Lessons from Charlie’s almanack
Poor Charlie’s Almanack is probably the most enjoyable compilation we have today on the life, wit and philosophy of Charlie Munger. The almanack also contains a transcript of an earlier talk, The Art of Stock Picking, that Munger gave to students at The University of Southern California in 1994. In this talk, Munger explored the art of investing as a subdiscipline of the practice of ‘worldly wisdom’. Students of Munger will recall his emphasis on cultivating mental models to guide one’s decision making. He outlines some of these models in his speech – a real treat for curious readers and listeners. This post will summarise some of the key ideas that I took from Munger’s reflections.
Remedial worldly wisdom
Firstly, a few words on ‘worldly wisdom’: Munger describes how most of us require a general education before we can specialise in anything. If we’re to be good investors, we’re going to need some general education. However, Munger points out that we can’t remember these facts in isolation. Rather, we have to arrange them into a lattice of mental models. It’s an important first step to understanding things deeply.
Furthermore, we can’t rely on just one or two models. Good lattices require multiple interacting and intersecting models. Otherwise, we risk distorting reality to fit our model of thinking. This means we have to be wary of intense ideology, and receptive to new information and relearning. As Munger recites on numerous occasions, “to the man with only a hammer, every problem looks a nail.”
Skip ahead
- The latticework
- The language of business
- The vagaries of competition
- Charlie, you’re at the racetrack
- The intelligent investor
- The long road to worldly wisdom
The latticework
“You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘here are three things’. You have to derive it yourself to ingrain it in your head for the rest of your life”.
Charlie Munger
When Munger says ‘multiple models’, he is referring to “80 or 90 important models”. These models he believes will account for “90 percent of the freight in making [us] worldly wise”. If this sounds somewhat daunting, you’re not alone. I also doubt we’ll get to know the full list of models that Munger is referring to. Fortunately, he does outline the few that he believes carry enormous value. They span across mathematics, engineering, biology, psychology and economics. We’ll highlight them briefly as follows.
Fermat & Pascal
“I’m like a poker player who’s learned to play pretty well without mastering Pascal”.
Charlie Munger
In mathematics, Munger outlines the value in grasping basic arithmetic, compound interest, permutations and combinations. He highlights the utility of Fermat and Pascal’s systems in understanding real life problems (i.e. thinking probabilistically). Munger also describes the value in understanding the nature of statistical distributions. While he doesn’t remember how to run large statistical computations, he understands what Gaussian and Poisson distributions look like, and where they may emerge in reality.
Braun’s iron rule
Munger has also gleaned several ideas from engineering and the physical sciences. This includes ideas in quality control, breakpoints and critical mass. He also cites Carl Braun’s (of CF Braun Engineering) rule for communications: you should say “who [is] going to do what, where, when and why”. Munger extends this into an “iron rule” for acquiring worldly wisdom: ask “why, why, why”. Such questions are simple and sensible guides to learning, business and management.
Psychology of misjudgement
“No pilot takes off without going through his checklist: A, B, C, D… But these psychology professors think they’re so smart that they don’t need a checklist. But they aren’t that smart. Almost nobody is.” “There’s only one right way to do it: you have to get the main doctrines together and use them as a checklist. And, to repeat for emphasis, you have to pay special attention to combinatorial effects that create lollapalooza consequences”.
Charlie Munger
Next, Munger highlights his appreciation for biology, physiology and psychology. To make good decisions, we need to understand our cognitive tendencies, limitations and malfunctions. To help with the recognition of misjudgement, Munger uses a “two-track analysis”. Firstly, he thinks about the interests or incentives that motivate us. Secondly, he considers the subconscious influences in the brain that lead to patterned behaviours in an automatic way. In his famous speech, The Psychology of Human Misjudgement, Munger described twenty-five principles that contributes to common thinking errors. It’s worth the read and/or listen.
Since we’ve written a lot about thinking errors previously, I omit them here for brevity. This includes: Atul Gawande’s Complications; Robert Cialdini’s Influence; Daniel Kahneman’s Thinking, Fast and Slow; Annie Duke’s Thinking in Bets; and Philip Fernbach and Steven Sloman’s The Knowledge Illusion.
The language of business
“If you think psychology is badly taught in America, you should look at corporate finance. Modern portfolio theory? It’s demented! It’s truly amazing.”
Charlie Munger
For investors, a working knowledge of accounting is essential, given it’s the language of business. Munger also sees value in decision tree theory (DTT) and cost-benefit analysis (CBA). He observes how Warren Buffett “automatically thinks in terms of decision trees…, permutations and combinations”, and how it’s aided the quality of his decision making. Munger also emphasises the importance of being well versed in these topics to recognise its limitations. We should remember that double-entry bookkeeping is only an approximation; and that DTT and CBA often depend on strong simplifications and assumptions.
Ecosystems and scale
After all of the above, we can turn to the useful (but not always reliable) field of microeconomics. Here, Munger likes to think about market economies as an ecosystem. One idea he likes to keep in mind is the advantages of scale. Scale may confer advantages in productivity (e.g. economies of scale), information (e.g. brand awareness) and/or psychology (e.g. social proof). In some markets, scale can create a “winner take all” environment.
However, scale also impose several disadvantages. It may hamper efficiency and specialisation in niches that smaller and focused competitors can better serve. Similarly, it may introduce bureaucracy and perverse incentives. Like a Darwinian ecosystem, companies that specialise well may find enormous success in their niche. Bruce Greenwald shares a similar view in his book Competition Demystified.
Hence, the growing company must manage this “everlasting battle between those two forces”: they must maximise the advantages of scale while keeping the costs of bureaucracy at bay. Munger observes how a combination of scale and fanaticism can be a powerful recipe for business. I think Amazon’s Jeff Bezos understood these forces extremely well.
The vagaries of competition
Munger also discusses the nature of one mental model that he has not yet resolved: the tendency for some oligopolies to engage in destructive competition (whether by price, reinvestment and so on). Here, he compares the extreme competition of airliners to the stability of cereal markets. Munger suggests that the ‘commodity’ nature of industry, and the personalities in the room, might have something to do with it.
Second level thinking
Similarly, Munger highlights the importance of recognising when technology will help or hurt the company. While new investments may improve productivity, they may not generate lasting returns if competitors replicate it. Here, the benefits of investment accrue largely to consumers as the result of competitive forces. Munger observes how management and consultants are quick to outline the immediate benefits of new investments, and slow to recognise the cost of competitive responses and retaliation. We can make the same argument about price wars as well.
Surfing on destruction
Munger also discusses the phenomenon of competitive destruction. He observes how new technologies can annihilate the incumbents in the wake of new businesses and industries. Some companies, like Microsoft and Intel, had the opportunity to catch these waves early and “surf” for a very long time. However, Munger doesn’t invest in companies at the frontier of technology. It remains outside his realm of expertise. But that’s not to say that they make poor investment opportunities for everyone.
Circle of competence
“If you play games where other people have the aptitudes you don’t, you’re going to lose”.
Charlie Munger
This brings us to Mungers’ emphasis on sticking to one’s circle of competence. You have to determine your edge and stay within those parameters. While you can expand your circle of competence through learning and experience, we’re less likely to find success in ventures outside this boundary. This is as true for businesses as it is for investors.
Charlie, you’re at the racetrack
“If people weren’t wrong so often, we wouldn’t be so rich.”
Charlie Munger
To Munger, believing in the theory that markets are perfectly efficient is “bonkers”. While efficient market theory is elegant in its mathematical formulations, its assumptions do not reflect market realities. Markets are usually efficient, but not always. And this creates opportunity.
Instead, Munger prefers to think about common stocks like a pari-mutuel system at the racetrack. Remember that in these systems, the betting odds change as people place their bets. While it’s easy to recognise the best horses, it’s often hard to place a good bet once their odds change. Investors in common stocks face a similar challenge.
Shrewdness and fanaticism
“Ninety-eight percent of the time, our attitude toward the market is … [that] we’re agnostics. We don’t know. Is GM valued properly vis-à-vis Ford? We don’t know.”
Charlie Munger
Furthermore, beating the market average is difficult, not because the markets are always efficient, but by definition. We cannot all beat the average! At the racetrack, Munger observes how infrequently the outperformers bet. They bet only when they see a favourable mispricing in the system. And when they do, they aren’t afraid to bet big. Munger applies a similar logic to investing.
One ticket, big punches
“With enough shrewdness and fanaticism, some people will get better results than others… they bet big when they have the odds. And the rest of the time, they don’t.”
Charlie Munger
Similarly, Munger notes how Berkshire Hathaway made most of their returns from just a few great investments (e.g. GEICO, Washington Post, etc.). He agrees with Buffett’s sentiment that investors would perform better if they limited their purchases to their very best ideas. This is to treat investing as a “ticket with only 20 slots… [for] 20 punches – representing all the investments you got to make in a lifetime”.
“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.”
Charlie Munger
The intelligent investor
“View a stock as an ownership of the business and judge the staying quality of the business in terms of its competitive advantage.”
Charlie Munger
With all that said, Munger returns to value investing, and highlights three timeless tenets from Benjamin Graham. The first is the concept of intrinsic value. Graham thought of value as the price a private owner would pay to own the entire enterprise. That is, price is not what you pay for the piece of paper, but for a fractional ownership in the company itself.
The second idea was the margin of safety. The larger the difference between purchase price and intrinsic value, the greater your investment edge. Finally, we have the idea of “Mr Market” – a manic-depressive that offers you a chance to buy (sell) stocks at some price every day. You don’t have to engage with the market if you don’t like what you see. Just like at the racetrack, we can choose to buy or sell once the odds are wildly in our favour.
The evolution of Berkshire Hathaway
“Once we’d gotten over the hurdle of recognising that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.”
Charlie Munger
Graham’s philosophy emerged at a time when the world and investing community was recovering from the Great Depression. Back then, it was easier to find profitable companies that traded at prices well below their book value or net-net working capital per share. While Graham’s tenets remain timeless to this day, the formula for finding cheap stocks or ‘cigarette butts’ don’t hold up as well.
Instead, Munger and Buffett adapted Graham’s principles to find high quality companies, with capable and honest managers, at reasonable prices. Munger describes how this is not so easy to do either, particularly as your capital base grows and your opportunity set shrinks. However, it remains a sufficiently reflexive and time-tested way to invest for the long-run. It also presents many roads to value creation. Ideally, Munger says you’ll find these wonderful companies while they’re small, with room for growth and reinvestment. In other instances, you might find quality companies with untapped pricing potential.
The long road to worldly wisdom
“Warren is one of the best learning machines on this earth… Warren’s investing skills have markedly increased since he turned 65. Having watched the whole process with Warren, I can report that if he had stopped with what he knew at earlier points, the record would be a pale shadow of what it is.”
Charlie Munger
This was a quick run through of Munger’s speech and mental models. In practice, building a satisfactory latticework takes a lifetime of reading and learning. To paraphrase Viktor Frankl, the answers we seek in life rarely come from the internal revelations of one’s own mind. Our personal discovery and worldly wisdom can benefit greatly from a biographical approach – to learn from the lives, successes and failures of others. And I think the life of Charlie Munger is a great place to start.
References
- Munger, C., & Kaufman, P. (2005). Poor Charlie’s Almanack, The Wit and Wisdom of Charles T. Munger. More info at < https://www.poorcharliesalmanack.com/pca.php>
- Munger, C., & Clark, D. (2017). The Tao of Charlie Munger: A Compilation of Quotes from Berkshire Hathaway’s Vice Chairman on Life, Business, and the Pursuit of Wealth With Commentary by David Clark.