5 Investment Lessons from Charlie Munger

May 27, 2014
Warren Buffett's right-hand man and investment partner has a lot of wisdom for investors to ponder upon.

It's virtually impossible to overstate the influence that Charlie Munger, who recently turned 90 years old, has had on Warren Buffett's investing discipline. Buffett regularly labels Munger as his "partner" at Berkshire Hathaway and fills the firm's annual shareholder letters with phrases like, "Charlie and I believe ..." In fact, in Berkshire's 2012 letter, Buffett makes reference to their long and fruitful working relationship, writing, "more than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price."

That insight has guided Buffett over the years and helped him become more comfortable with paying up for outstanding businesses with economic moats, or sustainable competitive advantages.

Given Munger's age, no one can say how much longer investors can expect to see him sitting at Buffett's side each May, delighting audiences with his wisdom and also chiming in with his favorite line, "I have nothing to add," immediately after Buffett expounds on a topic.

Some of the core investment principles that Munger has espoused can be found in the excellent 2005 book Poor Charlie's Almanack, a collection of Munger's best talks, quotations, and thoughts. Modeled after Poor Richard's Almanac by Munger's hero, Ben Franklin, Poor Charlie's Almanack lays out Munger's worldview, including his "multidisciplinary" approach to clear, elegant thinking.

1) Multiple mental models

One of Munger's principal frameworks is to more broadly understand, collect, and organise the factors affecting an investment candidate. This means drawing what he calls "multiple mental models" from a variety of disciplines, including engineering, mathematics, physics, chemistry, and psychology. Driving this need to understand the various dynamics surrounding an investment--both in its internal and external environment--is Munger's understanding that these various factors can work in concert. Munger termed that dynamic a "Lollapalooza Effect"--when anywhere from two to four forces all are driving the investment in the same direction. And yet, Munger noted in Outstanding Investor Digest in 1997 that the effect isn't "simple addition" but rather more akin to a "nuclear explosion."

One doesn't need to be an academic to tap these different models, including the modern Darwinian synthesis model from biology or cognitive misjudgment models from psychology. Indeed, Munger himself acknowledges that his understanding of these models is entirely self-taught.

2) Guiding principles

Munger's invocation of multiple mental models has given him a mindset characterized by four guiding principles that any ordinary investor should follow: preparation, patience, discipline, and objectivity. When practiced correctly, these attributes should result in buying great businesses at good prices and keeping one's portfolio turnover low.

Poor Charlie's Almanack describes his worldview, perhaps tongue-in-cheek, as "Quickly Eliminate the Big Universe of What Not to Do, Follow Up with a Fluent, Multidisciplinary Attack on What Remains, Then Act Decisively When, and Only When, the Right Circumstances Appear."

Munger and Buffett have proved that it works. Munger once said, "It's kind of fun to sit there and outthink people who are way smarter than you are because you've trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience."

3) Yes, no, and inbetween

In addition to favoring a narrow, concentrated portfolio, Munger holds the view that he should stick to his knitting when evaluating investment candidates. "Yes" candidates are easy-to-understand businesses with distinct and sustainable competitive advantages with a dominant franchise. He immediately dismisses other possibilities, especially in health care and technology, into what he calls the "too tough to understand" pile. Others-- deals pushed by brokers, including IPOs-- fall into the "no" pile.

4) An all-round perspective

Munger considers every aspect of a business when considering a candidate for investment, evaluating management's character and capital allocation decision-making. He also analyzes a business' competitive advantages, mindful that few businesses endure for multiple generations. Thus, understanding a business' sustainable competitive advantages is critical. Munger pays close attention to the company's operating and regulatory environment, the impact on it from changes in technology, hidden exposures, and the current and future impacts of stock options, pension plans, and retiree medical benefits.

5) Compute value

Finally, Munger carefully attempts to compute the business' underlying value. To avoid anchoring, he tries to calculate a business' value independently of the price at which a company trades.

Robert Goldsborough, fund analyst on the passive funds research team, wrote this piece for Morningstar.com. The above is an extract from the original. 

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