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Charlie Munger - Outstanding Investor
Business Finance (BU8201)
Nanyang Technological University
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#10973 Excerpt reprinted with permission of: OUTSTANDING INVESTOR DIGEST, INC. 14 East 4th Street, Suite 50l New York, NY 10012 (212) 777-3330 Outstanding Investor Digest Lecture b CHARLES T. M NCER to the students of Professor Guilford Babcock at the Universit of Southern California Sc ool of Business on April 14. I994 PERSPECTIVES AND ACTIVITIES OF THE NATION'S MOST SUCCESSRJL MONEY MANAGERS. Investors featured in this Issue: BERKSHIRE HATHAWAY‘S WARREN BUFFETI.., 2, 50 GLOBALVEST MGM'T‘S PETER GRUBER... 40 KAHN BROTHERS' IRVING KAHN... 2 WESCO FINANCIAL'S CHARLIE MUNGER... 7. 49 WALTER 8. EDWIN SCHLOSS ASSOCIATES LP'S WALTER SCHLOSS... 2 TWEEDY. BROWNE'S CHRIS BROWNE. WILL BROWNE & JOHN SPEARS... 10 Other Investors in this Issue: SMITH BARNEY INVESTMENT ADVISORS' BRUCE BERKOWI'IZ.. ROXBURY CAPITAL MGM‘T'S TONY BROWNE 8. KEVIN RILEY.. CUNDILL FUNDS' PETER CUNDILL... 4i WALLY GAYE.. GRAHAM-NEWMAN'S BEN GRAHAM ... 2. 26. 59 MUTUAL SERIES FUND'S MICHAEL PRICE.. GARDNER INVESTMENTS' TOM RUSSO... 16 TEMPLETON FUNDS‘ JOHN TEMPLETON .._ 15, 27 TRAIN SMITH COUNSEL'S JOHN TRAIN... 14, 57 MARSHALL WEINBERG.. (and more.) Companies & Investments in this Issue: AMERICA DO SUL.., 47-“ AMERICAN EXPRESS.. AMERICAN HOLDINGS.. ASTROSYSTEMS.. ATLE.. . AXEL SPRINGER.. BANCO ECONOMICO.. BANCO NACIONAL.. BANCO REAL.. BANPONCE.. BRADESCO.. BURE FORVALTNING.. CAP CITIES/ABC.. CASINO.. CEMENTERIA BARLETTA..,16_ 18 CHASE MANHATTAN.. CINBA.. COCA-COLA... 22, 52. 63 CST.. DISNEY... 62 DUPLEX PRODUCTS.. EASTMAN KODAK.. FEDERAL EXPRESS.. FIRST CHICAGO.. GEICO.. 4 GENERAL ELECTRIC... 61 GERDAU.., 47 GREY ADVERTISING.. HEINEKEN.. IBM... 60 JC PENNEY.. JOHNSON & JOHNSON... 13 KELLOGG.. KENT FINL SVCS.. MERCEDES BENZ.. MONDADORI.. MORIXE.. NATL WESTERN LIFE.. NESTLE.. NITTETSU MINING.., 17 PARTNER INVEST.. PETROBRAS.. POLAROID.. RALLYE.. SALOMON .. .64 SCOR US.. SEARS. ROEBUCK.. SHIKOKU COCA~COLA BOWLING. . .20 SOUTHWEST AIR.. STANDARD PACIFIC.. SYMS.. TELEBRAS.. UNILEVER.. USAIR.. VARIG.. VILLAGE SUPERMKTS.. WAL-MART. . .54 WELLS FARGO.. (and more.) Volume X Numbers 1 & 2 May 5. 1995 A TRIBUTE TO BENJAMIN GRAHAM AND JANET LOWE'S BENJAMIN GRAHAM ON VALUE INVESTING; WARREN BUFFETT. WALTER SCHLOSS. IRVING KAHN. ET AL. "THERE ARE ONLY A FEW IMPORTANT IDEAS — AND THEY'RE ALL IN GRAHAM‘S SECURITY ANAL YSIS." Nearly 20 years after his death. Wm continues to be a giant on the investment scene — directly through the Influence of his books and his virtual creation of the profession of security analysis and indirectly through his influence on a generation of highly successful investors — more than a few of them among our contributors. For those who missed the opportunity to get to know him (continued on page 2) TWEEDY. BROWNE'S CHRIS BROWNE. WILL BROWNE & JOHN SPEARS . “WE'RE LOOKING FOR STATISTICAL EXTREMES. AND HERE'S A PORTFOLIO FULL OF 'EM.' Since 1976. when three of four current general partners were in place. W has earned a compound annual return of 17% before fees and expenses vs. 13% for the S&P 500. More fascinating. however. is that their occasional foray into non-U. stocks produced a far higher return — over 31% for its average holding from 1983-91 and 27% before fees for Its international composite vs. 8% for the EAI-‘E Index and 7% for the Morgan Stanley Europe Index (continued on page 10) GLOBALVEST MANAGEMENT'S PETER GRUBER "BRAZIL IS STILL THE CHEAPEST MARKET AROUND -—- MANY EXAMPLES OF EXTRAORDINARY VALUATIONS." Under the direction of Management‘s President and Chief Investment Officer. W. W earned a compound annual return of 47% net of all fees versus 14% for the IFC Iatin America Index during the three years ended December 31. 1994 —- placing it on top of Nelson's 3-year rankings for emerging market managers. If you find those audited figures slightly hard to believe. you may be equally amazed to learn that according to unaudited figures going back to the second quarter of 1987. (continued on page 40) WESCO FINANCIAL'S CHARLIE MUNGER “A LESSON ON ELEMENTARY. WORLDLY WISDOM AS IT RELATES TO INVESTMENT MANAGEMENT 8 BUSINESS.‘ A particularly astute student of human nature — particularly Insofar as it relates to business and investing — We counsel is highly prized and relied upon by friend and partner W- His insights are equally valued and sought after by more than a few OID subscribers and contributors (and editors). Therefore. we were Very pleased to be allowed to sit In . on Munger's lecture on ‘investment expertise as a subdivision (continued on page 49) JMay 5. 1995 OUTSTANDING Iersrorz DIGEST Page 49 W WESCO FINANCIAL'S CHARLIE MUNGER (conI'd from page 1) of elementary. worldly wisdom' in Professor Guilford Babcock's class at the University of Southern California School of Business last year. We very gratefully acknOWIedge Munger's generous pcrrnisslon to share it with you. As always. we highly recbmmend a very careful reading (and re-readingl of his comments and insights and hope that you find them as valuable as we do: ALL TOO LITTLE WORLDLY WISDOM IS DELIVERED BY MODERN EDUCATION. WWW. Charlie Manger: l'm going to play a minor trick on you today — because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom — a much broader topic that interests me because I think all too little of it is delivered by modern educational systems. at least in an effective way. And therefore. the talk is sort of along the lines that some behaviorist psychologists call Grandma‘s rule — after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert. The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all. the theory of modern education is that you need'a general education before you specialize. . And i think to some extent. before you're going to be a great stock picker. you need some general education. So. emphasizing what I sometimes waggishly call remedial worldly wisdom. I‘m going to start by waltzing you through a few basic notions. V WITHOUT MODELS FROM MULTIPLE DISCIPLINES. YOU'LL FAIL IN BUSINESS AND IN LIFE. MW. Manger: What is elementary. worldly wisdom? Well. the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory. you don't have them in a usable form. You‘ve got to have models in your head. And you've got to array your uperienee —- both vicarious and direct — on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well. they fail in school and In life. You've got to hang experience on a latticework of models in your head. WWW. Munger: What are the models? Well. the first rule is that you've got to have multiple models —- because if you just have one or two that you're using. the nature of human psychology is such that you'll torture reality so that it fits your models. or at least you'll think it does. You become the equivalent of a chiropractor who. of course. is the great boob in medicine. it's like the old saying. 'To the man with only a hammer. every problem looks like a nail." And of course. that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous way to think and a perfectly disastrous Way to operate in the world. So you've got to have multiple models. And the models have to come from multiple disciplines — because all the wisdom of the world is not to be found In one little academic department. That‘s why poetry professors. by and large. are so unwise in a worldly sense. They don‘t have enough models In their heads. So you've got to have models across a fair array of disciplines. WWW...- Munger: You may say. “My God. this is already getting way too tough.“ But. fortunately. it isn't that tough —.— because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And. of those. only a mere handful really carry very heavy freight. So let's briefly review what kind of models and techniques constitute this basic knowledge that everybody has to have before they proceed to being really good at a ' narrow art like stock picking. YOU‘RE GIVING A HUGE ADVANTAGE TO OTHERS IF YOU DON'T LEARN THIS SIMPLE TECHNIQUE. Munger; First there's mathematics. Obviously. you‘ve got to be able to handle numbers and quantities — basic arithmetic. And the cat useful model. after compound interest. is the elemengy'mmmmons; AW high school. i suppose by now in great private schools. it's probably down to the eighth grade or so. It's very simple algebra. It was all worked out in the . course of about one year between Pascal and Fermat. They worked it out casually in a series of letters. Wm. Munger: it‘s not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique. Many educational institutions — although not nearly enough — have realized this. At Harvard Business School. the great quantitative thing that bonds~ the first-year class together is what they call decision tree theory. All they do Is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life.... By and large. as it works out. people can‘t naturally and automatically do this. lf you understand elementary psychology. the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/ Pascal. it uses a very crude. shortcut-type of (continued on next page) W W Wu wrru marrow, 01995 Ours-I'm Imam: Dram. inc. - I4 Eur I'm Snzsr, Sm: SOI - New Yomt NY l00|2 ' (211) 777-3130May 5. 1995 OUTSTANDING INVESTOR DIGEST Page 5] W WESCO FINANC IAL'S CHARLIE MUNGER (cont‘d irorn preceding page) know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up : distributed that way. So i can do a rough calculation. But if you ask me to work out something involving a Gaussian distribution to ten decimal points. I can‘t sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal. And by the way. that works well enough. But you ‘ have to understand that bell-shaped curve at least roughly as well as i do. WW. Munger: And. of course. the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints — that's a very powerful model. too. The notion of a critical mass — that comes out of physics — is a very powerful model. All of these things have great utility in looking at . ordinary mllty. And all of this cost-benefit analysis — hell. that‘s all elementary high school algebra. too. It's just been dolled up a little bit with fancy lingo. THE HUMAN MIND HAS ENORMOUS POWER. BUT IT ALSO HAS STANDARD MISFUNCTIONS. WWW. Manger: I suppose the mud most reliable models are from biology/physiolog because. after all. all of us are programmed by our genetic makeup to be much the same. And then when you get into psychology. of course. it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom. And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening. And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there. WWW. Hunger: Now you get Into the cognitive function as distinguished from the perceptual function. And there. you are equally — more than equally in fact — likely to be misled. Again. your brain has a shortage of circuitry and so forth -- and it's taking all kinds of little automatic shortcuts. So when circumstances combine in certain ways — or more commonly. your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction —- you're a patsy. And sojust as a man working with a tool has to know its limitations. a man working with his cognitive apparatus has to know its limitations. And this knowledge. by the way. can be used to control and motivate other people... V ' la Munger: So the most useful and practical part of psychology — which i personally think can be taught to any intelligent person in a week — is ungodly important. And nobody taught it to me by the way. i had to learn it later in life. one piece at a time. And it was fairly laborious. it‘s so elementary though that. when it was all over. I felt like a fool. And yeah. l'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places mlseducated people like you and me. WW- Monger: The elementary part of psychology — the psychology of misjudgment. as i call it — is a terribly important thing to learn. There are about 20 little principles. And they interact. so it gets slightly complicated. But the guts of it is unbelievably important. Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact. l‘ve done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes. WW- Munger: There's another saying that comes from Pascal which 'l've always considered one of the really accurate observations in‘the history of thought. Pascal said in essence. “The mind of man at one and the same time is both the glory and the shame of the universe.“ And that's exactly right. It has this enormous power. However. it also has these standard misi‘unctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example. roughly half of the army of Adolf Hitler-was composed of believing Catholics. Given enough clever- psychological manipulation. what human beings will do is quite interesting. . Wm- Munger: Personally. I‘ve gotten so that I now use a kind of two-track analysis. First. what are the factors that really govern the interests involved. rationally considered? And second. what are the subconscious influences where the brain at a subconscious level Is automatically doing these things — which by and large are useful. but which often misfunction. One approach is rationality — the way you'd work out a bridge problem: by evaluating the real interests. the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions — many of which are wrong. ________________.__.__—-——— OFIGANISMS. PEOPLE 8: COMPANIES WHO SPECIALIZE CAN GET TERRIBLY GOOD IN THEIR Ll'lTLE NICHE. ______._____—__.__-——-—-——-—-—— WWW Monger: Now we came to another somewhat less reliable form of human wisdbm — nucroeoonomics. And here. I find it quite useful to think of a free market (motioned on next page) —.—.——u——I——_——_—————__—— items-1mm rem-soon. 01995 OUI'S‘I’AHEIHG Iuvesroe DIGEST. in, - Ia Eur .11.. Sum, Sucre sol - New You. NY tall! - (112) 771-3310Page 52 OUTSTANDING INVESTOR DIGEST May 5. l995 ' . _ _—_—___ WESCO FINANCIAL'S CHARLIE MUNGER (conl'd from preceding page) economy —— or partly free market economy — as sort of the equivalent of an ecosystem.... This is a very unfashlonabie way of thinking because early in the days after Darwin came along. people like the robber barons assumed that the doctrine of the survival of the fittest authenticated them as deserving power — you know. 'i'm the richest. Therefore. l‘m the best. God's in his heaven etc. And that reaction of the robber barons was so irritating to people that it made it unfashionable to think ofan economy as an ecosystem. But the tnith is that it is a lot like an ecosystem. And you get many of the same results. 1W. Munger: Just as in an ecosystem. people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches. similarly. people who specialize in the business world —- and get very good because they specialize - frequently find good economics that they wouldn't get any other way. WW. Munger: And once we get into rnicroeconornics. we get into the concept of advantages of scale. Now we're getting closer to investment analysis — because in terms of which businesses succeed and which businesses fail. advantages of scale are ungodly important. For example. one great advantage of scale taught in all of the business schools of the world is cost reductions along the so—called experience curve. Just doing something complicated in more and more volume enables human beings. who are trying to improve and are motivated by the incentives of capitalism. to do it more and more efficiently. The very nature of things is that if you get a whole lot of volume through your joint. you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail.... AND THERE ARE OTHER ECONOMIES: GEOMETRIC. ADVERTISING. INFORMATION. EVEN PSYCHOLOGICAL. WWW. Manger: Let's go through a list — albeit an incomplete one -- of possible advantages of scale. Some come from simple geometry. if you're building a great spherical tank. obviously as you build it bigger. the amount of steel you use in the surface goes up with the square andthe cubic volume goes up with the cube. So as you increase the dimensions. you can hold a lot more volume per unit area of steel. And there are all kinds of things like that where the simple geometry-—- the simple reality — gives you an advantage of scale. WWW Manger. For example. you can get advantages of scale from TV advertising. When TV advertising first arrived — when talking color pictures first came into our living rooms i — it was an unbelievably powerful thing. And in the early days. we had three networks that had whatever it was — say 90% of the audience. Well. if you were 3mm. you c0uld afford to use this new method oiadvertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore. he couldn't use it. in effect. if y0u didn't have a big volume. you couldn‘t use network TV advertising — which was the most effective technique. 50 when ’iV came in. the branded companies that were already big got a huge tall wind. indeed. they prospered and prospered and prospered until some of them got fat and foolish. which happens with prosperity — at least to some people... WWW Munger: And your advantage of scale can be an informational advantage. if i go to some remote place. I may see Wrigley chewing gum alongside Glotz's chewing gum. Well. i know that Wrigley is a satisfactory product. whereas 1 don‘t know anything about Glotz's. So if one is 40¢ and the other is 30¢. am i going to take something i don't know and put it in my mouth —— which is a pretty personal place. after all — for a lousy dime? So. in effect. mm. simply by being so well known has advantages of scale — what you might call an infonnationai advantage. Wm. Manger: Another advantage of scale comes from psychology. The psychologists use the term "soeial prooi‘. We are all influenced — subconsciously and to some extent consciously — by what we see others do and approve. Therefore. if everybody's binng something. we think it's better. We don't like to be the one guy who's out of step. Again. some of this is at a subconscious level and some of it isn't. Sometimes. we consciously and rationally think. 'Gee. i don't know much about this. They kn0w more than i do. Therefore. why shouldn't i follow them?‘ WWW. Manger: The social proof phenomenon which comes right out of psycholoy gives huge advantages to scale -— for example. with very wide distribution. which of c6urse is hard to get. One advantage of mm is that it's available almost everywhere in the world. Well. suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup — which is slowly won by a big enterprise - gets to be a huge advantage... . And if you think about it once you get enough advantages of that ~. type. it can become very hard for anybody to dislodge you. THINGS TEND TOWARD WINNER TAKE ALL. THEREFORE. IT PAYS TO BE #1, #2 OR OUT. W - - . Manger: There's another kind of advantage to scale. in some businesses. the very nature of things is to sort of cascade toward the overwhelming dominance of one firm. (continued on next page) W W Rename wrni remnsvou. Ol99$ Oursrmomc investor: Diem. Inc. - I4 EAST 4m STREET. Surr: SOI - New You. NY IOOIZ - (212)717-3130
Charlie Munger - Outstanding Investor
Course: Business Finance (BU8201)
University: Nanyang Technological University
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