Friday, September 12, 2014

Munger on Airlines, Cereal Makers, and Bottlers

From this 1994 USC speech by Charlie Munger:

"Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors—or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.

Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.

If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.

Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.

And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.

In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.

For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening."

The above is just one good example among many that investment inevitably requires lots of qualitative judgments. The math matters, of course, but completely insufficient when it comes to sound investment decision-making.

Munger explained it this way in a 2003 speech at UC Santa Barbara:

"...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."

At the 2002 Wesco annual meeting, Munger had this to say about the tendency to focus too much on the calculations:

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

Also, here's a revealing exchange between Warren Buffett and Charlie Munger: 

Munger: "You really have to understand the company and its competitive positions. ...That's not disclosed by the math.

Buffett: "I don't know how I would manage money if I had to do it just on the numbers."

Munger, interupting, "You'd do it badly."

Big mistakes are likely to get made by the investor who looks only at, -- or, at least, mostly at -- the numbers while ignoring the more qualitative things like, for example, industry dynamics. An industry with a particular set of characteristics -- even if for a very long time -- may change.

The investment process is necessarily subjective and imprecise. Both qualitative and quantitative factors have to be fully integrated with the former often being more significant than the latter.

Margin of safety can, up to a point, account for the some of unknowns and uncertainties. Yet even something as important as always buying with a sufficient margin of safety has its limits. Sometimes the worst case scenario, even if not very probable, is simply intolerable. Howard Marks mentions in his latest memo the skydiver who's successful 95% of the time. That's a good example of this.

In other words, for some potential investments with lots of upside but also the possibility of a very bad outcome, no price will be low enough.

So, in the context of an investment portfolio, it becomes necessary to forgo a big possible gain to keep something really bad from happening.

Unfortunately, the probabilities will almost never be as precise as something like 95%.

Mostly, a qualitative judgment will have to be made.


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