The Tao Of Charlie Munger

Crumbs of wisdom from Berkshire's vice-chairman.

Charlie was born in Omaha, Nebraska, in 1924. Though they wouldn’t meet until later, he effectively lived in parallel to Warren in his earliest years, being at home in the same neighbourhood and attending the same school. Charlie even worked in the grocery shop of Warren’s grandfather, where he learned some accounting, how to manage inventory, and good work principles like being punctual. He spent much of his spare time reading then, as he does now. After finishing school, Charlie enrolled at the University of Michigan to study mathematics. But he dropped out in early 1943 to sign up for the US Army, where he learned how to play cards and bet heavily when the odds were in his favour - a skill that he would adjust to investing later on. His high score on the military’s intelligence test led him to be assigned to study meteorology at Caltech in California.

Post-war, Charlie applied to Harvard Law School, his father’s alma mater, but he was turned down because he didn't have an undergraduate degree. Luckily for him, the retired dean of Harvard Law school - a family friend - pulled some strings for him. Charlie performed very well in his studies at Harvard, and graduated magna cum laude in 1948. Next, he won a position at a prestigious corporate law firm, also in California, where he learned some more about business operations. When his father died, Charlie went back to Omaha to settle his estate. Whilst there, he met some old friends at the Omaha Club who, certainly unaware of the profound implications of their decision, decided to bring along Warren himself. Charlie and him hit it off, and they spoke for hours about stocks - ignorant to the fact that their other companions had left long before.

Back in California, Charlie decided to start an investment partnership with Jack Wheeler, a poker friend and trader on the Pacific Coast Stock Exchange. The results were fantastic; Wheeler & Co. achieved a 1962-75 CAGR of 19.8% compared to 5% for the Dow Jones. Charlie made the leap of quitting law for good and going full time for the partnership in 1965. Whilst he was undoubtedly sophisticated, his approach was inarguably high risk: the fund was constantly levered and Charlie made regular merger arbitrage bets, sometimes looking to exploit his legal edge.

When the oil crisis came in the 1970s, it inflicted steep losses, and Charlie and Wheeler chose to shut down the partnership in 1975. Charlie became Berkshire’s first vice-chairman in 1979, and from there he was instrumental in growing the conglomerate’s stock price from around $965 in 1983 to $517,408 currently. Not bad at all. Charlie has officially been credited with shifting Warren’s investment strategy from one of buying fair businesses at wonderful prices to buying wonderful businesses at fair prices.

“This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view; it was the power of Charlie’s mind.”

Warren Buffett

In this piece, I want to cover what I think are some of the best quotes in the Tao Of Charlie Munger, as compiled by David Clark. As difficult as it is, I’ll keep it to no more than 5 per section.

On Successful Investing…

"Acknowledging what you don’t know is the dawning of wisdom.”

In today’s economy, our real knowledge is typically confined to a single field, at least a subfield within that field, and likely a subsubfield within that subfield, if not deeper. On the one hand, this specialisation makes us very good and knowledgeable about that particular thing, and in aggregate we’re all better off if we do a single thing well instead of multiple things badly. On the other, it makes us hopelessly ignorant, which we’re often not inclined to acknowledge.

It’s imperative that we figure out what we know and don’t know, which is easier said than done, and second, that we tread lightly and carefully around the latter topics. This is the circle of competence principle of playing to your strengths, not to your weaknesses. If you have even minor doubt that you don’t understand a certain business model or the nature of an industry, just move on… there are lots of opportunities out there. The fact that Munger adheres to this rule despite his fabulous investing acumen should be testament to its importance.

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying: ‘It’s the strong swimmers who drown.’”

This makes total sense. There are lots of highly intelligent investors active in the stock market, so an edge has to be found somewhere else, like in consistent rational thinking with a long-term view. As humans, this doesn’t come naturally, and temptations to be stupid are everywhere, though they tend not to be obvious. Often, like a slow-burning fuse that triggers an explosion later, we realise that we screwed up in hindsight - such is the Karmic nature of the investing game.

I guarantee even index fund investors, whom it would benefit to fall asleep and wake up decades later, are tempted to fiddle with the knobs at times - despite knowing they shouldn’t. Similarly, fed up with vanilla investing, smart hedge fund managers might wade deeper into derivatives and even more complex strategies with the dangerous confidence of a strong swimmer going further out than usual. This typically ends badly - for their investors.

“You should remember that good ideas are rare - when the odds are greatly in your favour, bet heavily.”

In those rare circumstances where you do find an excellent company at a very attractive price, bet the ranch to take full advantage. Such an opportunity will likely arise in a full market crash, where everything is irrationally sold off regardless of the merits of individual companies. Berkshire has successfully used this strategy again and again, with the prime examples being American Express and Coca-Cola.

However, this advice rests on our capability to identify whether the price is right. Constant learning and the emotional discipline to act when people flee for the exits is therefore crucial. It also helps, of course, to have “$10m in your checking account in case a good deal comes along.”

“I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit earnings’.”

A company, in particular if it has dishonest management, will always put its best foot forward. This is why reports and presentations need to be viewed with a critical eye. Investors care about revenue, operating earnings, net income, and cash flow, but these metrics are never as smooth or upward sloping as management’s adjusted EBITDA, or what I think of as The Number. Yes, adjustments for distorting factors can be useful in that they make fiscal periods comparable, but one should never lose sight of the fact that these are fictional earnings.

Charlie is also famously fanatical about the power of incentives, and it gets critical when management is incentivised through compensation to maximise bullshit earnings instead of real earnings. Read the fine print; decide whether adjustments are reasonable or not; and never forget that interest, taxes, and depreciation (a proxy for maintenance capex) are real expenses that must be paid.

“This worshipping at the altar of diversification, I think that is really crazy.”

Almost all of the great fortunes in history were built through extremely large holdings in single companies; look at Rockefeller, Carnegie, Vanderbilt, Bezos, and Gates - the list is endless. Charlie is a fan of a concentrated portfolio in line with his wonderful business at a fair price strategy. When he ran his investment partnership, Blue Chip Stamps accounted for around 61% of assets in the later years, and today, Berkshire’s public portfolio is similarly concentrated, with around half of its value locked into Apple stock.

It’s better to invest in a few excellent performers than to dilute your returns in pursuit of statistical diversification. But again, there’s a caveat, which is that you need to be good at investing. As Buffett says, “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

On Business, Banking, And The Economy…

“Capitalism without failure is like religion without hell.”

This relates to the big banks, whose irresponsibility and lack of accountability caused the subprime crisis. Most were bailed out or saved somehow by the central banks. Personally, and emotional considerations aside, if you knew that there were zero consequences for your actions apart from some reputational damage that would likely fade in a few years, would you continue to live a morally good life? I think a significant portion of us would choose the dark side.

No wonder banks haven’t changed; they have an official safety net that fuels their extreme risk appetite - after all, it’s typically not their money. As David Clark writes, “Sometimes it is better to save the sinners than to take down an entire nation with them.” Executives know this. If the financial system doesn’t change, specifically our dependence on banks, then neither will the boom-bust cycles.

“I do not think you can trust bankers to control themselves. They are like heroin addicts.”

The principle here is the same as above. Imagine you could shoot heroin up your arm with the deleterious health consequences transferred to someone else. For the worst bankers, who have no moral compass, this is paradise - a free ride at someone else’s expense. Prior to the mortgage bubble, the heroin for bankers was the sale of CDOs, their abstractions, and the linked bonus all in one, with the negative impact felt by the entire economy and the unsuspecting people within it.

“If we’re going to prosper, we have to work. We have to have people subject to carrots and sticks. If you take away the stick the whole system won’t work. You can’t vote yourself rich. It’s an idiotic idea.”

In essence, we avoid pain and seek pleasure. To work means that we get paid, which provides, for example, disposable income that we can spend on fun things (the carrot). But most people dislike their profession, hence it is critical to note this process also works in reverse: not to work means no income, which means that, sooner or later, we will struggle to survive (the stick).

Charlie, a fierce proponent of capitalism, thinks that this simple principle is the key to a nation’s economic performance, and he would be right. Still, I believe it would be better if we refined the education system to help people discover their passion - if we did, I think people would happily work harder.

“Koreans came up from nothing in the auto business. They worked 84 hours a week with no overtime for more than a decade. At the same time, every Korean child came home from grad school, and worked with a tutor for four full hours in the afternoon and the evening, driven by these Tiger Moms. Are you surprised when you lose to people like that? Only if you’re a total idiot.”

This quote reminds me of the documentary American Factory which showed, among other things, the differences in manufacturing efficiency and work culture between the US and China (it’s a great watch). National economies rise and fall due to various factors - it’s inevitable. People work harder when their circumstances are relatively bad, and work less when they’re relatively good. Even Charlie, who, like Buffett, is a strong believer in America’s future, recognises this fact.

Charlie’s Philosophy Applied To Business And Investing…

“When you mix raisins with turds, you still have turds.”

There are lots of companies who are successful serial acquirers. They tend to operate in fragmented industries, have disciplined policies, and do not consider firms which do not directly generate synergies and returns above the cost of capital to be targets. Still, most M&A is value destructive. Even Coca-Cola stumbled into the movie business in 1982 (they got back out quickly). Buying bad businesses in unrelated industries (the “turds”) dilutes the value of the acquirer (“the raisin”), and whenever a firm decides to do this, it’s time to think about selling.

“In business we often find that the winning system goes almost ridiculously far in maximising and or minimising one or a few variables - like the discount warehouses of Costco.”

Sometimes borderline fanatical managers are the cream of the crop - if they’re fanatical about the right things, like minimising costs (Costco), obsessing about customers’ wants and needs (Amazon), or having extreme pricing discipline (LVMH).

“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 of his equipment and says, ‘There’s all of my profit’. We hate that kind of business.”

Companies which grow quickly and earn high returns logically invest a large proportion of their operating cash flow back into the business. But there is a fine line between a decision to reinvest and necessary reinvestment. Airlines, for instance, are mature businesses in oligopolistic industries with little room for growth. But they’re forced to blow most of their operating cash just to maintain their competitive positioning, even if it earns low returns. The same can probably be said for most other capital intensive industries.

Real profit is free cash flow - not accrual earnings. This is why it’s important to figure out what a firm’s maintenance capex is, as this can indicate how much cash will drop into shareholders’ pockets when the company approaches maturity.

“From all business, my favourite case on incentives is Federal Express. The heart and soul of their system - which creates the integrity of the product - is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a product full of integrity to Federal Express customers. And it was always screwed up. They could never get it done on time. They tried everything - moral suasion, threats, you name it. And nothing worked. Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift - and when it’s all done, they can go home. Well, their problems cleared up overnight.”

Like I said earlier, it’s all about incentives. And most people’s incentive to come to work is the fact that they get paid.

On Life, Education, And The Pursuit Of Happiness…

“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”

We naturally seek to paint ourselves in a positive light all the time, as this makes us appear more capable and less flawed. But the pain of being open about mistakes reinforces learning, which makes us less likely to repeat our blunders. Charlie and Warren did this all the time during their past Berkshire AGMs (I recommend listening to them). It’s worth adding that such a tendency will also lead others to trust and respect you, precisely because it’s so difficult to do.

“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 when they got up, and boy, does that help, particularly when you have a long run ahead of you.”

It’s about taking small steps consistently. Even an hour of reading a day, added up over weeks, months, and years, can go an extremely long way towards building knowledge. Charlie has said that Warren is one of the best learning machines on earth, and that if “he had stopped with what he knew at earlier points, the record would be a shadow of what it is.” This idea applies to us equally.

“In my whole life, I have known no wise people who didn’t read all the time - none, zero. You’d be amazed at how much Warren reads - and how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”

I think a good reading habit is a huge competitive advantage, in particular for younger generations like mine, for two reasons. First, it obviously helps us become more knowledgeable, and second, it takes a great deal of discipline, with more and more distractions appearing around us.

We might think that we remember ever so little after reading a book, but I find that most of the value comes from pattern recognition and not free recall. Read a hundred historical business biographies, and common successes and failures will be much more accessible when you do your due diligence on a company, supporting your judgement.

“Life is always going to hurt some people in some ways and help others. There should be more willingness to take the blows of life as they fall. That’s what manhood is, taking life as it falls. Not whining all the time and trying to fix it by whining.”

Life has its ups and downs. It’s critical to be prepared for the latter, and to react in a stoic fashion. This is the right thing to do, and it’s what being a strong person is all about. Something I didn’t know was that Charlie lost a son to leukaemia in 1952. But he soldiered on to where he is now - a happy place.

“Three rules for a career: don’t sell anything you wouldn’t buy yourself; don’t work for anyone you don’t respect and admire; and work only with people you enjoy.”

I’m grateful for Charlie’s wisdom, and hope he’ll be around for some time still (he’ll hit the big 100 in January). I recommend getting a copy of Clark’s book for yourself, if you want to see the other 100 or so quotes. I found that all of them were useful.