Berkshire's Architect - Charles T. Munger

In this year’s annual letter to Berkshire Hathaway shareholders, Warren Buffett wrote a beautiful eulogy for his long-time partner, Charlie Munger, who passed away on November 28, just 33 days shy of his 100th birthday. I wanted to share some of Warren’s remarks, followed by my own thoughts, as Munger inspired much of my philosophy on not just investing but life. First, though, a little background:

Charles Thomas Munger was born on Jan. 1, 1924, in Omaha, Nebraska. Coincidentally, as a teenager he worked at a grocery store called Buffett & Son, owned by Warren Buffett’s grandfather. (Buffett also worked there, but being six years younger, he and Charlie never met). Munger later attended the University of Michigan to study mathematics but dropped out in 1943 to serve in the U.S. Army Air Corps during WWII. After achieving an unusually high score on the Army’s General Classification Test, however, the Army sent him to study meteorology at Caltech in Pasadena, California. Thanks to the G.I. Bill, Munger was also able to take a number of advanced courses through several universities and was ultimately accepted to Harvard Law School in 1945. After Harvard he moved back to California to begin his law career.

Munger and Buffett first crossed paths at a dinner party in Omaha in 1959. As Buffett would later recount, “About five minutes into it, Charlie was sort of rolling on the floor laughing at his own jokes, which is exactly the same thing I did. I thought, ‘I’m not going to find another guy like this.’ And we just hit it off.” The two stayed in touch with Buffett ultimately convincing Munger in 1962 to give up law and focus instead on managing investments, which he did with notable success. In fact, Munger turned out to be such an astute investor he was soon advising Buffett, as Warren related in his eulogy:

Three years later he told me – correctly! – that I had made a dumb decision in buying control of Berkshire [a mediocre textile company that Buffett had acquired because the stock looked “cheap”]. But, he assured me, since I had already made the move, he would tell me how to correct my mistake.

[He] advised me: “Warren, forget about ever buying another company like Berkshire. But now that you control Berkshire, add to it wonderful businesses purchased at fair prices and give up buying fair businesses at wonderful prices.” With much backsliding I subsequently followed his instructions. Many years later [in 1978], Charlie became my partner in running Berkshire and, repeatedly, jerked me back to sanity when my old habits surfaced.

In reality, Charlie was the “architect” of the present Berkshire, and I acted as the “general contractor” to carry out the day-by-day construction of his vision. Charlie never sought to take credit for his role as creator but instead let me take the bows and receive the accolades.

With a background and interests as varied as meteorology, architecture (with no formal training he contributed heavily to numerous building designs including at Stanford University), law, business, science, psychology, philosophy, and more, Munger was a polymath who cast his net widely for knowledge to better navigate the world. As he once expounded:

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.

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…What are the models? Well, the first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does. It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.”

And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department…You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough—because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.

Among Munger’s models that pertain to investing, the ones that most heavily impacted my thinking were 1) buying better businesses even if you must pay a higher price, 2) staying within your circle of competence, 3) betting rarely but meaningfully, 4) destroying your ideas (knowing the counterarguments better than your opponents), and 5) solving problems by inverting the question.

Buy Better Businesses – As Buffett noted in his eulogy, Munger taught him to favor better vs. cheaper businesses. As Munger explained:

The bulk of the billions in Berkshire Hathaway have come from the better businesses…Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% 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’ll end up with a fine result. So the trick is getting into better businesses.

Paying reasonable prices for good businesses – those with sustainable competitive advantages, secular growth tailwinds, strong balance sheets, and reasonable capital spending requirements – has been the hallmark of PASI’s investment style since its inception.

Circle of Competence – Munger and Buffett famously avoided technology stocks throughout their careers (a notable exception being Apple, which they first started purchasing in early 2016). Munger said that he and Warren were “at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies…Every person is going to have a circle of competence. And it’s going to be very hard to advance that circle. So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make.”

It’s for this reason that PASI has avoided smaller and/or newer companies for which there’s limited publicly available information, those with business models or products we struggle to understand, companies heavily dependent on external financing or a single, risky product for their existence (e.g. small biotech companies), and those without a history of solid operating performance. Like Buffett and Munger, we put these companies into a metaphorical pile labeled “too hard.”

Bet Rarely but Meaningfully – As Munger counseled, “It’s 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 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 when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

The PASI stock portfolio is fairly concentrated typically holding 30 to 35 stocks. This number captures most of the benefits of diversification (less risk without sacrificing expected returns – the only free lunch in investing), while still allowing our individual stock picks to exert a potentially significant impact on the overall portfolio’s performance. Opportunities to buy outstanding companies at reasonable prices are rare, and when they do arise, we want our positions in the stocks to matter.

Destroy Your Ideas – I love these two quotes from Munger:

“Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

“I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”

I have often described the financial markets as infinitely complex, mathematically chaotic, and thus inherently unpredictable (with any sort of precision). Accordingly, successful investing demands humility and the ability to change course when confronted with new and contradictory information. Of course, adaption is impossible for those who only seek news which merely confirms their prior held beliefs.

Solve Problems by Inverting the Question – In his commencement address to Harvard, Johnny Carson said that while he hadn’t found the secret to happiness, he knew from personal experience sure-fire ways to guarantee failure. Carson’s “prescriptions for guaranteed misery in life” were 1) ingesting chemicals in an effort to alter mood or perception, 2) envy, and 3) resentment. Years later in his own Harvard commencement speech, Charlie Munger added the following to Carson’s list:

4) Be unreliable. Do not faithfully do what you have engaged to do.

5) Don’t learn from the mistakes of others, living and dead. Become as non-educated as you reasonably can.

6) Go down and stay down when you get your first, second, or third severe reverse in the battle of life.

Concerning success in life and general happiness, Carson’s and Munger’s insight was that the problem is better tackled by turning the question around – that is, instead of asking what to do, they focused on what to avoid. Both were applying the mathematician Karl Jacobi's maxim to "invert, always invert." A variety of paths can lead to happiness, but, as Munger observed, “How little originality there is in the common disasters of mankind.”

In this spirit, over a decade ago I wrote a newsletter article titled, “Prescriptions for Guaranteed Investment Misery” where I detailed surefire ways to lose money in the financial markets:

1)Believe you can predict the future with 100% accuracy (don’t destroy your ideas).
2) Make sure your predictions are extreme (large changes from the status quo are usually the lowest probability bets).
3) Invest in the fastest growth stocks and industries with which investors are currently enamored (surprisingly, rapidly growing companies and industries tend to underperform over the long-term, as their stocks are usually overvalued).
4) Invest in what you don’t understand (venture outside your circle of competence).
5) Invest today where you wish you’d invested five years ago (ignore the danger of mean reversion).

Charlie Munger once observed, “I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up.” Indeed, Munger’s own success was a product of his insatiable curiosity about the world and a lifetime devoted to continuous learning. Ultimately, this is the lesson from Munger I find most inspiring.