In an interview with BBC, Charlie Munger outlines a checklist for Berkshire investments. It takes him about a minute to run thorough it, but it contains a wealth of information. In this post I hope to dig into the four point Charlie Munger names. The interview can be found here. Charlie names the list about 6 minutes into the video, and it is outlined below.
- We have to deal with things we are capable of understanding.
- We have to have a business with some intrinsic characteristics that give it a durable competitive advantage.
- We would vastly prefer a management in place with a lot of talent and integrity.
- Finally no matter how wonderful it is its not worth an infinite price. so we have to have a price that makes sense, and gives a margin of safety considering the natural vicissitudes of life.
Being Charlie, he of course rounds it off with how obvious and simple it is. Also saying the simpleness of it is the reason it hasn’t been copied, even though it has been “out there” for decades.
Simplifying this list once more, I would argue, gives us “Buy quality companies at reasonable prices”. Lots of investors out there claim that they are looking for quality companies, but are unable to put “quality” into other words, or in numbers. This is why I think it valuable to take a good hard look at this list, and what it means and how we can find such companies.
We have to deal with things we are capable of understanding.
This one seems incredibly obvious, but still most of us tend to dabble in stocks in a large number of sectors and industries. I’m not saying that is necessarily stupid, but do we really have the capability of understanding all kinds of companies?
Another interesting bit in this sentence is the word “capable”. We don’t need to know every single in and out of the specific industry, but we must at least have the capability of understanding it. This is the reason why Berkshire have opted out of most of the high tech businesses. This is probably applicable to their holding in Apple. Even though they have opted out of most of the tech businesses, the largest holding is Apple. Apple to most of us is a tech-company, right? I think Warren has re-framed Apple to be a consumer products company, which he and charlie are capable of understanding.
Finally, if we don’t meet the potential investment does not pass this first filter, we are clearly unable to evaluate the next three points on the list.
We have to have a business with some intrinsic characteristics that give it a durable competitive advantage
This point is what I think many investors usually refer to a moat. However, I don’t think most investors have really thought about this statement, what constitutes a moat, and how to find companies that have a moat? For now, I’ll leave the discussion on what kinds of moats there are, and skip ahead one step. I would argue that companies which have strong moats are able to earn more money than companies who do not have those same moats. That is relatively obvious, but how does that manifest itself? Margins and ROIC. I would state that companies with moats will be able to have higher margins, for a longer period of time. This includes margins all throughout the income statement: gross margin, operating margin, and net profit margins. This also lets the company earn a larger percent of its revenues in operating cash flow. These higher margins, should also help the company earn a larger return on their invested capital for a longer period.
Finding companies with a moat
Unfortunately we can’t simply screen for “moat”, but we can screen for margins and ROIC! Therefore, sorting through a list of companies who enjoy high margins and have a high ROIC, you might find a few companies that turn out to have a strong moat.
Why do we care about moats?
What we as shareholders care about in an investment are future cash flows. Before there can be cash flow to you as the shareholder, there has to be revenues, and those revenues have to be larger than the sum of all cash expenses. The moat does several things to further this agenda, for example, it lets companies keep prices higher than if there would be no moat. Higher prices equal more revenues, without increased costs. The moat is what enables the business to fight competition, and in turn protect its margins and its return on invested capital.
We would vastly prefer a management in place with a lot of talent and integrity
Given that the two preceding points are met, if the company has incapable and dishonest managers the company is likely doomed anyway. Stupid managers might not realise their own moat, and thus neglect to service it. Thus allowing competitors a chance to build a moat of their own, surpassing this once fantastic business.
Management can play an integral part of creating value in a business. The right manager in the right business can make billion for themselves and for their shareholders. Meanwhile, poor management in a decent business can end in ruin. Unfortunately, discerning the good from the bad is not an easy task.
Some things one might use in order to determine management capability and honesty are their track record, and how you perceive them in their letters, announcements, or interviews. This is one part of investing that is closer to art than science in according to me, and note that many managers do not write their own CEO comments to the reports. Some do, but my guess is that most don’t. One thing I look for when trying to asses the managers honesty is how much of their comments is just fluff, and how much is “real”. I try to create my own narrative of what happened the past quarter or year, and what I think the company should focus on going forward, and then compare that to what the manager is saying. Furthermore, does management admit mistakes, and do a good analysis of what went wrong and how it will be prevented from happening again. And finally, are they correctly assessing the reason for the positive things that happened, or are they simply assigning it all to their own brilliance and genius?
No matter how wonderful it is its not worth an infinite price
Buying a 100-dollar bill is only a great idea if you can buy it for less than 100 dollars. In other words, a great business can make for a horrible investment if you pay too much for it. The opposite is not true for a bad business.
After a good, or maybe even a great business has been identified, with strong competitive advantages and an able and honest management, we want to buy it. But if we want to make it a good investment we should be very careful not to pay too much for it!
Mr Munger does not say what a good price is, and neither does Mr Buffett, but we know that its relative. When using multiples, the fair multiple varies with the industry, the predicted future growth rate, and the predicted future return on invested capital. In other words, a multiple that is too high for one business might be a great price for another. Its not easy, and it shouldn’t be. What I do is in general, that I use a multiple, and I compare it to what I think the future growth and ROIC will be. Then I also make rough comparisons to peers, in order to see how its priced compared to competitors.
As Aswath Damodaran says, valuation is a skill best learnt by practising. So go practice!
Final remarks
I really like this list of criteria Charlie has for us here. Its short and relatively high level, while each point can be elaborated on for pages and pages on end! They are a decent starting point for aspiring investors to start looking for in businesses, and its something I try to look for in the stocks that I buy.
As the final section, I want to summarise the list in one sentence: Find businesses you can understand, that has some competitive advantages and an able and honest management at the helm. Then buy it without paying too much and sit on it until something better comes along.
I hope you enjoyed this post, we owe a lot to Charlie Munger and Warren Buffett and I am forever thankful for them sharing so much knowledge and wisdom!
