Charlie Munger – Brotchie Capital Management

“I find it quite useful to think of a free market economy—or partly free market economy—as sort of the equivalent of an ecosystem… ”
“Common stock investors can make money by predicting the outcomes of practice evolution. You can’t derive this by fundamental analysis — you must think biologically.”
“[In picking stocks] You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market.”
“The number one idea, is to view a stock as an ownership of the business [and] to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.”
“Over many decades, our usual practice is that if [the stock of] something we like goes down, we buy more and more. Sometimes something happens, you realize you’re wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices.”
“There are a lot of things we pass on. We have three baskets: in, out, and too tough…We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.”
“Warren talks about these discounted cash flows. I’ve never seen him do one.” [“It’s true,” replied Buffett. “If (the value of a company) doesn’t just scream out at you, it’s too close.”]
“It is an unfortunate fact that great and foolish excess can come into prices of common stocks in the aggregate. They are valued partly like bonds, based on roughly rational projections of use value in producing future cash. But they are also valued partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far.”
“I think that, every time you saw the word EBITDA [earnings], you should substitute the word “bullshit” earnings.”
“Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.”

“’ The only reason a person at Mass General is any good at reading bone tumor scans is that they have been doing it every day for years. There is no magic formula for understanding different businesses”
“If you have competence, you pretty much know its boundaries already. To ask the question [of whether you are past the boundary ] is to answer it. You don’t really have a competency if you don’t know the edge of it.”
“We don’t believe that widespread diversification will yield a good result. We believe almost all good investments will involve relatively low diversification.”
“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”
“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.”
“If you’re going to be an investor, you’re going to make some investments where you don’t have all the experience you need. But if you keep trying to get a little better over time, you’ll start to make investments that are virtually certain to have a good outcome. The keys are discipline, hard work, and practice. It’s like playing golf — you have to work on it.”
“Organized common (or uncommon) sense — very basic knowledge — is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little.”
“The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So, Graham had a lot of wonderful ideas.”
“In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting.”
“Using [a stock’s] volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. Some great businesses have very volatile returns – for example, See’s [a candy company owned by Berkshire] usually loses money in two quarters of each year – and some terrible businesses can have steady results” “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.”
“Of course, the best part of it all was his concept of “Mr. Market”. Instead of thinking the market was efficient. He treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think it is worth.” And other days, “Mr. Market” comes by and says, “I’ll sell you some of my interest at a price that is way higher than you think it is worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all.”

To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it has been very useful to Buffett, for instance, over his whole lifetime.”
“I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant. It’s not a smart thing for the country to legalize gambling [in the stock market] and make it very accessible.”
Brotchie Capital ( LOGO?) Annotation: The insights below are from a speech Charlie gave on Worldly Wisdom and the Art of Stock Picking. We consider these words to be among the most important and pragmatic advice we have ever received on common stocks.

“It is not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced bet—that they can occasionally find one.

And the wise ones bet heavily when the world offers them that opportunity. They bet big heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It is just that simple. That is a very simple concept. And to me it is obviously right—based on experience not only from the pari-mutuel system, but everywhere else.

And yet, in investment management, practically nobody operates that way. We operate that way—I’m talking about Buffett and Munger. And we’re not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything about everything all the time.

To me, that is totally insane. The way to win is to work, work, work, work and hope to have a few insights. Most of Berkshire’s billions came from a handful of ideas.

How many insights do you need? Well, I’d argue that you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that is with a very brilliant man—Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he is only had ten insights. I am just saying that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as heavy odds against game full of bullshit and craziness with an occasional mispriced something or other. And you are not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It is just that simple.

When Warren (Buffett) lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”

He says, “Under those rules, you’d really think carefully about what you did and you would be forced to load up on what you really thought about. So you would do so much better.”

As long as clients buy salt, investment managers will sell it.

Again, this is a concept that seems perfectly obvious to me. And to Warren, it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn’t the conventional wisdom.

To me, it is obvious to me that the winner has to bet very selectively. It has been since very early life. I don’t know why it is not obvious to many other people.

I don’t think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, “My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.”

Investment managers are in the position of that fishing tackle salesman. They are like the guy who was selling salt to the guy who already had too much salt. And as long as the guy will buy salt, why they will sell salt. But that isn’t what ordinarily works for the buyer of investment advice.”

“…Missing out on some opportunity never bothers us. What’s wrong with someone getting a little richer than you? It’s crazy to worry about this….”
“Gigantic macroeconomic predictions are something I’ve never made any money on, and neither has Warren ”
“I think democracies are prone to inflation because politicians will naturally spend [excessively] – they have the power to print money and will use money to get votes. If you look at inflation under the Roman Empire, with absolute rulers, they had much greater inflation, so we don’t set the record. It happens over the long-term under any form of government.”
“Neither Warren nor I have any record of making large profits from interest rate bets. That being said, all intelligent citizens of this republic think a bit about this. In my lifetime, I’ve seen interest rates range from 1% to 20%. We try to operate so that really extreme interest rates in either direction wouldn’t be too bad for us. When interest rates are in a middle range, as they are now, we’re agnostic.”
“It’s not given to human beings to have such talent that they can just know everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet keenly when the world offers that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”
“Most investment managers are in a game where the clients expect them to know a lot about a lot of things. We did not have any clients who could fire us at Berkshire Hathaway. So we didn’t have to be governed by any such construct. And we came to this notion of finding a mispriced bet and loading up when we were very confident that we were right. So we are way less diversified. And I think our system is miles better.

However, in all fairness, I do not think a lot of money managers could successfully sell their services if they used our system. But if you are investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else’s so long as it is all going to work out well in the end? So what if there is a little extra volatility.

In investment management today, everybody wants not only to win, but also to have the path never diverge very much from a standard path except on the upside. Well, that is a very artificial, crazy construct. That is the equivalent in investment management to the customer of binding the feet of the Chinese women. It’s the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it.

That is really hobbling yourself. Now, investment managers would say, “We have to be that way. That is how we are measured.” And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system is “bonkers” and draws a lot of talented people into socially useless activity.

And the Berkshire system is not “bonkers”. It is so damned elementary that even the bright people are going to have limited, really valuable insights in a very competitive world when they are fighting against other very bright, hard-working people.

And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times. You are much more likely to do well if you start out to do something feasible instead of something that is not feasible. Isn’t that perfectly obvious?

How many of you have 56 brilliant insights in which you have equal confidence? Raise your hands please. How many of you have two or three insights that you have some confidence in? I rest my case.

I would say that Berkshire Hathaway’s system is adapting to the nature of the investment problem as it really is.

We have really made the money out of high quality businesses. In some cases, we just bought the whole businesses. And in some cases, we just bought a big block of stock. But when you analyzed what happened, the big money has been made in the high quality businesses.

Over the long term, it is hard for a stock to earn a much better return than the business, which underlies it earnings. If the business earns 6% on capital over 40 years and you hold it for 40 years, you are not going to make much different than a 6 percent return—even if you originally 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 end up with one hell of a result”

“We have this investment discipline of waiting for a fat pitch. If I was offered the chance to go into business where people would measure me against benchmarks, force me to be fully invested, crawl around looking over my shoulder, etc., I would hate it. I would regard it as putting me into shackles.”
“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.”
“Understanding how to be a good investor makes you a better business manager and vice versa.”
“If you don’t keep learning, other people will pass you by. Temperament alone won’t do it – you need a lot of curiosity for a long, long time.”

“Finally, I’d like to once again talk about investment management. That is a funny business, because on a net basis, the whole investment management business together gives no value added to all buyers combined. That is the way it had to work.

Of course, that is not true of plumbing and it isn’t true of medicine. If you are going to make your careers in the investment management business, you face a very peculiar situation. And most investment managers handle it with psychological denial—just like a chiropractor. That is the standard method of handling the limitations of the investment management process. But if you want to live the best sort of life, I would urge each of you not to use the psychological denial model.

I think a select few—a small percentage of the investment managers—can deliver value added. But I don’t think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up—if you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.

But I’m just talking about investment managers engaged in common stock picking. I am agnostic elsewhere. I think there may well be people who are so shrewd about currencies and this, that and the other thing that they can achieve good long-term records operating on a pretty big scale in that way. But that doesn’t happen to be my milieu. I’m talking about stock picking in American stocks.

I think it is hard to provide a lot of value added to the investment management client, but it is not impossible”

“Here is a model that we have had trouble with. Maybe you’ll be able to figure it out better. Many markets get down to two or three big competitors—of five or sixes. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.

Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor point of view so that the shareholders do well, and in other markets, there is destructive competition that destroys shareholder wealth.

It is a pure commodity like airline seats; you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that has been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Yet, in other fields—like cereals, for example—almost all the big boys make out. If you are some kind of medium grade cereal maker, you might make 15% on your capital. And if you are really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they are competing like crazy with promotions, coupons and everything else? I don’t fully understand it.

Obviously, there is a brand identity factor in cereals that doesn’t exist in airlines. That must be the main factor that accounts for it.

And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who is hell-bent on gaining market share…For example, if I were Kellogg and I decided that I has to have 60% of the market, I think I could take most of the profit out of cereals. I’d ruin Kellogg in the process. But I think I could do it.

In some businesses, the participants behave like a demented Kellogg. In other businesses, they don’t. Unfortunately, I do not have a perfect model for predicting how that is going to happen.

For example, if you look around at bottler markets, you will find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you would have to know the people involved to fully understand what was happening”

“Everybody in economics understands that comparative advantage is a big deal, when one considers first-order advantages in trade from the Ricardo effect. But suppose you’ve got a very talented ethnic group, like the Chinese, and they’re very poor and backward, and you’re an advanced nation, and you create free trade with China, and it goes on for a long time.

Now let’s follow and second- and third-order consequences: You are more prosperous than you would have been if you hadn’t traded with China in terms of average well-being in the U.S., right? Ricardo proved it. But which nation is going to be growing faster in economic terms? It’s obviously China. They’re absorbing all the modern technology of the world through this great facilitator in free trade and, like the Asian Tigers have proved, they will get ahead fast. Look at Hong Kong. Look at Taiwan. Look at early Japan. So, you start in a place where you’ve got a weak nation of backward peasants, a billion and a quarter of them, and in the end they’re going to be a much bigger, stronger nation than you are, maybe even having more and better atomic bombs. Well, Ricardo did not prove that that’s a wonderful outcome for the former leading nation. He didn’t try to determine second-order and higher-order effects.

If you try and talk like this to an economics professor, and I’ve done this three times, they shrink in horror and offense because they don’t like this kind of talk. It really gums up this nice discipline of theirs, which is so much simpler when you ignore second- and third-order consequences.”

“Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland. In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics. The game hasn’t changed at all. That’s why Modern Portfolio Theory is so asinine”

“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 approximation. It’s got elements of Fermat/Pascal in it. However, it’s not good. So you have to learn in a very usable way this very elementary math and use it routinely in life just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”

“Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain can’t use what it can’t remember or when it’s blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it…” “…the Deep structure of the human mind requires that the way to full scope competency of virtually any kind is learn it all to fluency – like it or not.”

“Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.”

“Invert, always invert.”
“The great lesson in microeconomics is to discriminate between when technology is going to help you and when it is going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.

For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, “They’ve invented a new loom that we think will do twice as much work as our old ones.” And Warren said, “Gee, I hope this doesn’t work—because if it does, I’m going to close the mill.” And he meant it.

What was he thinking? He was thinking, “It is a lousy business. We are earning substandard returns and keeping it open just to be nice to the elderly workers. But we are not going to put huge amounts of new capital into a lousy business.”

And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of buyers of the textiles. Nothing was going to stick to our ribs as owners.

That is such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that is still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers”

“Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally—more 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 are a patsy.

And so just 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….

Very eminent places miseducate people like you and me.

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 is so elementary though that, when it was all over, I just felt like a total horse’s ass.

And yeah, I’d been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me. Psychology of misjudgment is terribly important to learn”

“Double-entry bookkeeping was a hell of an invention. You have to know accounting. It is the language of practical business life. But you have to know enough about it to know its limitations—because although accounting is the starting place, it is only a crude approximation. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know.

In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created CF Braun Engineering Company. It designed and built oil refineries—which are very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.

He threw out his accountants and used his engineers to devise a new accounting method for building refineries. Carl Braun who demonstrated both the importance of accounting and the importance of knowing its limitations.”

“We don’t claim to have perfect morals, but at least we have a huge area of things that, while legal, are beneath us. We won’t do them. Currently, there’s a culture in America that says that anything that won’t send you to prison is OK.”