An Afternoon with Charlie Munger

An Afternoon with Charlie Munger
by Toan Tran
Morningstart, 07-26-06

I had the pleasure of attending Wesco Financial's WSC annual meeting in early May. The main attraction, of course, was Wesco chairman and Berkshire Hathaway BRK.B vice chairman Charlie Munger. Although Munger is sometimes obscured by the long shadow of his more famous partner, Warren Buffett, his contributions to the philosophy of value investing cannot be overstated. Buffett never hesitates to say that without Munger's influence, Berkshire may have never purchased great growth businesses like See's Candy or Coca-Cola KO .

We also owe much of what we do at Morningstar GrowthInvestor, the monthly newsletter that I edit, to Munger's thinking, so the annual meeting was a superb opportunity to learn at the foot of the master. Here are some of his nuggets of wisdom.

Opportunity Cost
"There is this company in an emerging market that was presented to Warren. His response was, 'I don't feel more comfortable buying that than I do of adding to Wells Fargo.' He was using that as his opportunity cost. No one can tell me why I shouldn't buy more Wells Fargo. Warren is scanning the world trying to get his opportunity cost as high as he can so that his individual decisions are better."

When you are evaluating any investment, you must compare it to every other available investment, including ones you may already own. Instead, many investors collect stocks like baseball cards and the resulting portfolio bloat will likely not increase returns or reduce risk. So when you hear about the new hot stock in the next can't-miss sector, ask yourself two questions: (1) Do I understand the investment as well or better than one I already own? (2) Is the risk and reward profile of the investment superior to all other alternatives? If the answer is "no" to either questions, it is probably best to stay away.

Rationality
"Rationality is not just something you do so that you can make more money, it is a binding principle. Rationality is a really good idea. You must avoid the nonsense that is conventional in one's own time. It requires developing systems of thought that improve your batting average over time."

Munger is an evangelist for the virtues of rationality and his outstanding investment record is testimony to a lifetime of disciplined thought. To succeed as an investor, one has to make good decisions that are anchored in reality and free from emotional and cognitive distractions. At GrowthInvestor, we are searching for companies with significant market potential, rising demand, an economic moat, and growth-oriented management for purchase in the portfolio. This is not merely a checklist, but a research process focused on helping us make the most-rational decisions. If we make enough rational decisions, we will eventually have the returns to show for it.

Envy
"Harvard and Yale concentrated with venture capitalists that got the best calls and brainpower. Very few firms made most of the money, and they made it in just a few periods. Everyone else returned between mediocre and lousy. When returns happened, envy rippled through institutional money management. The amount invested in venture capital went up 10 times post-1999. That later money was lost very quickly. It will happen again. I don't know anyone who successfully resists this stuff. It becomes a new orthodoxy."

Munger and Buffett often say that envy is worst of the seven deadly sins because it is the only one that isn't fun to commit. When a group of people make money, others are compelled by an irresistible force to get a piece of the action, even though prices have risen so far above fair value as to guarantee disappointing returns and there are much better alternatives available. I am completely puzzled by this behavior, but I am also glad it exists.

Learning
"We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side. If you can't state arguments against what you believe better than your detractors, you don't know enough."

Carl Jacobi, a noted 19th-century mathematician, counseled his students to "invert, always invert" when they encountered a particularly vexing problem. I think this is a great way to approach investing. After you compile all the reasons you should buy a stock, invert the question and state the reasons why you should not buy the stock. By doing this, you ensure that your research process is more complete.

Mistakes
"Chris Davis [of the Davis funds] has a temple of shame. He celebrates the things they did that lost them a lot of money. What is also needed is a temple of shame squared for things you didn't do that would have made you rich. Forgetting your mistakes is a terrible error if you are trying to improve your cognition. Reality doesn't remind you. Why not celebrate stupidities in both categories?"

I have kept track of my investing mistakes for some time now, and it is a painful, but illuminating, experience. Without doubt, I am a better investor for it. I will be keeping track of our mistakes at GrowthInvestor, and I suggest you do the same with your portfolio. With a post-mortem catalog of your mistakes, you will be able to identify patterns in your decision-making process that produce unforced errors.

Risk
"I know a man named John Arriaga. After he graduated from Stanford, he started to develop properties around Stanford. There was no better time to do it then when he did. Rents have gone up and up. Normal developers would borrow and borrow. What John did was gradually pay off his debt, so when the crash came and 3 million of his 15 million square feet of buildings went vacant, he didn't bat an eyebrow. The man deliberately took risk out of his life, and he was glad not to have leverage. There is a lot to be said that when the world is going crazy, to put yourself in a position where you take risk off the table. We might all consider imitating John."

Palatial casinos are built in the desert because people find risk to be fun and exciting. I am not much of a gambler, so whenever I visit Las Vegas, I spend most of my time watching friends try their luck. One intriguing thing I have noticed is that when things are going well and money has been won, it is nearly impossible for many people to walk away from table. Instead, they take on more risk by betting larger amounts, even though the odds are clearly stacked in favor of the house. Taking on risk only makes sense when it is sufficiently outweighed by the potential reward, which is why we only buy stocks when there is a margin of safety. Otherwise, consider Munger's advice and imitate John Arriaga.