From a man who only had a couple of dollars to his name…
To a billionaire worth US$1.6 billion.
Charlie Munger, the vice-chairman of Berkshire Hathaway, is one of the greatest investment thinkers today. His name itself will go down as a legend in the field of investing.
Charlie Munger’s personal life journey as well is nothing short of inspiring. When he was just shy of 30, his first wife separated. He was left with nothing but his three children.
Just 1 year later, more tragedy struck when his 9-year-old son died of cancer. Later in life, Charlie Munger also had one of his eyes removed.
Despite all these hardships, he went on to become one half of a two-man dream team that runs Berkshire Hathaway!
How did he do it? How did he make this bucket load of money? What does Charlie Munger think while making his investing decisions?
In this article, you’ll find some of the most valuable rules from Charlie Munger’s investment philosophy.
Munger Rule #1
Find a business you are capable of understanding
Would you be a good driver if you didn’t know how the car ignition starts?
The stock market can help you make a lot of money quickly. However, you can also lose all your money faster. Yes, read that again!
If you invest randomly without knowing the nitty-gritty of the market you WILL lose money.
This is when the concept of intrinsic value enters the conversation.
It is how you value the company based on your own fundamental analysis of the company’s financial statements and filings. You do this while ignoring the market.
Every smart investor estimates a range of intrinsic value for the company before buying its stock.
This is impossible, however, if you don’t understand how the company makes money. If, for instance, you know nothing about cosmetic manufacturing, you shouldn’t invest in L’Oréal.
Unless you understand the company’s products, market, competitive strengths, and weaknesses, you won’t be able to project the future cash flows. You won’t be able to safely assume whether people will still use beauty products 5–10 years from now. Therefore you can’t assess if its earnings will be stable.
Now, what if you do understand the L’Oréal business? You will be more competent in evaluating the stock. Thus, you will be able to make a more competent investing decision with the buying or selling of the stock.
Munger Rule #2
Make sure the company has a durable competitive advantage
We’re all familiar with tales from ancient eras that featured castles surrounded by large trenches of water, fending off hordes of knights and enemy armies.
These were known as moats. They were designed to keep out intruders. The wider and deeper the moat, the more protected the castle would be.
Moat exists in the business empires too. It refers to the intrinsic characteristic that gives the company a durable competitive advantage.
What counts as an intrinsic characteristic? One that is at the very core of the business. It cannot be removed without destroying the company.
Take the instance of Coca-Cola. Its moat is its recipe (kept secret for more than a century). If you remove the secret syrup, Coke won’t be Coke anymore.
A durable competitive advantage is an advantage that allows the company to survive (and thrive) despite other competitive businesses trying to make money in the same way.
Coming back to Coke; It has many competitors, the most obvious being Pepsi. Despite that, it has continued to be in business for 125+ years.
All because of a secret recipe.
You don’t ask for a cola, you ask for a Coke. It has thus built a strong brand moat that consumers trust.
Every good company has at least one of these kinds of moats: brand, secret, toll bridge, switching, or price. It gives the company a predictable cash flow. This allows us to assess the future cash flow and value of the company today. This then helps us to know whether we can buy it on sale or not.
Munger Rule #3
Invest in a company with trustworthy management
There is something more important than the balance sheet of the company.
Think about it.
It is not a company that runs people. But people that run the company.
Human capital is undoubtedly the most valuable asset of a business firm. An incompetent management’s decisions can drive a prospering firm to the dirt. We all remember how Lehman Brothers went down in 2008.
So, always remember: You invest in people, not the idea.
It’s crucial to choose a company that promises talent and integrity.
Is it honest about its growth and pitfalls?
You want a business where the CEO talks openly about when the business is doing well. AND especially when it’s not.
Choose a firm that isn’t immune to human error but can get up from it nonetheless.
Ask, how does it deal with crises?
Suppose the management deals with a problem in a poor or unethical way. They may try to cover it up to preserve goodwill. But once the truth comes to light, the company’s reputation may be tainted for good. Consequently, it will struggle to regain the confidence of its customers and investors in the market.
Munger Rule #4
Buy stocks at a fair price
What came to your mind when you read the word “fair”?
Is it a discount? Or is it something on the lines of ‘value for money?
Or a mix of both?
Now, hold that thought.
Let’s play a round of one of those classic ‘Spot the difference’ games.
Take a good look at the two statements written below.
1. “Fair businesses at wonderful prices”
2. “Wonderful businesses at fair prices”
Which one of the above would you rather buy?
Each one of us hunts for good value. Whether it’s stocks or a seasonal shopping sale, one is bound to get excited when prices fall to “wonderful prices”.
However, one should not get excited at everything whose prices fall.
But, why the hell not?
Because what comes before the price is the quality of the business you are investing in.
Borrowing Charlie Munger’s words, “If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return even if you 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. So the trick is getting into better businesses.”
Do you get the core of this rule now?
When it comes to smart investing, don’t simply look for under-priced opportunities. Look for quality in the company first.
High-quality companies normally don’t come cheap. But if you can find them at “fair prices” or at a slight premium, it is still a good bargain.
Take the instance of Facebook.
When Facebook first listed in its early years, its P/E ratio went as high as 100. Pure value investors would have said it was expensive and crazy to buy a stock at that valuation.
But great companies tend to outperform their competition and consistently grow their earnings.
If we were to value Facebook at 33 times earnings then, its intrinsic value would have been US$12.60. This is a far cry from Facebook’s IPO price of US$38.
If you had demanded a 50% margin of safety, Facebook would have needed to trade at US$6.30 for you to make a move. The lowest Facebook ever went was around US$18 a few months after its listing.
Today, Facebook is trading at nearly US$220. This is a stunning 579% return from its IPO in 2012.
By now the distinction between those two statements in question earlier must be crystal clear.
Don’t buy fair businesses at wonderful prices. Instead, buy wonderful businesses at fair prices.
Time to get started
“You don’t have to have the kind of ability that quantum mechanics requires. You just have to know a few simple things and really know them.”
Charlie Munger did not earn an undergraduate degree. Yet, Charlie Munger graduated magna cum laude from Harvard Law School. He never took a course in business, economics, or finance. Yet, he managed to become a billionaire in the field of investments.
Reading the 4 rules above you may have realized that Munger’s investment philosophy is simple but effective.
Charlie Munger is living proof that you don’t have to be an accounting genius to become a successful investor.
So, don’t let the fear of balance sheets and unpredictability hold you back. Start small, but do start investing today.