One core idea Munger has borrowed from algebra is that many problems are best addressed backward. For example, by avoiding stupidity, a person can often discover what he or she wants through subtraction. By eliminating the stupid paths that one can take in life, a person can find the best way forward, even given inevitable risk, uncertainty, and ignorance. Not only does one often know a lot more about what is wrong than what is right, but disproving something may also require only one observation. In short, Munger’s view is that being smart is often best achieved by not being stupid. Once, in an interview with Jason Zweig, Munger said it simply: “Knowing what you don’t know is more useful than being brilliant.”
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John Maynard Keynes defined speculation as “the activity of forecasting the psychology of the market.” 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 not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we
devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.
—JOHN MAYNARD KEYNES, GENERAL THEORY, 1936
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Munger does not own gold as an investment because it is impossible to do a bottom-up fundamental valuation, because gold is not an income-producing asset. Gold has speculative value and commercial value, but in Munger’s view it has no calculable intrinsic value. Buffett has said that he would be happy to accept a gift of gold, but he would not buy it as an investment
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There are two kinds of businesses: The first earns 12 percent, and you can take it out at the end of the year. The second earns 12 percent, 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.
—CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2003
When Munger and Buffett value a business, they use what they call owner’s earnings as the starting point. Owner’s earnings can be defined as: Net income + Depreciation + Depletion + Amortization – Capital expenditure – Additional working capital. Berkshire uses the owner’s earnings figure in this process to take into account capital expenditures that will be necessary to maintain the business’s return on equity.
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I’m really better at determining my level of incompetency and then just avoiding that. And I prefer to think that question through in reverse. We have a good batting average and that is probably because we are a little more competent than we think we are.
—CHARLIE MUNGER, CNBC INTERVIEW, 2014
Understanding the limits of your own competence is very valuable. Venture capitalist Fred Wilson put it simply: “The only way you win is by knowing what you’re good at and what you’re not good at, and sticking to what you’re good at.” Munger similarly believes that investors who get outside of what he calls their circle of competence can easily find themselves in big trouble. Within his or her circle of competence, an investor has expertise and knowledge that gives them a significant advantage over the market in evaluating an investment.
The idea behind the circle of competence is so simple that it is arguably embarrassing to say it out loud: when you do not know what you’re doing, it is riskier than when you do know what you’re doing.
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When Charlie thinks about things, he starts by inverting. To understand how to be happy in life Charlie will study how to make life miserable; to examine how a business becomes big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market.
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there’s no significant barrier to entry that creates a sustainable competitive advantage, inevitable competition will cause the return on investment for that business to drop to opportunity cost and there will be no economic profit for the producer.
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The most important task in capital allocation is to take cash generated by a company and deploy it to the very best opportunity and avoid what Buffett called the institutional imperative:
Rationality frequently wilts when the institutional imperative comes into play.
For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
—WARREN BUFFETT, BERKSHIRE ANNUAL MEETING
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