Charlie Munger Interview

I highly recommend reading everything you can about Warren Buffett's partner Charlie Munger. If you are unfamiliar with him you are in for a treat. He is incredibly intelligent and he knows it -which adds a certain (well deserved) brashness and arrogance to his message. For me this makes him that much more engaging.

Here are some notes from a recent interview. I recommend visiting him at the Berkshire and Westco meetings so that you can experience him in person. I GUARANTEE you'll learn something.

Tonight I got to see A Conversation with Charlie Munger at Caltech in Pasadena. I took some notes on the discussion below. C refers to Charlie Munger speaking, while T stands for Tom Tombrello, the interviewer. These are not their exact words.


C: I love Occum's Razor (Wikipedia). Einstein once said make everything as simple as possible, but not simpler. In the field of messy social sciences, use a variety of disciplines and look for a confluence of factors when dealing with "lollapaloozas". (significant and strange events, black swans)

For example, I was fascinated about what made people join Moonies, a cult-like group. It didn't make sense until I ran into Pavlov, who experimented on dogs by pushing them to nervous breakdowns (He did this by locking them in cages and then raising the water level up to mouth height, making them think they were about to drown) . Afterwards, they would act in the complete opposite fashion. This was very similar to one of the Moonies conversion methods: "causing the target to snap".

Continue the Interview

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Post of the Day: 10 Investing Tips From Warren Buffett

From the 2007 Letter to Shareholders:

1. When you know you're the best, you can afford to tell it like it is. Buffett says: "Our insurance business had an excellent year... that party is over. It's a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. So be prepared for lower insurance earnings during the next few years."

2. Only four things really count when making an investment (or buying whole companies if, like Buffett, you have $141bn to spend) - "a business you understand, favourable long-term economics, able and trustworthy management, and a sensible price tag". That's investment, everything else is speculation.

3. Invest this way and you don't need to constantly look for the next "new" thing, with all the risk that necessarily entails.

Buffett's biggest investments (companies he doesn't own in their entirety) include American Express, Wells Fargo, Procter & Gamble and Coca-Cola.

These four businesses, he notes, were founded in 1850, 1852, 1837 and 1886 respectively. "Start-ups are not our game".

4. Businesses are run by people and the best people are not necessarily the ones with the flashiest CVs. Buffett singles out Susan Jacques, chief executive of his jewellery retailer Borsheims. "Susan came to Borsheims 25 years ago as a $4-an-hour saleswoman. She's smart, she loves the business and she loves her associates. That beats having an MBA degree any time."

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Hat Tip: Controlled Greed

John Burr Williams says "Discounting Matters"

Intuition

In his 1938 investing text "The Theory of Investment Value" John Burr Williams introduced the ideas of discounting and intrinsic value to investors.

For our purposes "intrinsic value" is synonymous with the value of a business. The value can be expressed as the value of the entire enterprise or (to make easier to compare to the stock price) as a per share value.

"Discounting" is a way of expressing something we understand intuitively, that a dollar today is worth more than a dollar a year from know.

No this isn't another dig on the U.S. dollar. This is true even if our currency wasn't under pressure. No one likes to wait around to reinvest their earnings. If we have to wait then we reasonably expect to be compensated for our time. This compensation for waiting is expressed as a rate, in this case as a discount rate. A discount rate represents our opportunity cost of waiting for a certain cash flow.

A Little Math: What should we pay today to receive $100 in the future?

Let's explore for a moment the math behind discounting the cash paid to us in the future. Here is the formula:
Example: What should we pay today to receive $100 in the future? Let's make a couple of assumptions.

1. We will take the money to purchase the future $100 out of our savings yielding 5% (Our opportunity cost or discount rate).
2. We are willing to wait 1, 5, or 10 years.

Using those assumptions: Future Value (FV) = $100; Discount Rate (i)= 5% or 0.05; Number of Periods (n) =1

What should we be willing to pay for a cash flow with those characteristics? $95.24

What if we wait 5 years (n=5)? $78.35

And 10 years (n=10)? Only $61.39

Clarification

The implications of the Future Value of money might not be entirely clear. Discounting future cash flows helps us avoid overpaying for money received in the future; our required rate of return is built into the equation. Said another way, should you decide to purchase that 2018 cash flow of $100 for $61.39 today you are assured a 5% rate of return. Clear as mud?

More on why discounting cash flows matter in future posts...

Valuation Matters: A Case for Business Valuation

Every Business has a Value

Off Wall Street and outside of lecture halls the idea that every business has a certain value that a prospective owner would pay for the complete enterprise is intuitive. In fact, playing Monopoly with my eight year old and watching her haggle for Illinois Ave. illustrates just how intuitive price vs. value is, but somewhere between elementary school and when we first look at a stock's ticker we get lost. We start assuming that the stock price represents the business's value. This is usually not true.

Ignore Stock Prices

Let's look at a large stable company's stock price over the last year. I'm going to use Johnson & Johnson (JNJ) as my example, but any company would do. Here is a one year chart of the stock price:


Theoretically, an investor could have purchased JNJ for as little as $173 Billion or as high as $196 Billion over just 52 weeks. Do you really think that Johnson & Johnson's business value fluctuated by $23 Billion? That is what the stock price suggests. Let's look at another company's stock price Apple (AAPL) to see if its price gyrations are equally irrational.


52 weeks ago you could buy Apple for about $73 Billion then it shot up $100 Billion to $178 Billion and now you can buy it for less than $110 Billion. Talk about a roller coaster! Unlike amusement parks -watching charts, stock prices, and the market is hazardous to both your health and your wealth.

A business's value changes much more slowly than the quoted stock price. Over the short term the stock price is a proxy for investors expectations and emotions (two things that, for the most part, should be ignored).

Price Equals Value

Price is what you pay for, value is what you get"
-Warren Buffett

As investors we can profit by purchasing business when there is a large discrepancy between the price the market is offering a company for and the value of the underlying business. It is important to note that business's value isn't quoted on the stock market (or anywhere else) so it will take bit more work to find bargains. In future posts we will explore business valuation tools.

Efficient Markets

If you disagree, believe the market is efficient, or find that the idea that there is a disconnect between price and value inherently flawed, then I suggest investing in a low cost index fund. Please read my post on why indexing matters. There is nothing wrong with investing passively AND earning your fair share of the market's return. I'm very happy that many people subscribe to the Efficient Market Theory (I.e. Price = Value Theory) it creates opportunities for the enterprising investor.

Tea Leaves, Soothsayers, and Technical Analysis

Worse yet, if feel that the charts, and therefor the price, is signaling you and believe in soothsayers, tea leaves, and fortune tellers then you should search for "technical analysis" on your favorite search engine.

Indexing Matters

Want to invest better than most professional and amateur investors alike? Then stop chasing mutual fund returns and heed this advice:

By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals." -Warren Buffett

Time Frame

Year to date the market is down around 9%; not since July 2006 has a month ended with the S&P 500 trading below 1300. Does that matter? No. An investment's success (and failure) should be measured over time frames longer than 17 months. How long? That is topic I'll tackle later. How about a 10 years? Certainly a decade is a sufficiently long enough time frame to determine an investment's success.If we wisely invested in a market tracking low-cost index fund ten years ago, how much would our purchasing power have increased?

S&P 500

To test our 10 year performance let us explore the performance of the Standard & Poor's 500. This index represents the largest 500 companies in the United States with each company's relative weight based on market capitalization (think market price times the number of shares outstanding). Many investors simply refer to the the S&P500 as "The Market." So this index's job is to provide us with our fair share of the stock market's return.

Performance

What has the largest 500 companies in the USA returned to their investors over the last 10 years? 3% (and yes that includes the dividends)! What!?? A lousy 3% including dividends. Let's not even talk inflation.

Three Alternatives to Index Funds: Mutual Funds, No Stocks Market (Bank CD), Do-It-Yourself

#1 You might be thinking to yourself "Certainly we could have done better in mutual funds." That depends on a couple of things. First, what expertize do we have in selecting mutual fund managers? And what does that fund manager's hard work, research, and market beating performance cost?We might have beat the market if we properly selected one of the less than 1 out of every 100 mutual funds that successfully beats the market over longer time frames. That means that for every 1 that does beat the market 99 don't. For that manager's exceptional performance we'd probably pay at least 1.5% annually. That means that our manager needs to earn 4.5% every year that the Market earns 3% just to match the returns of the market. Otherwise we would have been better off just buying the index fund.Ultimately we need to be 100% confidant in our ability to select fund managers that can constantly beat the market in excess of their management fee. With probabilities like that you'd be well advised to stick with the index.

#2 At this point it is easy to get frustrated, run to your nearest bank and get yourself a certificate of deposit yielding a guaranteed 4% and forget the stock market all together. That would be a serious long-term mistake. If you are unwilling (or unable) to explore alternative #3, investing in an Index Fund is a very viable option (much more attractive than a CD). Don't give up.

#3 Fortunately, there is a better alternative than Wall Street's mutual funds, index funds, ETFs, hedge funds, and whateverelse-funds! Using a couple of tools and a few mental models we can successfully invest in businesses (stocks), earn an acceptable (if not damn-right fantastic) rate of return, AND sleep well at night. More on this in my next post.

And alternative #3 is what this blog is all about!