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by
Tren Griffin
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June 18 - June 27, 2020
The four fundamental principles of value investing as created by Ben Graham are as follows: 1. Treat a share of stock as a proportional ownership of the business.
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Once, in an interview with Jason Zweig, Munger said it simply: “Knowing what you don’t know is more useful than being brilliant.”
people will often ask, “Do you mean Graham value investors wait for mispriced assets to appear rather than predict the future in the short term?” The answer is an emphatic yes!
What Munger looks for is a business that has a significant track record of generating high, sustained, and consistent financial returns.
Munger believes that treating shares of a company as if they should be valued like baseball cards is a loser’s game because it requires that you predict the behavior of often irrational and emotional herds of human beings.
Graham value investors price assets based on their value to a private investor now (based on data from the present and past) rather than making predictions about markets in the future.
If you focus on the value of the business, you have no need to predict short-term changes in the economy because that takes care of itself. When stocks are a bargain, people are fearful; when stocks are expensive, people are greedy.
Mimicking the herd invites regression to the mean (merely average performance). —CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
If you’re an investor, you’re looking on what the asset is going to do; if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game. —WARREN BUFFETT, OUTSTANDING INVESTOR DIGEST, 1997
Seth Klarman
John Maynard Keynes defined speculation as “the activity of forecasting the psychology of the market.”5 Keynes went on to say that the speculator must think about what others are thinking about, what others are thinking about the market (and repeat). In what is now called a “Keynesian beauty contest,” judges are told not to pick the most beautiful woman but instead to pick the contestant they think the other judges will choose as the most beautiful. The winner of such a contest may be very different than the winner of a traditional beauty contest. Keynes said this about such a contest: It’s
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Howard Marks advised that Graham value investors focus on what they know now and not where they are going because, rather obviously, your data about the present is extensive while your data about the future will always be zero.
We never look at projections but we care very much about, and look very deeply, at track records. If a company has a lousy track record but a very bright future, we will miss the opportunity.”6 Munger agreed:
What is a margin of safety? Ben Graham’s definition of a margin of safety is “a favorable difference between price on the one hand and indicated or appraised [intrinsic] value on the other.”8 Intrinsic value is the present value of future cash flows.
Simply put, your objective as a Graham value investor is to buy a share of stock at a sufficiently large bargain that you do not need to predict short-term price movements in the stock market.
Seth Klarman wrote: A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world. —SETH KLARMAN, MARGIN OF SAFETY, 1991
As a result of the new post-Great Depression environment, Munger and many other Graham value investors began to apply the same Graham value investing principles to businesses that were of high quality instead of businesses trading below liquidation value—and the margin of safety process worked just as well.
Third Principle: Make “Mr. Market” Your Servant Rather Than Your Master
Mr. Market’s emotional problems arise because he is composed of many people who, in the short term, vote to establish a price for an asset based on their emotions and predictions about the predictions and actions of all the other people who make up the market.
As long as the fundamentals of the business itself remain in place, a market’s short-term views on the price of the shares can be ignored and will be corrected in the long term.
There are essentially three steps in the process: analyze the business to determine intrinsic value, buy the assets at a significant bargain, and wait.
One might say that Munger believes in a mostly efficient hypothesis. He believes that the difference between mostly and always efficient is a huge opportunity for a Graham value investor. Stocks are sometimes underpriced and sometimes overpriced. Anyone who invested through the Internet bubble (as I did) and who still thinks that markets are always efficient (a so-called extreme view of market efficiency) is bonkers.
For a Graham value investor, reacting quickly and aggressively to favorable prices when they unpredictably appear is essential. Munger pointed out: To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. —CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
Graham value investors price stocks rather than time markets.
Patience is a difficult part of the Graham value investing system. If you expect the market to give you enough profit to buy a car or a speedboat next week, you will inevitably fail to achieve your financial goals.
Falling in with the crowd will put you under the sway of Mr. Market because Mr. Market is the crowd. If you are the crowd, then you cannot, by definition, beat the crowd. Munger believes that short-term price movements are not rationally based, based on always-efficient markets, or predictable with certainty. The best advice is simple; Buffet says, “Be fearful when others are greedy, and be greedy when others are fearful.”14 This is easy to say but hard to do, because it requires courage at the hardest possible time.
Graham’s value investing system is based on the premise that risk (the possibility of losing) is determined by the price at which you buy an asset. The higher the price you pay for an asset, the greater the risk that you will experience a loss of capital.
Robert Hagstrom wrote a wonderful book on worldly wisdom entitled Investing: The Last Liberal Art, in which he states that “each discipline entwines with, and in the process strengthens, every other. From each discipline the thoughtful person draws significant mental models, the key ideas that combine to produce a cohesive understanding. Those who cultivate this broad view are well on their way to achieving worldly wisdom.”
A large part of the difference between the experienced decision maker and the novice in these situations is not any particular intangible like “judgment” or “intuition.” If one could open the lid, so to speak, and see what was in the head of the experienced decision maker, one would find that he had at his disposal repertoires of possible actions; that he had checklists of things to think about before he acted; and that he had mechanisms in his mind to evoke these, and bring these to his conscious attention when the situations for decisions arose. —HERBERT SIMON, MCKINSEY QUARTERLY, 1986
You’ve got to have models in your head. And you’ve got to array your experience—both vicarious and direct—on this latticework of models. —CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
Simply put, Munger believes that people who think very broadly and understand many different models from many different disciplines make better decisions and are therefore better investors. This view should not be a surprise because he believes that the world is composed of many complex systems that are constantly interacting:
A multiple-model approach that is only approximately right will produce a far better outcome in anything that involves people or a social system.
Munger argued persuasively that activities like reading great books can help someone become a better investor:
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. —CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
Munger believes that thinking broadly in many disciplines makes you a better thinker because everything is literally related.
You have to realize the truth of biologist Julian Huxley’s idea that “Life is just one damn relatedness after another.” So you must have the models, and you must see the relatedness and the effects from the relatedness. —CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough—because eighty or ninety important models will carry about 90 percent of the freight in making you a worldly wise person. And, of those, only a mere handful really carry very heavy freight. —CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
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’s 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 to learn it all to fluency—like it or not. —CHARLIE MUNGER, HARVARD UNIVERSITY, 1995
Capitalism inherently means that others will always be trying to replicate any business that is profitable. You are always in a battle to keep what you have. Dexter Shoes lost that battle quickly. If you make a mistake, capitalism’s “competitive destruction” forces will expose it swiftly and, sometimes, brutally.
Buffett has said that if you cannot explain why you failed after you have made a mistake, the business was too complex for you. In other words, Munger and Buffett like to understand why they made a mistake so they can learn from the experience. If you cannot understand the business, then you cannot determine what you did wrong. If you cannot determine what you did wrong, then you cannot learn. If you cannot learn, you will not know what you’re doing, which is the real cause of risk.
The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes—we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes: 1) doing nothing—what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of. —CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2001 Our biggest mistakes were things we didn’t do, companies we didn’t buy.
WARREN BUFFETT, BERKSHIRE ANNUAL MEETING, 1989
Upton Sinclair said it best of all. He said, “It’s very hard to get a man to believe non-X when his way of making a living requires him to believe X.” On a subconscious level, your brain plays tricks on you and you think [that] what is good for the true little me is what you should believe. —CHARLIE MUNGER, HARVARD-WESTLAKE SCHOOL, 2010
For example, it is surprising how many people fail to recognize how performance suffers if you pay someone in advance rather than after the work has been completed. It’s precisely because of the dangers of misaligned incentives that Munger and Buffett chose to make compensation decisions themselves, whereas they delegate almost all management responsibilities.
It is usually a far better idea to simply give away money to needy friends and relatives—or, if you do make a loan, to never expect it back. Relatives and friends in receipt of your money as a loan too often acquire a short-term and fuzzy/selective memory.
Disliking/Hating Tendency Avoid evil, particularly if they’re attractive members of the opposite sex. —CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2004
Doubt-Avoidance Tendency [It’s] counterproductive for a prey animal that is threatened by a predator to take a long time in deciding what to do. —CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005
