Wednesday, September 1, 2010

Investing Models

Below are some thoughts from Glenn Greenberg and Charlie Munger on the various investing models they have used over time. Obviously, there is no one best model...just build on those that resonate in some way.

In my case, one of the most effective is simply the great brands combined with powerful distribution (Diageo, Philip Morris International, Altria, Coca-Cola, Pepsi etc.) model. The fact that it is so simple I'm guessing is one of the reasons it gets underutilized*. The combination of scale advantages and psychological factors that result in repeat behavior produces pricing power. It's a reliably useful model. I know of nothing else that produces so many examples of wide moats and durable high returns on capital. There may be but I just don't know of it. If bought with an appropriate margin of safety, the above tend to provide attractive risk-adjusted returns (what Grantham calls "the one free lunch").

"In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest." - Jeremy Grantham

Another model I like is the consolidation of a fragmented industry around 1-2 powerful competitors (Mohawk Industries or Home Depot are examples). The cost advantages of the bigger competitors tend to provide at least a decent moat.

So the above are just two examples of models that can be used but clearly there are many others.

In this Charlie Munger speech, he describes some of the investing models that he and Warren Buffett use.

Munger on Investing Models

Here is an example of one:

"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. - Charlie Munger


Here is an excerpt of what Greenberg had to say:

I have been in the business since 1973, so I have been looking at companies for a long time. There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn't going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models - Glenn Greenberg.

Over time, I have learned those that work most effectively for me. Some don't. For example, I doubt I will ever be able to gain the insights necessary to find the next Google (there are obviously those who have models of some kind that help them identify that sort of thing).

Improve on the one's that have worked and hopefully add some new one's over time.

Adam

* Some expect shares of companies like this to have more modest returns than the market. They are often treated as defensive (and in the short run, they are) but they can be more long-term offensive than many think.

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