Friday, August 28, 2009

Munger on Elementary, Worldly Wisdom - Part II

A follow up to this previous post:

In this section of a 1994 speech by Charlie Munger at USC Business School, he gets beyond the "carrots" and talks more specifically about stocks and investing models.

Again, it's worth checking out the whole speech but below I've included some highlights:

Microeconomics
"Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered?

And 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 misfunction.

One approach is rationality the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions many of which are wrong.

Now we come to another somewhat less reliable form of human wisdom...microeconomics. And here, I find it quite useful to think of a free market economy or partly free market economy as sort of the equivalent of an ecosystem..."

"Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world ‑ and get very good because they specialize frequently find good economics that they wouldn't get any other way.

And o­nce we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis..."


Advantages of Scale
"Let's go through a list albeit an incomplete one of possible advantages of scale. Some come from simple geometry. If you're building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.

And there are all kinds of things like that where the simple geometry—the simple reality—gives you an advantage of scale.

For example, you can get advantages of scale from TV advertising. When TV advertising first arrived when talking color pictures first came into our living rooms it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was say 90% of the audience.

Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising which was the most effective technique."

"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 cents and the other is 30 cents, 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.

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."

"The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you."

"And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, 'To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #1 or #2 or out.'

That was a very tough‑minded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there."

"On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization."

"If o­ne little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.

So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise."

"And it makes sense to load up o­n the very few good insights you have instead of pretending to know everything about everything at all times. You're much more likely to do well if you start out to do something feasible instead of something that isn't feasible. Isn't that perfectly obvious?

How many of you have 56 brilliant ideas in which you have equal confidence? Raise your hands, please. How many of you have two or three insights that you have some confidence in? I rest my case.

I'd say that Berkshire Hathaway's system is adapting to the nature of the investment problem as it really is."


High Quality Businesses, Low Frictional Costs
"We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses.

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

"There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes o­n your behalf? Lots of luck."

"Are there any dangers in this philosophy? Yes. Everything in life has dangers. Since it's so obvious that investing in great companies works, it gets horribly overdone from time to time. In the "Nifty-Fifty" days, everybody could tell which companies were the great o­nes. So they got up to 50, 60 and 70 times earnings. And just as IBM fell off the wave, other companies did, too. Thus, a large investment disaster resulted from too high prices. And you've got to be aware of that danger...

So there are risks. Nothing is automatic and easy. But if you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed especially for an individual."

Pricing Power
"Within the growth stock model, there's a sub-position: There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer."

"You will get a few opportunities to profit from finding underpricing. There are actually people out there who don't price everything as high as the market will easily stand. And o­nce you figure that out, it's like finding money in the street - ifyou have the courage of your convictions."

Newspapers
"If you look at Berkshire's investments where a lot of the money's been made and you look for the models, you can see that we twice bought into two newspaper towns which have since become one newspaper towns. So we made a bet to some extent...

In one of those The Washington Post we bought it 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.

Of course, that came about back in '73 - 74. And that was almost like 1932. That was probably a once-in-40-years type denouement in the markets. That investment's up about 50 times over our cost.

If I were you, I wouldn't count on getting any investment in your lifetime quite as good as The Washington Post was in '73 and '74.

But it doesn't have to be that good to take care of you."

Marketing & Technology Advantages
"Let me mention another model. Of course, Gillette and Coke make fairly low‑priced items and have a tremendous marketing advantage all over the world. And in Gillette's case, they keep surfing along new technology which is fairly simple by the standards of microchips. But it's hard for competitors to do.

So they've been able to stay constantly near the edge of improvements in shaving. There are whole countries where Gillette has more than 90% of the shaving market."

GEICO
"GEICO is a very interesting model. It's another o­ne of the 100 or so models you ought to have in your head. I've had many friends in the sick business fix up game over a long lifetime. And they practically all use the following formula I call it the cancer surgery formula:

They look at this mess. And they figure out if there's anything sound left that can live o­n its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn't work, they liquidate the business. But it frequently does work.

And GEICO had a perfectly magnificent business - submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.

All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated over and over again.

And, in GEICO's case, think about all the money we passively made....It was a wonderful business combined with a bunch of foolishness that could easily be cut out. And people were coming in who were temperamentally and intellectually designed so they were going to cut it out. That is a model you want to look for.

And you may find o­ne or two or three in a long lifetime that are very good. And you may find 20 or 30 that are good enough to be quite useful." - Charlie Munger

With so much focus on the many macro problems, it's easy to forget it is things like some of the above investing models that matter when it comes to successful stock picking.

By the way, if you look over the past century or so, there are relatively few periods when there were not serious macro challenges yet lots of money was made by owning shares of the quality businesses.

Adam

Munger on Elementary, Worldly Wisdom

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