their own cooking. Warren and I sat down and said we’re never going to see a better deal; it’s a legal product; and we can buy it at a wonderful price; but we’re not going to do it. Another fellow did and made a couple of billion easy dollars. But I don’t have an ounce of regret. I think there are a lot of things you shouldn’t do because it’s beneath you.”
 
“Once you start doing something bad, then it’s easy to take the next step – and in the end, you’re a moral sewer.” I have seen this set of issues play out multiple times in my life. As an example, the caretaker or trustee decides that they will “borrow” from funds entrusted for a beneficiary. They may say: “I will just borrow a small amount for a short time and I pay it back with interest.” Another example is an investment manager hiding a loss from clients.  From this small seed a massive fraud can grow and often does grow. Creeping incrementalism is a huge source of ethical problems. Once unethical behavior starts you have a very slippery slope to deal with.
 
“If your ethics slip and people are rewarded, it cascades downward.” “Terrible behavior spreads.” “Sometimes you have to resist sinking to the level of your competitors. But fomenting bad practices often becomes its own punishment. “If you do things that are immoral and stupid, there’s likely to be a whirlwind” that sweeps you away.” If people see other people cheating, particularly if they are viewed by the public as leaders, the ethical lapses can start to spread like the flu.
 
“You’re never going to have perfect behavior in a miasma of easy money.” “When the financial scene starts reminding you of Sodom and  Gomorrah, you should fear practical consequences even if you would like to participate in what is going on.” “Investment banking at the height of this last folly was a disgrace to the surrounding civilization.”  “You do not want your first-grade school teacher to be fornicating on the floor or drinking alcohol in the closet and, similarly, you do not want your stock exchange to be setting the wrong moral example.” “The SEC is pretty good at going after some little scumbag whom everybody regards as a scumbag. But once a person becomes respectable and has a high position in life, there’s a great reticence to act. Madoff was such a person.” “You should have personal standards that are way better than the criminal law requires. Why should the criminal law determine your behavior? It would be crazy. Who would behave that way in marriage, or in partnership, or anything else? Why should you do it in your general dealing? I think this mess, and, of course, it’s a little dispiriting to find that many of the people who are the worst miscreants don’t have much sense of shame and are trying to go back as much as they can to the old behavior.  The truth of the matter is, once you’ve shouted into the phone, “I’ll take x and y,” and three days later, you have an extra 5 million, once that has happened, the people just become hopeless addicts, and they lose their bearings.” There will always be some measure of ethical problems. But during times like the Internet bubble or the run up to the credit crisis the presence of easy money can make things worse.
 
“With so much money riding on reported numbers, human nature is to manipulate them. And with so many doing it, you get Serpico effects, where everyone rationalizes that it’s okay because everyone else is doing it. It is always thus.” These sentences describe an ancient problem. For example Augustine of Hippo once said: “Right is right even if no one is doing it; wrong is wrong even if everyone is doing it.” The problems that can be created by social proof can go beyond ethics. Warren Buffett has said that: “The five most dangerous words in business are: ‘Everybody else is doing it’.” Munger puts it this way: “Once some banker has apparently (but not really) solved his cost-pressure problem by unwise lending, a considerable amount of imitative ‘crowd folly,’ relying on the ‘social proof,’ is the natural consequence.”
 
“If we mix only a moderate minority share of turds with the raisins each year, probably no one will recognize what will ultimately become a very large collection of turds.” A manager must be careful about the negative impact of a few bad apples on the quality of the other apples in the barrel. Hire slow, and in the case of a turd, fire fast.
 
“I talked to one accountant, a very nice fellow who I would have been glad to have his family marry into mine.  He said, ‘What these other accounting firms have done is very unethical.  The [tax avoidance scheme] works best if it’s not found out [by the IRS], so we only give it to our best clients, not the rest, so it’s unlikely to be discovered.  So my firm is better than the others.’  I’m not kidding.  And he was a perfectly nice man.  People just follow the crowd. Their mind just drifts off in a ghastly way.” What Charlie Munger is talking about in these sentences is the power of the psychology of human misjudgment. A lollapalooza of biases kicks in to cause this accountant to fall into unethical behavior. There is self-interest bias and social proof and psychological denial and other heuristics at work in a case like this.
 
“It’s hard to judge the combination of character and intelligence and other things. It’s not at all simple, which explains why we have so many divorces. Think about how much people know about the person they marry, yet so many break up.” “Avoid dealing with people of questionable character.” “One of the reasons the original Ponzi scheme was thrown into the case repertoire of every law school is that the outcome happens again and again. So we shouldn’t be surprised that we have constant repetition of Ponzi schemes.” Judging the ethical nature of anyone is not simple. One clue is how they treat people generally.  I has an assistant for many years who would let me know how job applicants treated the receptionist and others they met. People who are rude and condescending to anyone reveals much about who they are as people. Munger has said: “I think track records are very important. If you start early trying to have a perfect one in some simple thing like honesty, you’re well on your way to success in this world.”
 
“The best single way to teach ethics is by example.” “Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat.” It is far easier to preach about ethical standards than to live up to them. And living up to ethical standards is the best possible teaching method anyway. Children especially know when someone is walking the talk. Both Munger and Buffett have said that it is wise to “take the high road, since it is less crowded.”
A Dozen Things I’ve Learned from Charlie Munger about Moats
Posted by trengriffin
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1. “We have to have a business with some inherent characteristics that give it a durable competitive advantage.” Professor Michael Porter calls barriers to market entry that a business may have a “sustainable competitive advantage.” Warren Buffett and Charlie Munger call them a “moat.”  The two terms are essentially identical. Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” A complete discussion about the nature of moats can’t be done well in a ~3,000 word blog post since it is one of the most complex topics in the business world.  For this reason, in my book on Charlie Munger I put the material on moats in an appendix since I feared readers would bog down and not focus on the more important points such as making investment and other decisions in life. But the complexity of the topic does not change the fact that to be a “know-something” investor you must understand moats. Even the fate of the smallest business like a bakery or shoe store will be determined by whether they can create some form of moat.  The small business person may not now what a moat is called but the great ones know that they must generate barriers to entry to create a profit. The underlying principle involved in moat creation and maintenance is simple: if you have too much supply of a good or service, price will drop to a point where there is no long-term industry profit above the company’s cost of capital. Michael Mauboussin, in what is arguably the best essay ever written on moats put it this way, “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive return, which will drive aggregate industry returns to opportunity cost of capital.” The best test of whether a moat exists is quantitative, even though the factors that create it are mostly qualitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for a period of years, it does not have a moat.  If a business must hold a prayer meeting to raise prices it does not have a moat. A business may have factors that may create a moat in the future, but the best test for a moat is in the end mathematical.  The five primary elements which can help create a moat are as follows: 1. Supply-Side Economies of Scale and Scope; 2. Demand-side Economies of Scale (Network Effects); 3. Brand; 4. Regulation; and 5. Patents and Intellectual Property.  Each of these five elements is worthy of an entire blog post or even a book. These elements and the phenomenon they create are all interrelated, constantly in flux and when working together in a lollapalooza fashion often create nonlinear positive and negative changes. For me, questions related to the creation, maintenance and destruction of moats are the most fascinating and challenging aspects of the business world.  There are no precise formulas or recipes that govern moats but there is enough commonality that you can get better at understanding moats over time.
2. “We’re trying to buy businesses with sustainable competitive advantages at a low – or even a fair price.” “Everyone has the idea of owning good companies. The problem is that they have high prices in relations to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case.” Buying a business with a moat is a necessary but not a sufficient condition for achieving financial success in a business. What Charlie Munger is saying in these sentences is that if you pay too much for a moat you will not find success. No one makes this point better than Howard Marks who writes: “Superior investors know – and buy – when the price of something is lower than it should be… most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them.” Some people have this idea that value investing is only about buying cheap assets. The reality is that many assets are cheap for good reason. Genuine value investing is about buying assets at a substantial discount to their value. This is why Charlie Munger says that: “All intelligent investing is value investing.” What he means is: is there any type of investing whether the objective is to pay more than an asset is worth? There are some assets for which an intrinsic value can’t be computed, but that is a different question than whether an asset should be purchased at a discount to its value. Buffett writes: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
 
3. “You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “Yes, but I didn’t run around asking people how to do it.”We buy barriers. Building them is tough… Our great brands aren’t anything we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins.” While there is no formula or recipe for creating a moat there are many common principles that can be used in trying to create or identify one. For example, Munger has said: “In some businesses, the very nature of things cascades toward the overwhelming dominance of one firm. It tends to cascade to a winner take all result.” On another occasion he said: “Do you know what it would cost to replace Burlington Northern today? We are not going to build another transcontinental.” It is important to note that there is a world of difference between creating a new moat than buying an existing one. For example, the venture capital business is fundamentally about building moats and the value investing discipline, as practiced by Munger and Buffett, is instead about buying existing moats at a discount to the intrinsic value of the business.
 
4. “The only duty of corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it’s too tough.  But your duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you.” What Charlie Munger is saying in these sentences is that operational excellence in running a business is very important, but the factors that maintain the barriers to entry of the business must also receive proper attention by management. For example, if the moat of a business is based on network effects or intellectual property those factors can’t be ignored. Sometimes playing defense is needed in whole or in part, as was the case when Facebook bought several potential moat destroyers. The Instagram, Oculus and WhatsApp acquisitions were in no small part designed to widen the existing Facebook moat. Of course, the companies were bought to create new moats too, so in that sense they served two purposes (i.e., the acquisitions served both offensive and defensive purposes for Facebook). Startups potentially have an asymmetrical advantage since often they are bought by incumbents just for defensive reasons (i.e., sometimes in an acquisition only consumers benefit since the new service or good is all, or nearly all, consumer surplus).
 
5. “How do you compete against a true fanatic? You can only try to build the best possible moat and continuously attempt to widen it.”  The job of a businessperson is to try to create product or service which are sufficiently unique that constraints are placed on  other companies who desire to provide a competing supply of those goods or services. For this reason moat creation and maintenance is a key part of the strategy of any business. What this means is that the essential task of anyone involved in establishing a strategy for a business is defining how a business can be unique. Creating a business strategy is fundamentally about making choices.  It is not just what you do, but what you choose not to do, that defines an effective strategy. Professor Michael Porter argues that doing what everyone must do in a business is operational effectiveness and not strategy.  The people who most often create unique compelling offerings for customers are true fanatics. Jim Sinegal of Costco is just such a fanatic which is why Charlie Munger serves on their board.  Going down the list of Berkshire CEOs reveals a long list of fanatics.
 
6. “Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.” This set of sentences is an example of Charlie Munger applying his inversion approach. He believes that when you have a hard problem to solve the best solution often appears when you invert the problem.  For example, Munger applies the inversion process to moat analysis. Instead of just looking at why a moat exists or can be made stronger, he is saying you should think about why it may weaken. He is looking for sources of unique insight that might have been missed by others who may be too optimistic. Not being too optimistic is consistent with his personality. Munger has called himself a “cheerful pessimist.” Over time the forces of competitive destruction will inevitably weaken any moat. Munger has said: “It is a rare business that doesn’t have a way worse future than a past.” “Capitalism is a pretty brutal place.” “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.” Bill Gates describes what Berkshire is looking for in a business as follows: “[they] talk about looking for a company’s moat — its competitive advantage — and whether the moat is shrinking or growing.”
 
7. “Kellogg’s and Campbell’s moats have also shrunk due to the increased buying power of supermarkets and companies like Wal-Mart. The muscle power of Wal-Mart and Costco has increased dramatically.”  Wholesale transfer pricing power, also sometimes called supplier bargaining power (e.g., in the Michael Porter five forces model) is a potential destroyer of moats. Understanding who has pricing power in a value chain is a critical task for any manager. As an example of a moat being attacked in this way, the venture capitalist Chris Dixon wrote once about a chain of events in the gaming industry : “In Porter’s framework, Zynga’s strategic weakness is extreme supplier concentration – they get almost all their traffic from Facebook. It is in Facebook’s economic interest to extract most of Zynga’s profits, leaving them just enough to keep investing in games and advertising.” As another example, most every restaurant which does not own its building faces this same wholesale transfer pricing problem.  If you have an exclusive supplier of a necessary input, that supplier controls your profits. It is wise to have multiple suppliers of any good or service, at least potentially.
 
8. “What happened to Kodak is a natural outcome of competitive capitalism.” “The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else—they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors Company, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It’s very Darwinian—it’s tough out there. Technological change is one of the toughest things.” I don’t know of any business in today’s business world that does not face significant disruptive threats. None. It is brutally competitive to be involved any business today. Do some businesses have moats that make their lines of business relatively more profitable? Sure. But I can’t think of any business which is not under attack right now. When I say every business is competitive in todya’s world I mean every business. Life as the owner of a sandwich shop, a food processor, marketing consultancy, etc. is inevitably tough. Pricing power in the business world today is rarer than a Dodo bird. Technology businesses present a special case when it comes to moats since disruptive change is much more likely to be nonlinear. Businesses in the technology sector that seem relatively solid can disappear in the blink of an eye. The factors like network effects that can create startling success for a technology company can be just as powerful on the way down as they were the way up.
 
9.  “The perfectly fabulous economics of this [newspaper] business could become grievously impaired.” The newspaper business once had a strong moat created by economies of scale inherent in huge printing plants and large distribution networks needed for physical newspapers. The Internet has caused the moats of newspapers to quickly atrophy, which is problematic for owners and society as a whole given that the news itself is what is called a “public good” (i.e., non-rival and non-excludable). Charlie Munger has lamented the decline of newspapers: “It’s not good for the country. We’re losing something.” Buffett has said it “blows your mind” how quickly the newspaper industry has declined. The way commentators on the financial prospects of newspapers ignore the public good problems is amazing really.  Increasing something like quality does not fix a public good problem. Without some scarcity/a moat there will be no ability on the part of newspapers to generate a profit.  Solutions to journalism business model problems are likely to include philanthropy as is the case with other public goods.
 
10.“Network TV [in its heyday,] anyone could run and do well. If Tom Murphy is running it, you’d do very well, but even your idiot nephew could do well.” Some moats are so strong that even a weak management teams can prosper running the business. The broadcast television moat is not what it once was given the rise of things like over the top viewing. But at one time television had a bullet proof moat. Buffett believes: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Munger certainly wants a business in which he invests to be run by capable and trustworthy managers. Operational excellence is always desired. But having a moat is a protection against a poor manager running a business into the ground. Buffett said once:  “Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.” 
 
11. “I think it’s dangerous to rely on special talents — it’s better to own lots of monopolistic businesses with unregulated prices. But that’s not the world today.” In these sentences Charlie Munger uses a term that Peter Thiel likes to use when referring to a moat: “monopoly. While it is certainly profitable to own an unregulated monopoly, the number of businesses today that have moats which can be considered a monopoly is vanishingly small.  For this reason I think Peter Thiel takes the monopoly point too far.  The word monopoly is loaded and carries too much baggage to be useful. The reality is that the nature of moats is not binary. Moats come in all varieties, from strong to weak. They are always in flux and vary on multiple dimensions. For example, some big moats are more brittle than others. Some moats protect valuable market segments and some do not. In other words, moats can be classified along a spectrum from strong to weak, valuable to non valuable and from big to small.
 
12. “The informational advantage of brands is hard to beat.  And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage. Everyone is influenced by what others do and approve.  Another advantage of scale comes from psychology. The psychologists use the term ‘social proof’. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, ‘Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ All told, your advantages can add up to one tough moat.” The most important point made in these sentences by Charlie Munger is that the great moats which exist in the world tend to have an aggregate value that is more than the sum of the parts. Munger calls this a “lollapalooza” outcome. Others may refer to it as synergy. As an example, many moats in the technology business are based on what Munger calls an informational advantage, but there can be many other factors like economies of scale or intellectual property that feed back on each other to create and strengthen the moat.
I am at ~3,400 words in this post and if you are still reading the probability is good that you understand or soon will understand this critical aspect of investing called “moats.” The opportunities to learn never end. I think is the best game on Earth and that fact explains why Munger and Buffett love what they do so much that they plan to continue to be investors as long as they are physiologically able to do so.  Here’s Buffett to finish this post off:
“I will say this about investing: Everything you do earn is cumulative. That doesn’t mean that industries stay good forever, or businesses stay good forever, but in learning to think about business models, what I learned at 20 is useful to me now. What I learned at 25 is useful to me now. It’s like physics. There are underlying principles, but now they’re doing all kinds of things with physics they weren’t doing 50 years ago.
But if you’ve got the principles, if you know what makes a good business, if you know what makes a good manager, if you know what makes a good product, and you learn that in one business, there is some transference to other businesses.”
A Dozen Things I’ve Learned from Charlie Munger about Capital Allocation
Posted by trengriffin
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1. “Proper allocation of capital is an investor’s number one job.” Capital allocation is not just the number one job of an investor but of anyone involved in any business. This is a core part of why Buffett and Munger say that being an investor makes you a better business person and being a better business person makes you a better investor. Making capital allocation decisions is core to any business, including a hot dog stand. Everyone must decide how to deploy their firm’s resources. Michael Mauboussin and Dan Callahan describe the core task in allocating capital simply: “The net present value (NPV) test is a simple, appropriate, and classic way to determine whether management is living up to this responsibility. Passing the NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the present value of the long-term cash flow from an investment exceeds the initial cost.” Of course just passing the NPV test is not enough since the investor or business person’s job to seek the most attractive opportunity of all the opportunities that are available. Building long-term value per share is the capital allocator’s ultimate objective. Buffett puts it this way: “If we’re keeping $1 bills that would be worth more in your hands than in ours, then we’ve failed to exceed our cost of capital.”
2. “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” Munger is not a fan of academic approaches to capital allocation. He would rather keep the analysis simple. One issue that concerns both Buffett and Munger is that many CEOs arrive in their job without having sound capital allocation skills. The jobs that they have had previously in many cases do not provide them with sufficient capital allocation experience. Buffett has written: “Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The best way to learn to wisely allocate capital is to actually allocate capital and get market feedback on those decisions. Allocating capital requires judgment and the best way to have good judgment is often to have experienced some effects of bad judgment. This lack of capital allocation experience can create problems since many people tend to focus on short-term stock prices and quarterly results. Munger believes that if an investor or CEO focuses on wise capital allocation and long term value the stock price will take care of itself.
3. “In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics. The game hasn’t changed at all. That’s why Modern Portfolio Theory is so asinine.” “It’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.” “I’ve never heard an intelligent discussion on cost of capital.” Munger has on several occasions expressed his unhappiness with academic approaches to finance. Buffett describes their approach as follows: “Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it.” All capital has an opportunity costs – what you can do with the next best alternative. If your next best alternative is 1%, it is 1% and if it is 10% it is 10%, no matter what some formula created in academia might say. Allocating capital to a sub-optimal use is a mis-allocation of capital. As an example, if you are a startup founder and you are buying expensive chairs for your conference room the same process should apply. Is that your best opportunity to deploy capital? Those chairs can potentially be some of the most expensive chairs ever purchased on an opportunity cost basis. I have heard second hand that if you drive an expensive sports car Buffett has in the past on the spot calculated in his head what your opportunity cost is in buying that car versus investing.
4. “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.” “Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland.” The current interest rate environment is a big departure from the past. Andy Haldane has pointed out that interest rates appear to be lower than at any time in the past 5,000 years. These very low interest rates driven by a “zero interest rate policy” or ZIRP have created new challenges for investors and business people. One issue that seems to exists today is a stickiness of hurdle rate at some businesses. Hurdle rates that were put in place in the past may not be appropriate in today’s world. Buffett has said: “The real test is whether the capital that we retain generates more in market value than is retained. If we keep billions, and the present value is more than we’re keeping, we’ll do it. We bought a company yesterday because we thought it was the best thing that we could do with $3 million on that day.” In 2003 Buffett said: The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.” Warren also recently said that he wasn’t just going to buy using today’s very low rates just because they were his current best opportunity. These sorts of questions are very hard to sort out given the economic environment we are in now is new. The last point Munger makes is that when someone promises you a long term return of something like 20% for 40 years hold on to your wallet tightly and run like the wind.
5. “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” Munger likes a business that generates free cash flow that need not be reinvested and not just an accounting profit. Some business with an accounting profit require that you reinvest all or nearly all of any cash generated into the business and Munger is saying businesses like this are not favored. Coke and See’s Candies are attractive businesses based on this test. Airlines by contrast are not favored. Munger calls an airlines “marginal cost with wings.” Munger is also not a fan of creative accounting’s attempt to hide real costs: “People who use EBITDA are either trying to con you or they’re conning themselves. Interest and taxes are real costs.” “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” Buffett says: “Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money.”
6. “Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital.” “A phrase like cost of capital means different things to different people. We just don’t know how to measure it. Warren’s way of describing it, opportunity cost, is probably right. The answer is simple: we’re right and you’re wrong.” “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.” Berkshire does not “want managers to think of other people’s money as ‘free money’” says Buffett, who points out that Berkshire imposes a cost of capital on its managers based on opportunity cost. One thing I love about this set of quotes is Munger admitting that Buffett is only “probably” right and that they don’t know how to measure something others talk about. It indicates that Munger is always willing to consider that he is wrong. While he has said that he has a “a black belt in chutzpah,” he has also said that if he does not overturn a treasured belief at least once a year, it is a wasted year since it means he is not always looking hard at whether his beliefs are correct. In his new book Superforecasting, Professor Philip Teltock might as well have been writing about Charlie Munger when he wrote: “The humility required for good judgment is not self doubt – the sense that you are untalented, unintelligent or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.”
7. “We’re partial to putting out large amounts of money where we won’t have to make another decision.” Attractive opportunities to put capital to work at high rates of return don’t come along that often. Munger is saying that if you are a “know something investor” when you find one of these opportunities you should load up the truck and invest in a big way. He is also saying that he agrees with Buffett that their preferred holding period “is forever.” Buffett looks for a business: “where you have to be smart only once instead of being smart forever.” That inevitably means a business that has a solid sustainable moat. Buffett believes that finding great investment opportunities is a relatively rare event: “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. 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.” When he finds a really great business the desire of Charlie Munger is to hold on to it. Munger elaborates on the benefits of not selling: “You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.”
8. “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions.” Centralization of capital allocation decisions at Berkshire to take advantage of Warren Buffett’s extraordinary abilities is an example of opportunity cost analysis at work. Why allow your second best capital allocator or 50th best do this essential work? Here’s Buffett on his process: “In allocating Berkshire’s capital, we ask three questions: Should we keep the capital or pay it out to shareholders? If pay it out, then you have to decide whether to repurchase shares or issue a dividend.” “To decide whether to retain the capital, we have to answer the question: do we create more than $1 of value for every dollar we retain? Historically, the answer has been yes and we hope this will continue to be the case in the future, but it’s not certain. If we decide to retain and invest the capital, then we ask, what is the risk?, and seek to do the most intelligent thing we can find. The cost of a deal is relative to the cost of the second best deal.” As was noted in the previous blog post in this series, nearly everything else other than capital allocation and executive compensation is decentralized at Berkshire.
9. “We’re not going to put huge amounts of new capital into a lousy business. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” This is such an important idea and yet it is often poorly understood. Many investments in a business are only going to benefit customers because the business has no moat. In economic terminology, the investment produces all “consumer surplus” and no “producer surplus.” Some businesses must continue to plow capital into their business to remain competitive in a business that is still going to deliver lousy financial returns. Journalists often talk about businesses that “earn” some amount without noting that what they refer to is revenue not profit. What makes a business thrive is profit and absolute dollar free cash flow. One thing I am struck by in today’s world is how hard nearly every business is in terms of making a significant genuine profit. The business world is consistently hyper competitive. There is no place to hide from competition and potential disruption. If you have a profit margin, it is someone else’s opportunity. Now more than ever. People who don’t think this contributes the inability of central banks to create more inflation are not living in the real business world.  Making a sustained profit in a real business is very hard.
10. “I don’t think our successors will be as good as Warren at capital allocation.” There will never be another Warren Buffett just as there will never be another Charlie Munger. But that does not mean you can’t learn from the way they make decisions, including, but not limited to, capital allocation decisions. Learning from others is strangely underutilized despite its huge rewards. Some of this aversion to learning from others must come from overconfidence. This overconfidence is good for society since it results in a lot of intentional and accidental discovery. But at an individual level it is hard on the people doing the experimentation. Reading widely about how others investors and business people approach capital allocation is wise. As an example, Howard Marks and Seth Klarman are people who have learned from Buffett and Munger and vice versa. Having said that, we are all unique as investors. There is no formula or recipe for successful investing. But there are approaches and processes that are far more sound than others that can generate an investing edge if you are willing to do the necessary work. These better decision making process are applicable in life generally. If you are not willing to do the work that an investor like Munger does in his investing, you should buy a diversified low cost portfolio of index funds/ETFs. A dumb “know nothing investor” can transform themselves into a smart investor by acknowledging that they are dumb. Buffett calls this transformation from dumb to smart of they admit they are dumb an investing paradox.
11. “All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return.” Munger is saying that the more assets you must manage the harder it is to earn an above market return. Putting large amounts of money to work means it takes more time to get in and out of positions and for that reason it becomes hard to effectively invest in relatively smaller opportunities. Buffett puts it this way: “There is no question that size is an anchor to performance. We intend to prove that up to the point that it really starts biting. We can’t earn the same returns on capital with over $300 billion in market cap. Archimedes said he could move the world with a long enough lever. I wish I had his lever.”
12. “Size will hurt returns. We can only buy big positions, and the only time we can get big positions is during a horrible period of decline or stasis. That really doesn’t happen very often.” There are times when Mr. Market turns fearful and huge amounts of capital can be put to work even by Berkshire as was the case in 2008. To be able to take advantage of this requires that the investor (1) be patient and (2) be aggressive when it is time. Jumping in when things are falling apart takes courage. Not jumping is during a period of investing frenzy takes character. Bill Ruane believes: “Staying small in terms of the size of fund is simply good business. There aren’t that many great companies.” The bigger the fund the harder it is to outperform. Bill Ruane famously closed his fund to new investors to be “fair” to his clients. 
In terms of an example of outperforming during what for others was a horrible time, the following example of Munger in action below speaks for itself. Bloomberg wrote at the time: “By diving into stocks amid the market panic of 2009, Munger reaped millions in paper profits for the Daily Journal. The investment gains, applauded by Buffett at Berkshire Hathaway’s annual meeting in May, have helped triple Daily Journal’s own share price. While Munger’s specific picks remain a mystery, a bet on Wells Fargo (WFC) probably fueled the gains, according to shareholders who have heard Munger, 89, discuss the investments at the company’s annual meetings. ‘Here’s a guy who’s in his mid-80s at the time, sitting around with cash at the Daily Journal for a decade, and all of a sudden hits the bottom perfect.’”
Munger having the necessary cash to do this investment in size at the right time in 2009 was not accidental. You don’t have the cash at the right time by following the crowd. As Buffett points out holding cash is not costless: “The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time.” That available cash was a residual of a disciplined buying process focused on a bottoms-up analysis by Munger of individual stocks. His ability to do this explains why he is a billionaire and we are not.
A Dozen Things I’ve Learned from Charlie Munger About The Berkshire System
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1. “There are two main reasons Berkshire has succeeded. One is its decentralization. Decentralization almost to the point of abdication. There are only 28 people at headquarters in Omaha. The other reason is our extreme centralization of capital deployment. Our centralization is just as extreme as our decentralization.” Systems are important in Charlie Munger’s world. I have already written a blog post in this series about one system called “the value investing system.” This post is about another system known as “the Berkshire System.” These two systems are related, but distinct. A system can be defined as a set of processes and methods that produce a desired result that is more than the sum of the parts. Charlie Munger is an example of a “systems level thinker.” Munger thinks deeply about things like understanding that local optimizations that actually decrease performance of the overall system.  Munger also talks a lot about lollapaloozas and the impact of 2nd and 3rd order effects. Howard Marks is doing this too with his second level thinking idea. Nassim Taleb thinks in the same way, including the nonlinear impact of systems level interactions. The best investors and business people think hard and a lot about systems.
The Berkshire system is not the only system for operating a business but it is a very good one. Attempts have been made to replicate the Berkshire system but they are unlikely to be successful without adopting all of the elements that will be described below. In other words, half of the Berkshire system will not be much of an effective system. For example, delegating control without trustworthy people throughout the organization will fail. Decentralization of everything including capital allocation will fall prey to what Buffett calls “the Institutional Imperative: “rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated…Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.” Professor Lawrence Cunningham, who has written an excellent book on Berkshire writes: “The only qualifications on managerial autonomy at Berkshire appear in a short letter Buffett sends its unit chiefs every two years. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations.”
People sometimes are get confused about what Warren Buffett does at Berkshire. Munger puts it simply: “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions, and we have decentralization among our operations without a big bureaucracy. That’s the Berkshire Hathaway model.” It is worth noting that it is Buffett and not Munger who ultimately who makes the capital allocation decisions. Buffett seeks Munger’s guidance and thoughts but Buffett pulls the capital allocation trigger. I have another blog post in the works on the capital allocation process at Berkshire, which will take the total number of planned posts on Munger up to a Spinal Tap-style #11.  Buffett has said on the capital allocation system: “Berkshire wants the capital in the most logical place. Berkshire is a tax efficient way to move money from business to business, and we can redeploy capital in places that need them. Most of the managers of companies we own are already independently rich. They want to work, but don’t have to. They don’t horde capital they don’t need.” The management at a subsidiary like See’s Candies is given a capital allocation by Buffett, not the reverse. Superior capital allocation skill is one of Warren Buffett’s unique gifts. Some people can do things like skateboard very well and some people can allocate capital very well. Buffett has pointed out: “If all of us were stranded on a desert island somewhere and we were never going to get off of it, the most valuable person there would be the one who could raise the most rice over time. I can say, “I can allocate capital!” You wouldn’t be very excited about that. So I have been born in the right place.”
2. “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.” These three sentences capture the essence of what drives the success of the Berkshire System and the necessary preconditions for that system to work effectively. Firms exist to reduce the cost of coordinating economic activity versus the alternative approach. The Berkshire System implemented in a firm will not generate the desired efficiency and results unless the organization has trust in trustworthy people. That efficiency makes the businesses, managers and employees in the Berkshire system better able to adapt to changes in the environment. Professor Lawrence Cunningham relays this interesting snippet from a private conversation: “Munger told me: take Coase seriously/avoid middlemen.” People talk about capitalism being the most efficient way to allocate resources, but it is capitalism’s ability to drive innovation via discovering new innovation that makes is the best possible economics system. A person saying that socialism is more efficient than capitalism since it is more efficient to have only a few types of phones is an absurdity. Innovation and progress requires failure. Lots of failure. Munger has said, after giving the hat tip to Allen Metzger for the phrasing: “I regard it as very unfair, but capitalism without failure is like religion without hell.” If course, markets sometimes fail too, which is why programs and policies like a social safety net are needed. Munger described this in his typical blunt fashion: “Greenspan was a smart man but he overdosed on Ayn Rand at a young age.” Munger also said once at one of his most famous speeches given at USC: “Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind. … When you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out, what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind.”
3. “The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.” The culture of a business is more than the sum of its parts. The totality of the vision, values, norms, systems, symbols, language, assumptions, beliefs, and habits of a business is what creates the culture of a business. Munger and Buffett are huge proponents of creating a strong organizational culture: “Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.…Cultures self-propagate.” Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior.”
4. “We want people where every aspect about their personality makes you want to be around them. Trust first, ability second.” The greater efficiency that Munger talks about flows from trust. When trust exists you can eliminate lots of inefficient procedures which must exist in a system that must deal with people who are not trustworthy. This means trust is an essential element in hiring people and that exhibiting a lack of trust is something that should result in a dismissal from the business. Buffett’s stated philosophy on this point is well known: “Lose money for the firm and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.” Are they perfect in implementing this philosophy? No. They admit mistakes for the reasons my previous blog posts have discussed.  Mistakes are feedback and if you don’t try to learn from mistakes you are not only missing and opportunity, you are a fool.
5. “Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. But if you’re going to provide minimal oversight, you have to buy carefully.” “The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it.” The acquisition process Berkshire uses is very deliberate. Berkshire only buys businesses that meet certain criteria including having an existing moat and existing high quality management. They do not want to create moats or supply management. They greatly admire people who create moats but know that creating moats is not their best game in terms of circle of competence. Munger has said: “We don’t train executives, we find them. If a mountain stands up like Everest, you don’t have to be a genius to figure out that it’s a high mountain.” The same principle applies to moats: spotting a business with an existing moat is vastly easier than trying to spot a new moat emerging from a complex adaptive system.  Seeing something emerging from nothing is a really hard problem compared to seeing something that is already there. Munger does not like really hard problems.  He likes easy problems that have very favorable odds of a big payoff if he is right.
6. “We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.” Munger is talking about the importance of creating and maintaining the Berkshire culture which enables and depends upon trust. It is tremendously cost efficient to have a culture that is based on trust, since you don’t have the cost or the inefficiency associated with layers of management and complex systems that try to act as a substitute. David Larcker and Brian Tayan in a paper cited in the notes below write:“A trust-based system [requires] the development and maintenance of a culture that encourages responsible behavior. As Munger says, “People are going to adopt to whatever the ethos is that suffuses the place.” Which means that this ethos is worth paying close attention to and developing well including being based on a high degree of trust.
7. “A lot of people think if you just had more process and more compliance — checks and double- checks and so forth — you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.” “I think your best compliance cultures are the ones which have this attitude of trust and some of the ones with the biggest compliance departments, like Wall Street, have the most scandals.” Buffett has said: “Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.” Lawrence Cunningham writes in his book: “At most companies, CEOs might formulate a general acquisition program with little board involvement and then present specific proposals to the board, which discusses deal terms and approves funding. The board’s role in this setting is an example of its service as an intermediary. Berkshire does the opposite, enabling Buffett to seize opportunities that would be lost if prior board involvement occurred…. Berkshire’s success at such internal capital reallocation has vindicated its conglomerate business model that has otherwise been denigrated across corporate America. The strategy skillfully avoids intermediaries. Cash transferring subsidiaries distribute cash to Berkshire without triggering any income tax consequences. Cash-receiving subsidiaries obtain corporate funding without frictional costs of borrowing, such as bank interest rates, loan covenants, and other constraints. Some subsidiaries generate tax credits in their businesses that they cannot use but can be used by sister subsidiaries.”
8. “Everybody likes being appreciated and treated fairly, and dominant personalities who are capable of running a business like being trusted. A kid trusted with the key to the computer room said, ‘It’s wonderful to be trusted.’” “We promised our CEOs that they could spend 100% of their time on their business. We place no impediments on them running their businesses. Many have expressed to me how happy they are that they don’t have to spend 25% of time on activities they didn’t like.” People value working for a business that trusts them. In other words, working for a business that trusts you is a non-financial employee benefit. When this trust exists great people like to work for the business and that makes recruiting other people easier. This attracts other great people since this attribute and success feeds back on itself. One of the attractions of Berkshire as a buyer to a person selling a business is that Buffett and Munger will continue to let them run their business and won’t break it into pieces like an automobile chop shop like most private equity buyers. The managers of Berkshire subsidies love Buffett and Munger for giving them freedom to run their business.
9. “When you get a seamless web of deserved trust, you get enormous efficiencies. … Every once in a while, it doesn’t work, not because someone’s evil but because somebody drifts to inappropriate behavior and then rationalizes it.” “In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s big and whether it’s material. You can do a lot to mitigate bad behavior, but you simply can’t prevent it altogether.” “By the standards of the rest of the world, we over-trust. So far it has worked very well for us. Some would see it as weakness.” There will be instances where someone is not as trustworthy as anticipated. This is a necessary price to pay to harvest the operational efficiencies when trust is deserved. Mistakes will happen and must be corrected. For example, CNBC noted: “Buffett did admit that he “obviously made a big mistake by not saying ‘Well, when did you buy it?’ when Sokol first told him he owned Lubrizol stock in January.  Buffett also apologized for not including more ‘outrage’ in his March 30 letter announcing Sokol’s ‘resignation.” Munger added, ‘I think we can concede that that press release was not the cleverest press release in the history of the world.’” Everyone makes mistakes and will keep making mistakes.  Don’t let one or even a few lousy outcomes throw you off  the right path. If you have a sound process you will make less mistakes overall and come out ahead.
10. “There’s money in being trusted. It’s such a simple idea, and yet everybody rushes into every scummy activity that seems to work.” Munger is saying that not only is being trustworthy the right thing to do morally, ethically and in terms of being happy in life, but it is the most profitable way to live your life. In short, being trustworthy is more profitable than being untrustworthy. “A trust-based system can be more efficient than a compliance-based system, but only if self-interested behavior among employees and managers is low” write Larcker and Tayan in the previously cited paper.
11. “We want very good leaders who have a lot of power, and we want to delegate a lot of power to those leaders. It’s crazy not to distribute power to people with the most capacity and diligence. Every time I see an opportunity to choose somebody, the second best guy is just awful compared to the guy we hire. Usually the decision is a no-brainer. We have to give power to the people who can wield it efficiently in serious game of survival.” “A lot of corporations are run stupidly from headquarters, driving divisions to increase earnings every quarter. We don’t do that. The stupidity of management practices in the rest of the corporate world will last long enough to give us an advantage well into the future.” Tom Murphy once described the best approach to decentralization of operating decisions this way: “don’t hire a dog and try to do the barking.” Managers who are on the line in a business actually interacting with customers and systems are in the best position to make the necessary decisions if they are the right people.  So work really hard to get the right people with the right skills and let them do their job. By accepting that sometimes businesses have lumpy earnings and letting talented managers run their business without interference Berkshire earns a superior long term return. The idea that this advantage is not possible or sustainable because markets are perfectly efficient is rubbish to anyone actually running a business.
12. “One of the greatest ways to avoid trouble is to keep it simple.” “When you make it vastly complicated—and only a few high priests in each department can pretend to understand it—what you’re going to find all too often is that those high priests don’t really understand it at all…. The system often goes out of control.” “We operate Berkshire [via] a seamless web of deserved trust. We get rid of the craziness, of people checking to make sure it’s done right.” “Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional — it isn’t the way things are normally done. We have low overhead, don’t have quarterly goals and budgets or a standard personnel system, and our investing is much more concentrated than average. It’s simple and common sense.” A simpler system results in fewer mistakes and makes life much more pleasant. What could be more simple?
A Dozen Things I’ve Learned from Charlie Munger about Mistakes
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1. “There’s no way that you can live an adequate life without many mistakes.” “Of course, there’s going to be some failure in making the correct decisions. Nobody ‘bats a thousand.’” “I don’t want you to think we have any way of learning or behaving so you won’t make mistakes.” Everyone makes mistakes sang Big Bird on the first episode of Sesame Street. Albert Einstein said once that anyone who has never made a mistake (if there is such a person) has never tried anything new. Warren Buffett agrees: “I make plenty of mistakes and I’ll make plenty more mistakes, too. That’s part of the game. You’ve just got to make sure that the right things overcome the wrong.” Charlie Munger has learned about business in the best way possible: by making mistakes and being successful actually being in business. Reading about business is vital, but Munger has said that there is no substitute for wading in and actually taking the plunge as a business manager or owner. Yes, you can learn vicariously by watching others and by reading. Learning from the mistakes of others is essential. To maximize how much he learns Munger reads five newspapers a day and has been described as a book with legs sticking out. It is far better to learn vicariously when it comes to many of the more painful mistakes in life.  At one shareholder meeting Munger when describing Berkshire’s mistakes in the shoe business quoted Will Rogers: “There are three kinds of men. Some learn by reading. Some learn by observation. The rest of them must pee on the electric fence for themselves.”
2. “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” The flip side of mistakes for an investor is that they are not just a source of problems, but also the underlying source of opportunity for investors. Howard Marks writes: “In order for one side of a transaction to turn out to be a major success, the other side has to have made a big mistake. Active management has to be seen as a search for mistakes.” This inescapable math explains the old folk wisdom that if you don’t see who the sucker is at the poker table, it is you. Munger believes: “You have to look for a special area of competency and focus on that…. Go where there’s dumb competition.” If you don’t see who is the dumb competition, it is you. Mr. Market is often not wise so don’t treat him as if he is.  Mr. Market is your servant, not your master.
3. “Forgetting your mistakes is a terrible error if you are trying to improve your cognition. Reality doesn’t remind you.” Hindsight bias is the tendency of people to believe that their forecasts and predictions were more accurate than they were in reality. People tend to forget their mistakes and exaggerate their successes. In retrospect, events often appear to be much more predictable than at the time of any given forecast. One way to reduce hindsight bias is to write down your decisions in a journal and to go back and take an objective look at your decision-making record. Shane Parrish points out: “A decision journal will not only allow you to reduce your hindsight bias, but it will force you to make your rationale explicit upfront. We often get the outcome we think will happen, but for the wrong reasons.” Neal Roese, a professor of marketing at the Kellogg School of Management at Northwestern University, has said: “You begin to think: ‘Hey, I’m good. I’m really good at figuring out what’s going to happen.’ You begin to see outcomes as inevitable that were not.”
4. “Why not celebrate stupidities?” “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” It is through the process of making mistakes and having success in the real world that you can learn and establish sound business judgment. Buying Berkshire Hathaway itself can arguably be put into the mistake category. The New England textile mill when bought in the 1960s was a lousy business. Buying the textile business was certainly valuable in one way in that it taught Buffett and Munger what not to do. Munger notes: “Chris Davis [of the Davis funds] has a temple of shame. He celebrates the things they did that lost them a lot of money. What is also needed is a temple of shame squared for things you didn’t do that would have made you rich.” Learning from mistakes does not mean wallowing in failure too much. Buffett says: “it is better to learn from other people’s mistakes as much as possible. But we don’t spend any time looking back at Berkshire. I have a partner, Charlie Munger; we have been pals for forty years—never had an argument. We disagree on things a lot but we don’t have arguments about it.”
5. “A trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way for people to go broke.” “Warren and I aren’t prodigies. We can’t play chess blindfolded or be concert pianists. But the results are prodigious, because we have a temperamental advantage that more than compensates for a lack of IQ points.” Munger is getting at the importance of temperament to success as an investor. Most mistakes are psychological and emotional. Munger believes that he and Buffett have an advantage that is based more on temperament than IQ. If you can’t handle mistakes, Munger suggests that you buy a diversified portfolio of low fee index funds and leave active investing to others. Unfortunately, even if you do select an index-based approach you still must make some investing decisions such as assets allocation, fund selection and asset rebalancing periods.
6. “Terribly smart people make totally bonkers mistakes.” “Smart people aren’t exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages.” Munger is saying that smart people are not exempt from making mistakes. Overconfidence can cause a person with a high IQ to make more mistakes than someone who has an IQ that is 30 points lower. It is the person with the high IQ who falsely thinks that is 30 points higher than it really is that gets you into serious trouble says Munger. People who are genuinely humble about their IQ can sometimes make far fewer mistakes if they do the necessary work, have a sound investment process and think in rational ways.
7. “Most of Berkshire’s success grew from stupidity and failure that we learned from.” Berkshire has made many mistakes. Paying too much for Conoco Phillips was a mistake as was Berkshire buying US Airways. The best way to become a millionaire is to start with a billion dollars and buy an airline is an old joke in business. Munger has said that: “Hochschild, Kohn the department store chain was bought at a discount to book and liquidating value. It didn’t work [as an investment.” He added on another occasion: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Buying Dexter Shoes was definitely a multi-billion dollar mistake for Berkshire. In doing the Dexter due diligence analysis Buffett and Munger made the mistake of not making sure the business had what they call a “moat” and being too focused on what they thought was an attractive purchase price. Buffett said once about Dexter: “What I had assessed as durable competitive advantage vanished within a few years.” Capitalism inherently means that others will always be trying to replicate any business that is profitable and that means you are always in a battle to keep what you have. Dexter lost that battle in a very swift fashion. If you make a mistake, capitalism’s competitive destruction forces will expose it swiftly and sometimes brutally.
8. “Where you have complexity, by nature you can have fraud and mistakes.” “In terms of business mistakes that I’ve seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations. Warren and I personally don’t drill oil wells. We pay our taxes. And we’ve done pretty well, so far. Anytime somebody offers you a tax shelter from here on in life, my advice would be don’t buy it.” “We try more to profit from always remembering the obvious than from grasping the esoteric.” Complexity can be your friend or your enemy depending on the circumstances. I am somewhat surprised by the fact that fees and incomes in finance are so high when there seem to be a lot of competition. There is clearly an asymmetric information problem in finance. But it would seem like technology should have brought fees and incomes down faster in finance as it has in some other sectors. The answer must lie in the fact that humans tend to make so many psychological and emotional mistakes and what Professor Cialdini calls “compliance professionals” are able to milk that tendency to keep fees high.
9 . “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. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes [of omission]: 1) doing nothing; what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.” “Our biggest mistakes were things we didn’t do, companies we didn’t buy.” “Since mistakes of omission don’t appear in the financial statements, most people don’t pay attention to them.” Munger and Buffett not investing in Wal-Mart is just one example of a mistake of omission. Buffett has said that just this one mistake with Wal-Mart cost them $10 billion. In 1973 Tom Murphy offered to sell some television stations to Berkshire for $35 million and Buffett declined. “That was a huge mistake of omission,” Buffett has admitted.  Buffett also has said: mistakes of omission…are where we knew enough about the business to do something and where, for one reason or another, sat they’re sucking out thumbs instead of doing something. And so we have passed up things where we could have made billions and billions of dollars from things we understood, forget about things we don’t understand.”
10. “It’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it. I regard it as perfectly normal to fail and make bad decisions. I think the tragedy in life is to be so timid that you don’t play hard enough so you have some reverses.” Of course, you can also learn from success, particularly if you remember that success can be a lousy teacher since what you may believe is the outcome of skill may instead be an outcome based luck. As noted above they try to learn from mistakes but them to move on. Use the feedback from mistakes to improve the process if you can’t but spend no time wallowing in failure. If you never make mistakes, you are not being ambitious enough.
11. “Banking has turned out to be better than we thought. We made a few billion [dollars] from Amex while we misappraised it. My only prediction is that we will continue to make mistakes like that.” “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” Munger has said that more than once that he and Buffett have made a mistake only to be bailed out by luck. Confusing luck with skill is easy to do. If luck does happen, embrace it.  Bad luck may arrive soon enough to balance the score. On the topic of the relationship between luck and skill, read Michael Mauboussin. http://www.michaelmauboussin.com/books.html or watch him.  https://www.youtube.com/watch?v=zSgYqwuguPc  One of the luckiest things that ever happened to me was becoming his friend. As just one example, I would not have written my book on Charlie Munger if not for his friendship.
12. “You can learn to make fewer mistakes than other people- and how to fix your mistakes faster when you do make them.”“Confucius said that real knowledge is knowing the extent of one’s ignorance. Aristotle and Socrates said the same thing. …. Knowing what you don’t know is more useful than being brilliant.” “Around here I would say that if our predictions have been a little better than other people’s, it’s because we’ve tried to make fewer of them.”  Charlie Munger freely admits he still makes mistakes even after many decades as a business person and investor. But Munger does advise people to strive to make new mistakes rather than repeat old mistakes. Munger has said that he made more mistakes earlier in life than he is making now. In other words, even though he continues to make mistakes like everyone else, he has marginally improved his ability to avoid mistakes over the years. Munger likes to be able to understand why he made a mistake, so he can learn from the experience. The mistakes can be a source of clues for improving a decision making process. For example, if you can’t explain why you failed, the business was too complex for you to have invested in the first place or outside your circle of competence. Munger is fond of quoting Richard Feynman: “The first principle is that you must not fool yourself – and you are the easiest person to fool.”
A Dozen Things I’ve Learned from Charlie Munger about Inversion (including the Importance of being Consistently Not Stupid)
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1. “Think forwards and backwards — invert, always invert.” “Many hard problems are best solved when they are addressed backward.” “The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I’d even say usually are easier to solve, if you turn them around in reverse. In other words, if you want to help India, the question you should ask is not “how can I help India,” it’s “what is doing the worst damage in India? What will automatically do the worst damage and how do I avoid it?” “Figure out what you don’t want and avoid it and you’ll get what you do want. How can you best get what you want? The answer: Deserve what you want! How can it be any other way?” Charlie Munger has adopted an approach to solving problems that is the reverse of the approach that many people use in life. Inversion and thinking backwards are two descriptions of this method. As an illustrative example, one great way to be happy is to avoid things that make you miserable. Munger once gave a speech where he spoke about a famous Johnny Carson talk in which the comedian described all the ways one can be miserable. Munger said: “What Carson said was that he couldn’t tell the graduating class how to be happy, but he could tell them from personal experience how to guarantee misery. Carson’s prescriptions for sure misery included: 1) Ingesting chemicals in an effort to alter mood or perception; 2) Envy; and 3) Resentment. What Carson did was to approach the study of how to create X by turning the question backward, that is, by studying how to create non-X.” As another example of Munger’s inversion approach, a very effective way to be smart, is to consistently not be dumb. The good news about this approach is that is it easier to not be dumb than it is to be smart since you can often simply avoid certain types of decisions and activities that are ripe with opportunities to demonstrate that you are not smart. Munger gives some example here: “Just avoid things like racing trains to the crossing, doing cocaine, etc. Develop good mental habits.” “A lot of success in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc.” With regard to financial matters, you should avoid things like buying assets with a 200 page prospectus, or services from highly commissioned salespeople. Don’t attend the “free” dinner paid for by a salesperson or the “free” weekend stay in a time share.
2. “[The great Algebra pioneer Jacobi] knew that it is in the nature of things that many hard problems are best solved when they are addressed backward.” “In life, unless you’re more gifted than Einstein, inversion will help you solve problems.” Charlie Munger likes to say that simple high school Algebra can help anyone solve a lot of problems in life. Looking at a problem backward instead of just forward can help you create and reveal new solutions. Munger even jokes that he wants to know where he will die so he can just not go there. A process of elimination, can also be helpful in making decisions. Munger’s friend, the investor Li Liu, points out that “when you have a difficult problem in social science, a good way to solve it is to invert it. After you compile all the reasons you should buy a stock, invert the question and state the reasons why you should not buy the stock. By doing this, you ensure that your research process is more complete.” Munger himself tells this story: “I have a physicist son who has been trained more in the type of thinking I like. And he immediately got the right answer, and here’s the way he reasoned: It can’t be anything requiring a lot of hand-eye coordination. Nobody 85 years of age is going to win a national billiards tournament, much less a national tennis tournament. It just can’t be. Then he figured it couldn’t be chess, which this physicist plays very well, because it’s too hard. The complexity of the system, the stamina required are too great. But that led into checkers. And he thought, “Ah ha! There’s a game where vast experience might guide you to be the best even though you’re 85 years of age.” And sure enough that was the right answer. Anyway, I recommend that sort of mental trickery to all of you, flipping one’s thinking both backward and forward.” The memo from Howard Marks that was published this week (citation in the notes) contained a great inversion example: “If what’s obvious and what everyone knows is usually wrong, then what’s right? The answer comes from inverting the concept of obvious appeal. The truth is, the best buys are usually found in the things most people don’t understand or believe in. These might be securities, investment approaches or investing concepts, but the fact that something isn’t widely accepted usually serves as a green light to those who’re perceptive (and contrary) enough to see it.”
3. “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” The amazing thing is we did so well while being so stupid.” As an example of this idea being put to work, people often try to read too much into the “margin of safety” concept developed by Ben Graham as part of his value investing system. The idea is simple: If you buy at a very attractive bargain price you can make a mistake and still do well financially. For example, if you pay 30% less than the intrinsic value of an asset based on conservative calculations that bargain is a cushion that can help avoid mistakes caused by stupidity. The desire to avoid being dumb is why Seth Klarman describes value investing as a risk-averse approach. It is also why Warren Buffett says that the first and second rules of investing are “don’t lose money.” Again, it is a good idea to not over-complicate the margin of safety approach. The idea is to buy an assets at a substantial bargain to conservatively calculated intrinsic value and then wait. It’s that simple. The hardest parts of the value investing system are emotional and psychological rather than understanding the system itself.
4. “Let me use a little inversion now. What will really fail in life? What do you want to avoid?” “Having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control.” “When you have a huge convulsion, like a fire in this auditorium right now, you do get a lot of weird behavior. If you can be wise [during such times, you’ll profit].” Charlie Munger uses an inversion process not only on thoughts and processes, but emotions. Christopher Davis, the chairman of fund manager Davis Advisors points out that Charlie Munger: “seems to be able to invert emotions, becoming uninterested when other people are euphoric and then deeply engaged when others are uncertain or fearful.” By leaning against the wind emotionally, Charlie Munger harnesses the power of the “return to the mean” phenomenon. The advice is simple: Be greedy when others are fearful, and fearful when others are greedy. This is easy to say but hard to do. This is why successful investing is simple, but not easy.
5. “I’m really better at determining my level of incompetency and then just avoiding that. And I prefer to think that question through in reverse.” Humans remember when they mistakenly touch an electric fence or a hot stove. When we fail at something, particularly if it is a painful experience, we tend to remember it. One factor making failure so memorable is loss-aversion. We feel the pain of loss much more than a comparable gain. Charlie Munger points out: “People are really crazy about minor decrements down.” As an example, Larry Bird likes to say that he hates to lose more than he loves to win. Because we feel the pain of losses more it is easier to avoid incompetency than to determine whether you have the necessary skill. Natural human overconfidence makse this set of problems hard, but with practice you can improve your ability to “not be dumb.”
6. “It is remarkable how much long-term advantage [we] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Charlie Munger has pointed out that the long term advantage of not being stupid is under-appreciated. In other words, the benefits of not being an idiot as often as most people compound like interest on an investment. The word “consistently” in the quotation is important since consistency implies that you are not avoiding stupidity just via luck. By having a sound investing process you can prosper even if sometimes you have a bad outcome despite a good process. Adopting this attitude requires situational humility. Be humble especially, when you are out of your circle of competence. Munger says: “If you want to be the best tennis player in the world, you may start out trying and soon find out that it is hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably all right by two-thirds of you. It takes will. It takes the intelligence. But after a while, you will gradually know all about the plumbing business and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work. So some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor in Bemidji. Very few of us are chosen to win the world’s chess tournament.”
7. “There are a lot of things we pass on. We have three baskets: in, out, and too tough. We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.” “The amazing thing is we did so well while being so stupid. That’s why you’re all here: you think that there’s hope for you. Go where there’s dumb competition.” Investors often have a high IQ (or at least think they do) and for that reason will often assume that there is some sort of prize in investing for making difficult decisions. There is no such prize in investing. One irony of investing is that a high IQ may lead an investor to seek hard problems believing they will reap some benefits from their intelligence ig it is not coupled with humility. Munger believes that the far greater opportunity is to apply high IQ when the problem is easy and the odds of success are very favorable. He favors working with people who believe their IQ is less than is actually is. The idea of having a “too tough” or “too hard” pile is particularly appealing and has been very useful to me. This approach harnesses the idea of opportunity cost thinking. Investing your time and capital in your best opportunities is also such a powerful but simple idea. “Should you buy stock x” is not the right question. The right question instead is: “Of all the stocks I can buy, is x the very best alternative?”
8. “You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.” “The amazing thing is we did so well while being so stupid. That’s why you’re all here: you think that there’s hope for you. Go where there’s dumb competition.” In business, unlike sports, it pays to play against weak competition. In other words, business and investing are very different from professional sports where the players in the most competitive leagues make the most money. Why would an investor want to compete when they have no special advantage? What the wise investor seeks is an unfair advantage and odds of success that are very favorable.
9. “The secret to Berkshire is we are good at ignorance removal. The good news is we have a lot of ignorance left to remove.” “Just as a man working with his tools should know its limitations, a man working with his cognitive apparatus must know its limitations.” As you go through life you have the opportunity to learn from your inevitable mistakes and the mistakes of others. This process is unlikely to produce positive results unless you are honest with yourself and paying attention. Thinking your IQ is less than it actually is can be a significant benefit in investing. Humility helps reduce the number of mistakes caused by hubris. The work to learn more in life never ends. New information and ideas are constantly arriving and must be considered. If you don’t want to do that work you should buy a low cost diversified portfolio of index funds. As a test I suggest you buy my new book on Charlie Munger. If you can’t find the time and energy to read the whole book, you should definitely buy a low cost diversified portfolio of index funds.  Putting yourself to that test may be the best dollar-for-dollar investment you ever make!
10. “If you have competence, you pretty much know its boundaries already. To ask the question is to answer it.” “We know the edge of our competency better than most. That’s a very worthwhile thing.” The “circle of competence” idea is very simple. Risk comes from not knowing what you are doing. So it is wise to stay within a circle of competence where you know what you are doing. The margin of safety idea applies to circles of competence as well. Why get anywhere near the edge of your competence when you have the option not to do so? It is a very good idea to play it safe if the limits of your competence are unclear. Being less inept and dumb than the competition is such a huge advantage.
11. “Warren and I avoid doing anything that someone else at Berkshire can do better.” Life is both easier and better if you let people who do things better than you do those things. As an example, an investor like Charlie Munger finds his “comparative advantage” in investing rather than “making sure the trains run on time” as an operator of a business like Matt Rose of Burlington Northern. As another example, Munger has focused his efforts on buying moats rather than building them. It is easier for him to see an existing Mount Everest than to spot a mountain that may be created in the future. Munger leaves moat creation to entrepreneurs and venture capitalists and feels fine putting that activity in “too hard” pile. Munger has said that if he were young today he might devote his life to technology rather than investing, but at this point in his life technology is not the source of his greatest comparative advantage. Every business that he is involved in as an investor uses technology, but a pure technology business is not ideal for inclusion in his portfolio.
12. “Every person is going to have a circle of competence. And it’s going to be very hard to advance that circle. If I had to make my living as a musician…. I can’t even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.” We all have certain talents and skills. And we should all strive to advance those skills. But understanding the limits of your current skill development is wise. Especially when what is at risk is significant it is wise to be conservative when it comes to self-appraisals. One of the major problems that arises from the psychology of human misjudgment is overconfidence. Munger has famously said: “In the 5th century B. C. Demosthenes noted that: ‘What a man wishes, he will believe.’ And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.”
A Dozen Things I’ve Learned from Charlie Munger about Risk
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“Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” Risk has many different dimensions that must be considered including sources, magnitude, outcomes and decision making inputs. In terms of a definition, Seth Klarman writes that risk is: “described by both the probability and the potential amount of loss.” Charlie Munger emphasizes an important point in his quotation since it is the permanent loss which should be the focus of investors since temporary drops can actually represent an opportunity for an investor if they can purchase more of an asset at the lower price and ride out the drop in price. The focus of this definition of risk is on potential “outcomes.” In terms of “sources” of risk, Warren Buffett believes that “risk comes from not knowing what you’re doing” and that “the best way to minimize risk is to think.” This is why Charlie Munger spends so much time thinking about thinking. The magnitude of risk assumed by a given investor on any investment depends on the nature of the asset, but also the price paid for the asset. In addition to not knowing what you are doing, one way to increase risk to pay such a high price for an asset that there is no margin for error.  Seth Klarman makes the important point that “risk and return must be assessed independently or every investment…. risk does not create incremental return only price can do that.” Howard Marks makes the insightful point that risk itself cannot be counted on to generate higher financial returns, since if this was the case the assets would not actually be riskier. Richard Zeckhauser has his own definition of risk focused on the “inputs” a person has in the decision-making process rather that the “outcome” based definition of Buffett and Klarman.  Zeckhauser believes that “risk” is limited to situations where all potential future states and their probabilities are known. Roulette in his view involves risk since you know all future states and probabilities in playing the game.  When the probabilities of potential future states are not known, Zeckhauser calls that situation “uncertainty” and when you don’t know all potential future states he refers to that as “ignorance.”  Most of life is uncertain rather than risky. True risk, as Zeckhauser defines it, is actually not that common in real life. For the rest of this blog post when I refer to “risk” I will be referring to the Klarman/Buffett/Marks definition of risk as an outcome (‘the possibility of loss or injury”) because that is what I believe Charlie Munger is referring to in each quotation.
 
“Using [a stock’s] volatility as a measure of risk is nuts.” There is a yet another way that some people talk about risk.  Howard Marks writes: “Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory….However, while volatility is quantifiable and machinable – and can be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, ‘The prospective return isn’t high enough to warrant bearing all that volatility.’ What they fear is the possibility of permanent loss.” Munger rejects the use of volatility to define risk. He describes part of the reason for the desire of some people  to qualify risk as follows: “Practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.”  Munger has also said: “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.” Why do some people want so badly to equate risk with volatility? This assumption allows them to create beautiful mathematical models that can be included in their papers. Seth Klarman describes the motivation for this line of thinking in his book:  “A positive correlation between risk and return would hold consistently only in an efficient market.”  To be able to create this beautiful math Munger believes they distort the world to be fully rational to support their mathematical theories even though it defies common sense. This attempt to equate risk and volatility is a classic case of confirmation bias. Munger says: “I have a name for people who went to the extreme efficient market theory—which is ‘bonkers.’ It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.” Risk is not a number and it certainly can’t be calculated simply based on volatility. Volatility can be “a” risk for some people in some situations, but it certainly does not “define” risk.  As an analogy, an apple is fruit but apples do not define fruit. There is certainly a time element to risk and life events like retirement or a college bill can turn volatility into an important type of risk, especially over shorter time frames. But value investors are usually focused on long-term returns and understand that they may be able to earn a premium by accepting short-term volatility when buying an asset. As an example, short term US Treasuries may have lower short-term volatility but they have significant long-term risk of underperformance in comparison to equities.  Seth Klarman writes: “some insist that risk and return are always positively correlated…yet this is not always true. Others mistakenly equate risk with volatility, ignoring the risk of making overpriced, ill-conceived and poorly managed investments.” Volatility is actually the friend of the investor since lower prices are what create opportunities to buy mispriced assets at a significant discount to intrinsic value.
 
“Volatility is an overworked concept. You shouldn’t be imprisoned by volatility.” “Some great businesses have very volatile returns – for example, See’s usually loses money in two quarters of each year – and some terrible businesses can have steady results.” Charlie Munger and Warren Buffett are very focused on finding investments which possess odds of success that are substantially in their favor.  If the process of generating returns along the way is lumpy that is not only perfectly acceptable but it can be a significant financial advantage since others may be unwilling to do so creating mispriced assets that can be purchased at a bargain price. Howard Marks argues: “in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.” A regular reader of this blog will recognize what Howard Marks is taking about as an objective as positive optionality (big upside and a small downside).
 
“We don’t give a damn about lumpy results. Everyone else is trying to please Wall Street. This is not a small advantage.” Munger is pointing out that buying what is unpopular or requires a long term viewpoint tends to be underpriced. Since buying underpriced assets creates a margin of safety, it lowers risk and increases financial returns. On volatility, Ben Graham once wrote: “A serious investor is not likely to believe that the day-to-day or month-to-month fluctuations of the stock market make him richer or poorer…. The holder of marketable securities actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business.  Here his results are entirely dependent on the profits of the enterprise or a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment – when the market is open, that is — and often is far removed from the balance sheet value.” One reason why volatility is such a big focus for managers, as opposed to investors, is that it presents a big risk for them. Investors tend to flee an advisor or fund when there is underperformance or drop in price.
 
“This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way; as long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds.” Charlie Munger has said that he is a “focus” investor since he is not a “know nothing” investor. In his personal accounts and fund he manages he is not a believer in diversification. He is also careful to note that few people should invest like him and should instead buy a diversified portfolio of low cost index funds. Warren Buffett’s statement about what he and Charlie Munger do at Berkshire is as famous as it is succinct. “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” For Howard Marks, risk is “the possibility of permanent loss… downward fluctuation which by definition is temporary doesn’t present a big problem if the investor is able to hold on and come out the other side.” The same idea applies to a manager in a business investing capital. Some opportunities require that you be willing to have volatile earnings.  See’s Candies is just such an example. Since profits happen in the box candy business mostly during the holidays See’s will inevitably have poor financial results half the year but that will be offset by two very profitable quarters.
 
“All investment evaluations should begin by measuring risk, especially reputational. This is said to involve incorporating an appropriate margin of safety, avoiding permanent loss of capital and insisting on proper compensation for risk assumed.” If you decide to incur risk and face the possibility of loss or injury, you should insist on being paid for doing so. Munger is saying that the best way to manage investment risk is to buy assets at a price that reflects enough of a margin of safety that the outcome will be favorable even if you make a mistake (i.e., buy with a margin of safety- which is a discount to expected value). This is why Howard Marks says that risk is always relative to the amount paid for the asset.  Buffett wrote in his postscript to The Intelligent Investor (2003 edition) about the way value investors should view risk: “Sometimes risk and reward are correlated in a positive fashion… the exact opposite is true in value investing. If you buy a dollar for 60 cents, it is riskier than if you buy a dollar for 40 cents, but the expectation for reward is greater in the latter case.”
 
“[With] a lot of judgment, a lot of discipline and an absence of hyperactivity… I think most intelligent people can take a lot of risk out of life.” The three best ways to reduce risk are diversification, hedging and buying with a margin of safety argues Seth Klarman. Making life less risky is also assisted greatly if you make fewer decisions in domains where you do not know what you are doing after doing a significant amount of thinking about the domain involved and the decision. Doing this requires discipline since we all make psychological and emotional mistakes. One technique for avoiding risk is to place decisions that fall in the domain of “I don’t know” into a “too hard” pile if you can. Sometimes a decision is unavoidable and judgment will be required. Munger puts the investor’s objective simply: “What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often.”
 
“Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilize a very conservative patterns of investment and saving all your life. So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.” “If we’d used the leverage that some others did, Berkshire would have been much bigger… But we would have been sweating at night. It’s crazy to sweat at night.” There is no recipe or formula for investing or dealing with risk. Everyone has a unique tolerance for risk since we are all more or less comfortable with various factors that create it. Some people find it useful to have heuristics (rules of thumb) to guide them in assessing whether a comfortable level of risk tolerance exists. Whether you can sleep soundly at night is a one heuristic. If your investments are preventing you from getting a good night’s sleep it may be wise to adjust your portfolio so that it is consistent with a comfortable sleep. Seth Klarman agrees with Charlie Munger on this point: “Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”
 
“This is an amazingly sound place. We are more disaster-resistant than most other places. We haven’t pushed it as hard as other people would have pushed it. I don’t want to go back to Go. I’ve been to Go. A lot of our shareholders have a majority of their net worth in Berkshire, and they don’t want to go back to Go either.” “I wanted to get rich so I could be independent, and so I could do other things like give talks on the intersection of psychology and economics.”  The factors which determine the level of risk that is appropriate for any given person include life goals, age and wealth. For example, Charlie Munger left the practice of law to become an investor since he had a fierce desire to acquire wealth so he could be independent. He did not want to have other people dictate what he did in life. The value of that freedom once acquired can be so high that a person can become unwilling to put at risk the amount of money require to ensure that this independence continues. Playing the game of life with house money (money that you don’t really need to be happy) is underrated. At the point where you are playing with house money the game substantially changes since your basic financially driven level of happiness is not at stake. Of course, you can still be rich and miserable, but that comes from other problems, attitudes and mistakes.
 
“There is a lot to be said that when the world is going crazy, to put yourself in a position where you take risk off the table.” “Here’s one truth that perhaps your typical investment counselor would disagree with: if you’re comfortably rich and someone else is getting richer faster than you by, for example, investing in risky stocks, so what? Someone will always be getting richer faster than you. This is not a tragedy.” There are times in life when the world will not make much sense, at least to you. As an example, the Intent bubble of 1999-2001 was a time like that. In my book on Charlie Munger I describe a decision I made to sell half of my telecom and Internet portfolio near the height of the bubble. The sale ensured that I would not be a burden to anyone in my retirement and that my children would be able to go to college with my financial assistance. Taking a little risk off the table if you plan to double down on some new risky investments is wise.
 
“A lot of our major capitalistic institutions that parade as really respectable, they’re just casinos in drag. What do you think a derivative trading desk is? It’s a casino in drag. People feeling they’re contributing to the economy, and they’re managing risk. They make the witch doctors look good.” “I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant. It’s not a smart thing for the country to legalize gambling [in the stock market] and make it very accessible.” “Gambling does not become wonderful just because it pertains to commerce. It’s a casino.” One definition of gambling is: an activity involving chance that has a negative net present value after fees. Some people find gambling entertaining, since it produces brain chemicals that can be pleasurable.  I don’t personally see the point of doing something that could potentially turn into a destructive addiction and potentially wipe you out financially. In my view there are many other non-addictive things that one can do to get a dopamine buzz that are not addictive and are potentially profitable. Munger says: “intelligent people make decisions based on opportunity costs — in other words, it’s your alternatives that matter. That’s how we make all of our decisions…. Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other.” Gambling fails the opportunity cost test for me. The other point Munger is making is that gambling is not a productive activity. You are not building anything valuable when you gamble. The societal contribution of the activity is negative.
 
“When any person offers you a chance to earn lots of money without risk, don’t listen to the rest of their sentence. Follow this and you’ll save yourself a lot of misery.” When it comes to investing it is wise to follow the advice of Howard Marks and think of the future as a probability distribution rather than some fixed outcome that is knowable or predictable in advance.  Almost nothing about the future is certain except death and taxes. No one says it better than Howard Marks when it comes to risk: “not being able to know the future doesn’t mean we can’t deal with it. It’s one thing to know what’s going to happen and something very different to have a feeling for the range of possible outcomes and the likelihood of each one happening. Saying we can’t do the former doesn’t mean we can’t do the latter.”
A Dozen Things I’ve Learned from Charlie Munger About Benjamin Graham’s Value Investing System
Posted by trengriffin
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Charlie Munger has developed a powerful system that is useful in making any type of decision. One notable application of this system by Munger relates to investing and involves another system developed by Benjamin Graham. It is useful to understand what is known as “value investing” not just for its own sake, but to understand how Munger thinks and makes decisions. Even if you find value investing boring or have no intention to follow its principles, you can learn from understanding how it works and has evolved from its original nature based on the ideas of a few people including Munger. For this reason, it is important to understand a little about Graham himself.
“Benjamin Graham was salutatorian of the class of 1914 and, weeks before graduation, was offered teaching positions in three different faculties: Greek and Latin philosophy, English, and mathematics. He was all of 20 years old. Needing to support his siblings and widowed mother, he went to work on Wall Street. In 1934, he wrote Security Analysis, the first book ever to put the study of investments on a systematically logical footing. In 1949, he published The Intelligent Investor, which Warren Buffett has called “the best book about investing ever written.” Warren Buffett….has said that he was struck by the force of Graham’s teachings ‘like Paul on the road to Damascus.’”
What follows are the usual “dozen things” quotations from Charlie Munger stitched together from his writing and statements made at different times and places (in this case over many over decades).
1. “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. And he didn’t feel that the man in the street could run around and talk to managements and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Therefore, it was very difficult. And that is still true, of course human nature being what it is.” “Warren trained under Ben Graham, who said, ‘Just look at the facts. You might lose an occasional valuable insight, but you won’t get misled.’” The most important word in these quotations from Charlie Munger is “system,” which can be defined as a set of processes or elements that interact in ways that can achieve an objective not obtainable from the processes or elements alone. A second important point made by Charlie Munger is about Ben Graham’s desire to create something an “ordinary person” can potentially use successfully. It is important to note that Charlie Munger believes that only a tiny number of people can actually outperform a market using the value investing system because they lack factors like the necessary work ethic and the right emotional and psychological temperament. It is possible that an ordinary investor can us the value investing systems to outperform that market but it is far from the usual case. If an investor does try to outperform a markets Charlie Munger is also saying that it is easy to be misled by promoters and business managers about the value of a business or other assets. Ben Graham believed that by focusing on a rational appraisal of objective facts fewer investing mistakes will be made than by relying on subjective opinions.
2. “Ben Graham had this concept of value to a private owner – what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, 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, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety – as he put it – by having this big excess value going for you.” Ben Graham’s system involves four bedrock principles, two of which Charlie Munger introduces here: 1) a share of stock is a proportional ownership of a business and 2) buy at a significant discount to intrinsic value to create a margin of safety. On the first principle, if a security is not a proportional interest in a business then what exactly is it? It certainly isn’t a piece of paper to be traded like a baseball card or a painting. In terms of the second principle on “margin of safety,” the fundamental idea is to buy an asset at a significant enough bargain price that the result will be good even if a mistakes was made in evaluating the asset. Since risk is always relative to the price paid, buying with a margin of safety is a risk-averse approach. A range of future outcomes can still produce a satisfactory result if you buy an asset at a significant bargain.
3. “Ben Graham [had] his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think its worth.” And other days, “Mr. Market” comes by and says, “I’ll buy your interest at a price that’s way higher than you think its 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. That was a very significant mental construct.” Charlie Munger is introducing the Mr. Market metaphor in making these statements. Mr. Market shows up every day willing to quote you a price. Unfortunately, Mr. Market is, in the words of Warren Buffett, a drunk bipolar psycho. For this reason and others, Mr. Market should always be treated as your servant rather than your master. Why would anyone ever treat someone like this as wise? Mr. Market, in the short term, is a voting machine driven by highly volatile and fickle public opinion instead of a weighing machine measuring return on investment. When Mr. Market offers you a price for an asset you have the option to do nothing. In other words, there are no “called strikes” in investing. There is no premium given in investing for activity and in fact there is a penalty since it results in fees and taxes. For a value investor, it is Mr. Market’s irrationality that creates the opportunity for value investors. As Charlie Munger points out: “For a security to be mispriced, someone else must be a damn fool. It may be bad for world, but not bad for Berkshire.” The best returns accrue to investors who are patient and yet aggressive when they are offered a price for an asset that meets the requirements of value investing.
4. “The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So Graham had a lot of wonderful ideas. Warren worshiped Graham. He got rich, starting essentially from zero, following in the footsteps of Graham.” Charlie Munger introduces final bedrock principle of value investing here: be objective and dispassionate. In other words, be as rational as you can when making investing decisions. Despite this objective, an investor will always make some emotional and psychological mistakes, but if you can do things like learn from your mistakes, use techniques like checklists, have the right emotional temperament, exhibit a strong work ethic and are a “learning machine,” he believes some investors can outperform the market. Only a very small number of “know something” investors can do this. Charlie Munger believes that most everyone is a “know nothing” investor and should instead invest in a diversified portfolio of index funds and ETFs.
5. “The supply of cigar butts was running out. And the tax code gives you an enormous advantage if you can find some things you can just sit with.” “Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. The classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn’t click. Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well.” The beauty of some systems is that they have the ability to evolve so as to adapt to new conditions. And that is precisely what happened in the case of value investing. After the Great Depression many people simply gave up on owning stocks. Loss aversion was so strong among potential buyers that they were simply not rational when it came to the stock market. During this period it was possible for businesses to be bought at less than liquidation value. This was a boon for investors like Ben Graham. Unfortunately for them, that period of time only lasted for so long as memories faded and new investors entered the market. Every so often some pundit will drag out one quote from Ben Graham about how it became to do value investing at one point. These pundits not only take the quote out of context buy ignore the fact that the followers of Graham were even before then time taking Graham’s principles and defining a bargain in a new way considering the quality of the business and in some cases considering what are called “catalysts” to the value of a business. Value investing has evolved significantly since the time of Ben Graham and Charlie Munger has played a big part in that evolution.
6. “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 liked Graham, and he always interested and amused me. But I never had the worship for buying the stocks he did. So I don’t have the worship for that Warren does. I picked up the ideas, but discarded the practices that didn’t suit me. I don’t want to own bad businesses run by people I don’t like and say, ‘no matter how horrible this is to watch, it will bounce by 25%.’ I’m not temperamentally attracted to it.” Charlie Munger is always looking for ways to evolve, adopt and even reverse his views. He is a learning machine. Charlie Munger is also excited by great managers running great businesses. And he gets positively ecstatic when every once in a while these managers are running businesses that are available for purchase in whole or in part at bargain prices. This does not happen very often so most of the time he patiently does nothing. But Charlie is prepared to act very aggressively in a big way when the time is right.
7. “I think Ben Graham wasn’t nearly as good an investor as Warren 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 is in this set of quotations is discussing another reason why the value investing system had to evolve for Berkshire. The amount of money that Berkshire must put to work each year is way too big to hope that enough so-called “cigar butt” businesses with a few remaining puffs left in them can be found to compose a full portfolio. When buying a business anything remotely as big as Heinz or Precision Cast Parts it is very unlikely that they will be buying any cigar butts. Berkshire must find assets that represent a bargain defined in terms of quality. As an example Warren Buffett used $23 billion of Berkshire’s $66.6 billion in cash to buy Precision Castparts. Buffet has said that “We will always have $20 billion in cash on hand.” So they won’t be buying a business as big as Precision Castparts for a while.
8. “Having started out as Grahamites which, by the way, worked fine we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. 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.” Charlie Munger makes two key points here: 1) some bargains are only visible if you understand qualitative factors and 2) there sometimes are catalysts that can boost the value of the stock even further based on factors like scale advantages, favorable regulatory changes, improving secular phenomenon and better systems or business momentum. Charlie Munger likes to “find a few great companies and then sit on your ass.” When he finds a great business with excellent management like Costco he is like “a pig in slop” and does not want to leave the pig pen.
9. “The great bulk of the money has come from the great businesses. And even some of the early money was made by being temporarily present in great businesses. Buffett Partnership, for example, owned American Express and Disney when they got pounded down. However, if we’d stayed with classic Graham the way Ben Graham did it, we would never have had the record we have.” “Iscar is not a Ben Graham stock – in fact, it would be the ultimate non-Ben Graham stock. It’s located a few miles from the Lebanese border in Israel. It has a high ROE, doing business all over the earth, using a certain technology to produce carbide cutting tools. The reason I got so high on it so fast was that the people are so outstandingly talented.” Charlie Munger has made the point many times that only a few great decisions delivered most of Berkshire’s financial returns. Warren Buffett has said that as few as 20 bets in a lifetime can make you very rich. Charlie Munger has also said repeatedly that a high quality business selling a bargain price is not a common event and that if you are not prepared to act aggressively when that happens the opportunity will be lost. In thinking about the value of a business, Munger also strayed far from a view that looking at the quality of management is not something that should be considered because it is too easy to be misled. When Berkshire buys a business they want the moat and the management (the two M’s) to be in place already. Berkshire does not build moats itself and it does not want to supply management.
10. “We bought [the Washington Post] at about 20% of the value to a private owner. So we bought it on a Ben Graham-style basis – at one-fifth of obvious value – and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They’re very high class people – the Katharine Graham family. That’s why it was a dream – an absolute, damn dream.” These quotations list many of the elements that Charlie Munger looks for in a business. At the time it was first bought the business known as the Washington Post had both a strong management team and a moat. A significant partial ownership stake was also available for purchase at a bargain price. Of course, the moat of the Washington Post has significantly atrophied as the Internet has enabled competitors to avoid the need for big printing process and physical distribution systems. All moats are under attack by competitors and change in strength and value over time. It is perhaps not surprising that the Washington Post was purchased by an expert moat builder like Jeff Bezos. The task of the new owner is to rebuild the moat of the Washington Post which is not easy given that the news is non-rival and non-excludable.
11. “Ben Graham said it’s not the bad ideas that do you in. It’s the good ideas that get you. You can’t ignore it and it’s easy to overdo it.” Almost everything can be taken to a point where what is wonderful eventually becomes toxic. The great humorist Mark Twain said once that: “Water, taken in moderation, cannot hurt anybody.” Even water in sufficient quantity is not good for you. The same phenomenon applies to investing. What a wise person does at first, the fool does at the end. This particular quotations was made in the context of the Internet bubble which was an extreme example of good ideas taken way too far.
12. “Warren Buffett came to investing at the knee of Ben Graham, who ran a Geiger counter over the detritus of the 1930s. Stocks were ridiculously cheap. Graham bought companies that were quite mediocre on average, but made 20% when their stock bounced.” “Warren trained under this system and made money, so he was slower to come to the idea I learned that the best way to make money is to buy great businesses that earn high returns on capital over long periods of time. We’re applying Graham’s basic ideas, but now we’re trying to find undervalued GREAT companies. That concept was foreign to Ben Graham. Warren would have morphed into a great investor without Ben Graham. He is a greater investor than Graham was. Warren would have been great had he never met anyone else. He would have excelled at any field that required a high IQ, quantitative skills and risk taking. He wouldn’t have done well at ballet though.” The point about Warren Buffett being an unlikely ballet star is important since it raises the idea of “circle of competence.” Risk comes from not knowing what you are doing, so it is wise to know what you are doing (i.e., stay within your circle of competence). The skill of every human being has limits. Knowing in which situations you are skilled or not is very valuable in life. An important point in all of this is: you are not Charlie Munger and you are not going to be Charlie Munger. Having said that, you can learn from Charlie Munger and make better decisions than you would otherwise. Those decisions may be limited to things like choosing a mutual fund or allocating assets between categories. They also might include selecting a college or a spouse. Charlie Munger is trying to convey the idea that in making decisions in life it is wise to be rational, try to filter out sources psychological dysfunction and apply a range of mental models and worldly wisdom.
A Dozen Things I’ve Learned from Charlie Munger about Making Rational Decisions
Posted by trengriffin
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I have written a book about Charlie Munger. While the book is written in the context of investing, understanding what Charlie Munger teaches will help you make rational decisions about anything in your life.  Everyone must make decisions and by understanding how Charlie Munger thinks you can improve your decision making skills. Even people who have decided to use an index fund-based approach must chose index funds and allocate between asset classes. Making at least some investment decisions is unavoidable. Learning to make better decisions of any kinds requires that you spend some time thinking about thinking. The good news is that this learning process is fun. Charlie Munger puts it this way: “Learning has never been work for me. It’s play.” Life gets better if you adopt this approach to learning.
“‘Charlie,’ she said, ‘What one word accounts for your remarkable success in life?’ I told her I was rational.” If the actor in the television commercials for the famous beer is “the most interesting man in the world,” then perhaps Charlie Munger is “the most rational investor in the world.” His rationality and honesty in no small part explain why he is so popular. What Charlie Munger says is often so funny because he is perfectly willing to speak the truth in a completely unrestrained and direct manner. In other words, he appeals to so many people because of his honest insight about life, in much the same way as great comics like Louis C.K., Amy Schumer or Chris Rock are so appealing. Individuals who speak the truth openly are often interesting, insightful and funny. To understand Charlie Munger’s appeal it is useful to think about the nature of rationality. Michael Mauboussin explains that there are different forms of rationality: “Cognitive scientists and philosophers talk about “instrumental” and “epistemic” rationality. Instrumental rationality is behaving in such a way that you get what you want the most, subject to constraints. Expected utility theory, which is based on a series of axioms, provides a normative framework for how to do this. You’ll be instrumentally rational if you follow the axioms. Epistemic rationality describes how well a person’s beliefs map onto the world. If you believe in the tooth fairy, for instance, you are showing a lack of epistemic rationality. Here’s a catchier way to remember the two terms: instrumental rationality is “what to do” and epistemic rationality is “what is true.” Charlie Munger understands and is focused on being both “epistemically” and instrumentally rational.
 
“The right way to think is the way [Harvard Professor Richard] Zeckhauser plays bridge. It’s just that simple.” To be “rational” is to think in terms of expected value, which Michael Mauboussin points out “is the weighted average value for a distribution of possible outcomes.”  In the 1989 Berkshire Hathaway Annual Meeting Warren Buffett put it this way: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” Michael Mauboussin describes the rational approach perfectly: “Success in a probabilistic field requires weighing probabilities and outcomes — that is, an expected value mindset.” Robert Hagstrom argues http://blogs.cfainstitute.org/insideinvesting/2013/09/03/what-buffett-believes-but-cannot-prove/: “Jon Elster is a Norwegian social and political theorist who has written extensively on rational-choice theory. He tells us that being able to wait and using indirect strategies are central features of human choice. Indeed, Elster argues that human rationality is characterized by the capacity to relate to the future, in contrast to the myopic gradient-climbing organism found in the natural world. Elster’s gradient-climbing organism has eyes fixed to the ground, incapable of seeing what might happen next. Future events for the myopic organism have no effect on decision making. Put differently, for the myopic organism, tomorrow’s events are the same as today’s events. In contrast, Elster claims that man can be seen as a rational, global-maximizing machine capable of relating to the future, choosing the best alternative by scanning several possible moves and then selecting the best choice among them. The irrational investor, the myopic gradient-climber, sees only today and postulates that tomorrow will be much the same. In contrast, Buffett sees stock price declines as temporary. Irrational investors see the same price declines and believe them to be permanent. The cornerstone of rationality is the ability to see past the present and analyze possible scenarios, eventually making a deliberate choice.” As an aside, if you are not reading Robert Hagstrom’s books you are missing out on some very good thinking and writing.
 
“[What was] … worked out in the course of about one year between Pascal and Fermat… is not that hard to learn.” “So you have to learn in a very usable way this very elementary math and use it routinely in life ‑ just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”  Charlie Munger is saying that the expected value aspects of investing are relatively simple to learn but that it is not a natural way of thinking. He believes that using this process skillfully in real life is a trained response since aspects of the process will require you to overcome certain biases as well as certain often dysfunctional emotional and psychological tendencies. “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. ‘For example’, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response.” The best way to learn to play bridge or invest is to actually play. You can’t really simulate it. Over a lifetime you can learn from actual direct and indirect experience to overcome different types of dysfunctional thinking. For example, says Munger “If people tell you what you really don’t want to hear what’s unpleasant—there’s an almost automatic reaction of antipathy. You have to train yourself out of it.” 
 
 
“The Fermat/Pascal system is dramatically consonant with the way that the world works. If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest. You’re giving a huge advantage to everybody else.” Charlie Munger is famous for his view that simple mathematic techniques like algebraic inversion are essential to making wise decisions. Adopting this approach is neither easy or natural but will inevitably pay big dividends. He believes that if you don’t do this work you will inevitably end up being the patsy at the poker table of life.  If you are playing in a poker game and don’t see a sucker, get up and walk away from the table. You’re the sucker. The future is best thought of as a probability distribution so naturally thinking probabilistically puts you are a competitive advantage in relation to competitors.
 
“I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? The first track is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth.”  Having a system is important says Warren Buffett: “The approach and strategies [in bridge and investing] are very similar. In the stock market you do not base your decisions on what the market is doing, but on what you think is rational. With bridge, you need to adhere to a disciplined bidding system. While there is no one best system, there is one that works best for you. Once you choose a system, you need to stick with it.” The analytical system Charlie Munger uses starts with rationality. But that is only the first step in a two step process that is his systematic approach to investing. He is saying that the rational decision-making track comes first, just like putting on your pants should precede putting on your shoes.
 
“Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often malfunctions.” Ordinary people, subconsciously affected by their inborn tendencies.”  After an expected value process is completed and you believe your decisions is rational, Charlie Munger suggests that the decision be cross-checked for possible errors. The reality is that no one has a fully rational mindset. It would not be possible to get out of bed in the morning if every human decision had to be made based on careful expected value calculations. Heuristics have been developed by humans to get through a day which sometimes cause decisions to become irrational, especially in a modern world which is very unlike most of history.  In other words, no human is perfectly rational because everyone is impacted by emotional and psychological tendencies when making decisions. As a result, thinking rationally is a trained response. To be as rational in your daily life as Richard Zeckhauser is in playing bridge a person must overcome errors based on emotional or psychological mistakes. Rationality is in practical terms relative.  Charlie Munger believes staying rational is hard work and requires constant practice and lifelong effort. Making mistakes is inevitable and will never stop, but you can learn to make less than your statistical share of mistakes.
 
“Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. For example, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response. Thinking in a way that is as rational as possible requires work and training, especially when it comes to avoiding psychological and emotional mistakes. What is the source of these mistakes? The list of factors causing mistakes is very long. Warren Buffett writes: “It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it… we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.” What Buffett describes is an example of what Charlie Munger calls decisional inversion. Instead of just trying to be smart, it is wise to focus on not being stupid.
 
What is hard is to get so you use it routinely almost every day of your life.” Training your mind to do what Charlie Munger suggests is the ultimate goal of anyone who wants to emulate his system. Warren Buffett has written: “Chains of habit are too light to be felt until they are too heavy to be broken…At my age, I can’t change any of my habits. I’m stuck. But you will have the habits 20 years from now that you decide to put into practice today. So I suggest that you look at the behavior that you admire in others and make those your own habits, and look at what you really find reprehensible in others and decide that those are things you are not going to do. If you do that, you’ll find that you convert all of your horsepower into output.” One  good aspect of habits is that they can be put to good use if they are the right habits. It’s a bit like Alcoholics Anonymous, which Charlie Munger believes is a cult, but for the good. What an investor needs is a system that includes habits that reinforce rationality. If you want to say that people who follow Munger are a cult for the good, you won’t be far off in too many cases.  Munger himself has referred to people who attend Berkshire shareholder meetings as cult followers.
 
“We have a temperamental advantage that more than compensates for a lack of IQ points.” “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains.” Charlie Munger is making the point that high IQ does not mean you have high rationality quotient (RQ).  Temperament is far more important than IQ. Warren Buffett has said about Charlie Munger: “He lives a very rational life. I’ve never heard him say a word that expressed envy of anyone. He doesn’t waste time on senseless emotions.”  Warren Buffett suggests that some of this aspect of human nature may be innate: “A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.” High IQ can be problematic. What you want is to have a high IQ but think it is less than it actually is. That gap between actual and perceived IQ creates valuable humility and protects against mistakes caused by hubris. It is the person who thinks their IQ is something like 40 points higher than it actually is who creates the most havoc in life.
 
“Personally, I’ve gotten so that I have a full kit of tools … go through them in your mind checklist-style.” Charlie Munger is a big believer is the use of checklist and is fan of Atul Gwande’s book The Checklist Manifesto. Checklists are a foundational part of systems that can help people identify dysfunctional thinking and bias. A checklist is in effect a “nudge” that helps you deal with bias and dysfunction by prodding you in the right direction. As an aside the full kit of tools required when using Charlie Munger’s system requires that you have “worldly wisdom” which will be the topic of another blog post in this series.
 
“Rationality …requires developing systems of thought that improve your batting average over time.” “Luckily, I have selected very easy problems all my life, and I have a reasonable batting average.” “You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.” No one is going to make the right decision all the time even if they strive to be rational. Howard Marks believes:Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes.  Few people expect to find a lot of sure things or achieve a perfect batting average.” The important thing is to have a system, but don’t expect it to be perfect. Michael Mauboussin points out: “Constantly thinking in expected value terms requires discipline and is somewhat unnatural. But the leading thinkers and practitioners from somewhat varied fields have converged on the same formula: focus not on the frequency of correctness, but on the magnitude of correctness.”
 
“[Berkshire] is a very rational place.” “Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points. Mr. Munger continued: “People chronically mis-appraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant.” IQ is not the primary cause of investing success. Warren Buffett points out that the key to making wise decisions is rationality: “How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output–the efficiency with which that motor works–depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.” For Buffett and Munger the circle of competence point is critical. Since risk comes from not knowing what you are doing, know what you are doing when you are doing something. If you don’t know what you are doing put it in the too hard pile and move on to something else. The more you know, the more you know, that there is even more than you do not know.