By: Dave Ahern
“The difference between a good business and a bad business is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.”
We all want to know how to improve our investment decision making. How do we develop a better understanding of a company, its future, and present, its products? Over the years I have read all the Letters to Shareholders from Berkshire Hathaway. I have read most of the books and articles on Warren Buffett, and his mentor Benjamin Graham, and his partner Charlie Munger. I have also listened to hours of audio from interviews via Youtube. All in the effort to gain insights into how Warren Buffett developed their “framework” for investment decisions. And how they arrive at a winning investment decision.
During my research, I came across an interview that Charlie Munger gave to the BBC which discusses his thoughts on how a framework for making better decisions when making investment decisions. You can find the video here. The comments that we will be discussing occur at 5:59 of the video.
The framework is called the Four Filters and it first appeared in the 1977 Letters to Shareholders in this form.
“We select our marketable securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can easily understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at an attractive price.”
This outline has been repeated by Warren and Charlie over the years and they have utilized it to help frame all of their investment decisions.
The Four Filters
Warren and Charlie invented an investment formula that is underappreciated by the business community. This formula is a guideline that is followed by arguably the most successful investors of our generation. It deserves to be studied more thoroughly than it has thus far.
The formula is an innovation that uses both quantitative and qualitative properties to help ensure that we find the best investments and avoid making painful mistakes. If you follow the framework it will help you raise the odds of your investment success.
Here are Charlie’s comments from the BBC interview.
“We have to deal with things that we are capable of understanding and then, once we are over that filter we need to have a business with some characteristics that give us a durable competitive advantage and then, of course, we would vastly prefer management in place with a lot of integrity and talent and finally, no matter how wonderful it is, it’s not worth an infinite price. We have to have a price that makes sense and gives us a margin of safety considering the normal vicissitudes of life.”
You can find the transcript here.
Filter number one: Develop an understanding of the business.
Warren Buffett said it perfectly. “Seek whatever information will further your understanding of the business.”
Charlie is a huge proponent of developing checklists to help him make better decisions. For each company, he develops a checklist to keep him on track. The reason for a different checklist is that every company is different and have different guidelines to follow.
Charlie developed a system of “latticework of mental models” to help him sort through his thoughts and ideas. He used these models to help him think better.
Munger has come to the conclusion that in order to make better decisions in business and in life you need to find and understand the core principles from all disciplines.
In short, learn all the big ideas and how the interrelate and better, more rational thinking will naturally follow.
This is what he calls Elementary Worldly Wisdom, and using his Mental Models can help you succeed in almost any endeavor. This topic could be a blog post of its own but for our purposes today, let’s consider that Munger uses these models to help him understand a business more fully so that he can make a decision about whether or not to invest in it.
So how does this help us understand a company?
Step one is to read, read, read all that you can about the company. Shareholder letters, letters from the CEO, 10k filings, 10Q filings. Go to the website and read about all of their products. Look at any references to competitors and read about them. Just about every industry has a newsletter or magazine that follows that particular industry, read those publications for knowledge about the different trends, products, and services that other companies offer.
We do this to get a better understanding of how the company operates, what they produce and who they sell it to. Think about anything you buy for your own personal use. Do you buy a cell phone you don’t understand how to use? No way. Think about how these types of decisions affect our buying habits.
These are the types of information we need to digest as we learn more about a particular company. I will give you an example, recently I was looking at a company that produces railroad cars. A pretty simple straightforward business but I noticed something in a 10k that I was reading that mentioned that they were solely dependent on steel as their main resource they used in all of their products. That got me to thinking about the price of steel and how it could affect their business, so I researched more about that particular field because I knew nothing about steel. I came to learn that steel is an extremely volatile commodity that has huge price swings, which would obviously affect this company I was researching. And sure enough, as I learned more about steel pricing and tracked the downturns in steel I noticed that coincided with a downturn in the price of the company.
The first step when looking into a company is to look at their website to get a feel for the company and what they do. Look at their product list and see if they are things you understand.
The second step is to read the 10k filings. These are incredibly important documents and very insightful looks into the minds of the people who run the businesses. It is also a great place to learn more about the company and give you a rundown of what they do. If after reading the first part of the 10k outlining the business and you don’t understand it, move on.
If you do understand the business then continue looking at the financial filings.
When you read the company’s 10k reports you need to go back at least 5 years, the same goes for the 10q reports as well. Read them from the oldest to the more recent. This gives you a feel for the flow of the business, how the management handles their decisions and following through with their stated agendas. You can also learn a lot from the tenor of the reports as well.
A note about reading these reports, they can be very dry but you will find the well-written ones and they will sing to you. It will be such a joy to read those and you will learn tremendous amounts from them. I am always amazed at the amount of incredibly smart, creative people there are when I learn more about the different businesses.
Two thoughts I want to throw at you. Remember that value investing is like playing baseball, every company that you look at is like a pitch from a pitcher. The great thing is that you don’t have to swing at every pitch, you can let them go by until you find what you like and then swing for the fences. And you can let as many pitches go by as you like, there are no strike three and you’re out!
Second thought is that Buffett and Munger have both stated many times that their too hard pile is much bigger than their understand pile. They mention many times that one of the keys to investing is to stick to your circle of competencies and it doesn’t matter how big or small that is, but to stay within that circle is of utmost importance. This they feel will help lead to fewer mistakes.
Filter number two: Does the company have a durable competitive advantage?
A durable competitive advantage refers to a moat, according to Harvard Business School professor Michael Porter. According to Berkshire parlance, the business itself is the castle and the value of the castle will be determined by the strength of the moat.
The need for the business is so strong that Munger made it one of his Four Filters that he uses the help decide whether to invest in a business.
Munger had this story when he was asked to identify a moat.
“You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him to write a symphony. Mozart replied, “you are too young to write a symphony.” The man said, “you were writing symphonies when you were 10 years of age, and I am 21.” Mozart said, “yes, but I didn’t run around asking people how to do it.”
Very interesting response. Moats are all the rage today, especially among value investors, especially among the Buffett and Munger disciples. For good reason, because we would all like to own companies with a competitive advantage or a moat. The problem is that it is easy to identify a company that is doing well. It is much harder to look into the future and determine if the company will continue to do well.
The durability of a moat is much harder to determine than to identify the moat itself. And the durability is what we are really looking for because the price of the company will have the most current info figured into it. Most of the time.
Let’s talk a little bit about creators of moats. Examples would be Bill Gates, Ray Kroc, Sam Walton, Estee Lauder, and Jeff Bezos. These are all creators of great moats, some of which have stood the test of time so far. Moat creation requires superior management skill and a little luck.
All of these people have created products and businesses that have become so dominant that the barriers to entry are so huge that it is inconceivable that they could be broached, but they can.
Think about some of the recent declines in a few businesses that at the time were considered unbreakable. Kmart is a great example. They were the king of the world especially in the low-cost arena, Along comes Walmart who does it smarter, better and cheaper. Kmart is slow to react and soon enough they are on the run and into decline they go. Another example is Kodak. They were the dominant player out there for imaging. Then along comes the iPhone with its amazing camera and who needs film. Suddenly everyone is a photographer and the whole applecart is upset such that Kodak can’t compete and soon finds itself out of business.
Munger and Buffett are buyers of moats, not creators of them. At the 2012 Berkshire annual meeting, he admitted.
“We buy barriers, building them is tough…Our great brands aren’t anything that we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it’s hard to replace, then you have a big advantage. One competitor is enough to ruin a business running on small margins.”
Merely spotting a moat is one particular skill, but creating them is another whole set of different skills. The trick is to understand which set of skills it is that you own. As Munger said.
“You don’t need to know how to make hamburgers to spot that McDonald’s has a moat, but don’t try to build a business like McDonald’s without the abilities that Ray Kroc had.”
According to Munger, there are five primary components of a moat. Let’s touch on them a little bit.
- Supply Side Economies of Scale-Think Walmart as an example of this type of moat. They have massive supply-side economies of scale with their investments in distribution and other systems. These and other investments have given Walmart it’s moat. Walmart also possesses a high degree of operational effectiveness which also adds to their profitability.
- Demand-Side Economies of Scale(Network Effects)-Facebook, eBay, Craigslist, and Twitter would be some examples of this component. But probably the best example would be Google. First and foremost is their search engine dominance. Seriously, it has become such a force that even searching for something on the internet as become “Googling”. Munger mentions that he has never seen as wide a moat as Google’s. An example of a company which has both supply and demand economies of scale would be Amazon and each reinforce each other. For example, the more people comment on Amazon the more valuable it becomes to other users due to demand-side economies. Amazon also has huge advantages on warehouses and the supply-chain on the supply-side.
- Brand-Think Coke, Nike, Disney, Costco, and the like. The brand is one of the hardest moats to describe but you know it when you see it. When you think of Coke you think of the promise of what’s inside the can and what your reaction to that is going to be. Brands can fail over time but it is harder to pull them down unless they do it to themselves by poor marketing or changing their brand, such as Coke tried to do once. Munger and Buffett have a very important test that they use in determining the strength of a brand-based moat, whether a competitor can replace or weaken the brand with a massive checkbook. As an example during the 2012 Berkshire meeting Buffett commented that if you gave him $10, $20, $30 billion to knock off Coke he couldn’t do it. Firms like Nike and BMW have brands that help maintain their moats, they were hard to get and super valuable to have. The creation of the brand is a rare thing and it requires great skill and a large dose of luck as well.
- Regulation-There are certain businesses which have created a competence with regard to regulation that is so high that regulation actually serves as a barrier to entry for their competitors. Banks would be a good example of this, they have used regulations to become so good at what they do that they have regulators trapped by what they regulate. Airlines once were regulated and then once that regulation was taken away, it revealed who was swimming without their shorts on and were taken out with the tide. Without the regulations to help hide their weaknesses these businesses failed.
- Patents and Intellectual Property-Companies which have been granted patents or another type of intellectual property have been granted legal monopolies. This gives them to power to print money when it comes to their products. One example of this is Qualcomm. They have so many patents and has managed to get them embedded inside enough important wireless standards which have their own demand-side economies scales, that Qualcomm has created a substantial moat.
Filter number three: Is there management in place with integrity and talent?
For Munger and Buffett, management is part of the moat that they create with their businesses. Because they only have 20 people on staff at the home office they must rely on their managers to maintain their investments.
They have two criteria for their managers.
- Capital Allocation – This is the primary management activity at Berkshire. This is job number one. One of the managers of Berkshire’s reinsurance company, Ajit Jain, who according to Buffett “has created tens of billions of dollars in value for this company with nothing but his brains and hard work.”
- Compensation Systems – At Berkshire, because most of the managers that work for them are already rich, they have devised other compensation systems to entice talent to their businesses. They select management that loves what they do so much that it outweighs the financial aspects of the job.
They also understand that when the buy a business that they are buying a wonderful business, regardless of the state of management. They are looking for businesses that are so good that any “idiot” can run them because at some point they probably will.
Of course, when they buy a wonderful business and the management is superb as well, that is just icing on the cake. Another point to keep in mind is that no matter how wonderful the manager is he can’t overcome a terrible business. History is littered with people that thought they could take their awesome reputation and turn around a bad company but this usually ends up with them having their reputation tarnished.
Munger and Buffett also look for someone “with skin in the game.” They want to see the manager with a major portion of his wealth tied up into the company he is managing. They want everyone “to eat what they are cooking.”
They also want managers that have an “owner’s mentality” and not just a manager’s mentality.
To both Munger and Buffett, the only job of the manager is to widen the moat. Their job every day is to widen it.
Filter number four: A business with an attractive price with a margin of safety.
Anyone who wants to understand Munger needs to understand that when you invest you are buying a piece of that business, not just a stock or a piece of paper but an actual piece of the business. You need to treat it like you are an owner of a business, which you are. This gives you a different perspective on your purchase.
Charlie is a firm believer in what Benjamin Graham teaches which is this.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Munger is a firm believer that he is an investor and has a lot of disdain for those that are speculators. He feels that theirs is a losing game. People that “day trade” stocks use charts and other voodoo-like techniques are just guessing at the direction of the market, and anyone who is guessing on the behavior of the market is doing just that. Guessing.
One of the big weapons that Munger and Buffett look for is mispriced bets. One of Munger’s best and most famous essays, titled “A Lesson on Elementary, Worldly Wisdom As it Relates to Investment Management and Business. In this wonderful essay, which I would highly recommend you read in its entirety here. He states one of his favorite models for how he looks at the market.
“The model I like – to sort of simplify the notion of what goes on in a market for common stocks – is the pari-mutuel system at the racetrack…Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.”
You are looking for companies that the market has mispriced either by misjudging the financials of the particular company or not understanding the business enough.
Value investing is at odds with the “efficient market hypothesis” which states that each stock in the market has everything known included into the price. I would beg to differ. In the real world, sometimes stocks are underpriced and sometimes they are overpriced. Let’s look at an example. Take Facebook and it’s IPO. On the day it went public it supposedly had an “efficient” price factored in but several months later the price had fallen quite a bit. This illustrates that the market is anything but efficient, for how could Facebook fall that fast if everything is known just a short time earlier had the price much higher? During this time Facebook’s value didn’t change but it’s price changed drastically. Remember that price does not always equal value.
When looking for a margin of safety, many investors make the mistake of looking for quality companies. They equate quality with safety. This can be a mistake. As Howard Marks states.
“Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them…Elevated popular opinion, then, isn’t just the source of low-return potential, but also of high risk.”
The margin of safety concept is about making it likely that you have the odds very much in your favor by buying a misprice company at a significant discount to its price. Munger does not believe that this happens very often and within your circle of competence is that much rarer. So when he finds one of these bets he goes all in to take advantage of the mispriced bet in your favor.
Think of margin of safety in this way. As Buffett once said.
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And the same principle applies in investing.”
The last factor of pricing a company is figuring out a valuation for that company. As Munger stated.
“You must value the business in order to value the stock.”
Neither Munger or Buffett look for an of the fancy valuations out there. EBITDA and non-GAAP earnings mean little to them. They like genuine free cash flow. Munger stated.
“There are two kinds of businesses: the first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested – there’s never any cash. It reminds me of the guy who looks at all his equipment and says, “There’s all of my profit.” We hate that kind of business.”
Munger and Buffett have a simple process for valuing a company.
- The certainty that the long-term economic characteristics of the business can be evaluated.
- The certainty that management can be evaluated, both at its ability to realize the full potential of the business and to wise employ its cash flows.
- The certainty that management can be counted on to channel the rewards from the business to shareholders instead of themselves.
- The purchase price of the business
- The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing power return is reduced from his gross return.
Munger’s final thoughts on evaluating a company are this.
- Have the discipline to do the work
- Realize that mistakes will be made
- Build in a Margin of Safety
As you can see from the comments above Charlie Munger is one smart cookie. He has spent a lifetime thinking and it shows. His mental models might be one of the greatest gifts he has given to us. They show us so many different ways to look at things and how to use this information to make our lives better.
The formula that he follows to pick stocks is pretty simple on the surface but there is quite a bit more to it than it seems. We have talked about quite a lot of information and I wanted to drill home the point of this post was to dive into his methods of picking stocks.
His four filters are in a little more simple form are:
- A business with a moat
- A business that can be understood by an investor
- Management in place with talent and integrity
- A business that can be bought for an attractive price with an attractive margin of safety
Or to sum it up in his own words.
“The number one idea is to view the 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 are paying for. Move only when you have an advantage.”
The thing I have learned from investigating the information for this post is that Charlie Munger is not just Warren Buffett’s right-hand man but he is his own man. He has an amazing record as an investor himself and has been a great influence on Buffett through the years. He helped move Buffett away from some of his mentor, Ben Graham, investing ideas and to expand his thought processes about value investing and what would really work for them.
The four filters are a great starting point for any investor who is serious about looking for great companies to buy. They have so many layers to them and give you many ways to make better decisions when you are choosing your companies to buy.
I think that is the most important take away from my brief study of Charlie Munger, that he is a great teacher in the ways of teaching us to expand our thinking and the way that we look at things. Munger believes that being a good investor is more than just doing the math, but that it is about thinking differently about your decisions and learning from your mistakes. And always keep the flame of learning going, it is the path to riches.
As always thank you for taking the time to read this post, I do appreciate it.