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A couple of weeks spent in expensive, price gouging Ireland (over $10 for a six pack) was a great opportunity to step back, get away from the market, and do a reexamination on the core principles of Charley Munger. The time was well spent as I have come to realize that it is Munger, more than Buffett, who has had the most profound impact on my investing philosophy. I prefer Munger to Buffett for several reasons - mostly because as a small, individual investor it is Munger's philosophy which gives me the best chance to out-perform. Buffett's circle of competence is huge and he has spent a lifetime getting there. Munger's interests are more diverse and his investing circle of competence narrower. If I'm going to beat the market over time I'd damn well better focus intelligently because there are too many competing demands on my time. So with Irish rain falling every day I spent some of the two weeks trying to figure out how Munger mentally approaches the investment landscape. Most of you have a good idea of some of the basic "Mungerisms" and know that Munger influenced Buffett to transform from a pure Benjamin Graham style to look for high quality businesses. To begin, Munger's investment philosophy is a by-product with how he approaches life…..first look at what NOT to do:

1. Over-diversify
2. Leverage
3. Trade in and out of securities
4. Incur significant friction costs
5. Go with the crowd
6. Buy at unattractive prices
7. Own average to poor businesses
8. Destroy the laws of compounding
9. Force yourself to constantly make decisions which reduces the time spent on each

And by process of elimination we see what's left - Munger's core investing principles:

1. A lifetime of successful investing boils down to several key decisions - prepare your mind
2. Concentrate the portfolio in a few quality businesses
3. Buy the businesses at good prices
4. From there, Allow the superior economics of the great business model to do all the work for you

That is simplicity defined but a closer look I think shows just how hard it is and why Munger is a classic in his own right. In functional terms, Munger does not buy or sell very often - in fact one might characterize his transactions as rare. He has said that a successful investment life really boils down to but a handful of decisions (if you examine Buffett this is pretty close to the truth). When he likes something he makes a very large bet. Once he's made his decision he tends to stay with it for a long long time. As such a convergence of circumstances is rare, he's on record as saying that a portfolio of three companies is plenty of diversification. Most people I think would shudder in horror at the thought of owning only three companies. Why not Munger? .

The mental approach. I have come to realize that the key to owning only three and betting big has everything to do with Munger's mental approach to the process. To own three and sleep well at night FORCES one to thoroughly know and understand the business. The emphasis and bulk of time is by definition - reading, research, and attacking the problem with a multi-disciplinary approach from all angles. Munger has in essence spent a great deal of his "mental capital" developing a multi-disciplinary list of mental models which allow him to tear apart everything about a business so he has a very in-depth understanding of what he likes and why he likes it. No wonder he has no use for analyst opinion! His goal is a very deep understanding of a select few businesses. Once that mental capital and time is expended and a purchase made, a sell would in essence be a huge waste of his personal and mental resources unless of course something changed fundamentally with the business. When most people approach the investment landscape they use purely inductive thinking - constantly searching for things to buy and new ideas (adding on if you will). An inductive prism inevitably leads to numerous and frequent purchase decisions and a craving for more data. The end result is a portfolio of many names and insignificant portfolio percentages for each - as an example, Peter Lynch was a great inductive thinker and mastered it. Everything I've read of Munger shows that he is a multi-dimensional thinker (inductve AND deductive) with a bias towards deductive thinking (invert always invert). When Munger scans the market he's first looking for things that fit his narrow definition (the inductive part) and then from that list he looks for why he DOESN'T wish to buy (the deductive bias). This deductive bias has the result that Munger significantly narrows the investment universe (far moreso than Buffett), has a maniachial focus on only his few key variables, and then deduces a narrow core of very solid companies. If anything, this core would tend to shrink rather than expand. From this narrow core then when Munger says to "have a prepared mind" he is ready to execute and execute big when one of them falls to an attractive price. Most days he would cross everything off of his narrow list and derive at - no activity. If none of his core is selling at an attractive price then he'll sit on a pile of cash and wait - obviously for YEARS if necessary.

What does Munger look for and how does he deductively narrow the list? I think that part of what he first inductively looks for can be summarized in the underlying theme of much of his recommended reading material. After reading "Guns, Germs, and Steel," "The Selfish Gene," "Ice Age," and "Darwin's Blind Spot," I have deduced that there is one recurrent theme to all. The common theme is the ability of some entity to transform, thrive, and dominate over time. Each book in turn has a different transformation subject (peoples, gene carriers, theory, mankind) but the underlying thesis to all is what it takes to transform, thrive, and dominate through the ages. If one extrapolates this theory into the business realm then the natural bi-product would be business models and their 'naturally selective' environment. Some may thrive by out-competing (Selfish Gene) and some may thrive by out-cooperating (Darwin's Blind Spot). This ability of a business model to thrive and persist defines Munger's investment universe. From there he then INVERTS his thought process, attacks the issue from the opposite end, and begins his deductive bias. I have wondered aloud why Munger did not purchase say Home Depot at $21. I think the answer to that dilemma is Lowes - it is my guess that Munger may think that HD is a decent company but that over time he did not think that HD had the inherent competitive or cooperative advantages to thrive next to Lowes. Thus by process of elimination (deductive natural selection of the fittest rather than inductive addition) Munger would have eliminated HD from his core list. Transfer the same thought process to the hundreds of "undervalued" companies available in the market on any given day and I think we begin to get to the essence of Munger. On the other side, think for a moment of Berkshire Hathaway and what it was twenty years ago and what it is today. A core competency of the Berkshire business model is flexibility in capital allocation which over time has transformed the company from primarily an equity investment vehicle to an operating company. Much like a selfish gene carrier Berkshire has transformed itself to best thrive in the environment of the day. Twenty years from now Berkshire may look entirely different again and it is this ability to transform which Berkshire's competition can not match. The ability to transform, thrive, and dominate in the business world comes from many factors but one thing I've noticed is that it tends to be related to a secure stream of free cash flow which as Buffett says, "gives management pleasant choices [and flexibility] rather than headaches." Does Cort furniture rental have any significant competition? Can Pepsi compete with Coke's logistics network across the globe? Is there any competing tax preparation business for H&R Block? All three dominate and there is nothing visible on the horizon to change that fact.

Why a very concentrated portfolio? Think for a moment what it means to have a portfolio of say 33 stocks equally distributed (3% weighting for each company). Such a portfolio would be "focused" for a mutual fund. Hagstrom I believe owns from twenty to twenty-five in his focus fund. Even if one of those companies hits the lights out its impact on the overall portfolio would be minimal. In this light, with billions to deploy, it's obvious to see why Buffett has moved away from the equity markets. He just can't load up on a company he really likes in any meaningful way without hitting the 15% ownership threshold. What are the chances of making twenty or thirty purchase decisions and having those decisions first be correct and second having them result in significant impact to the overall portfolio? Why spend months or years learning a company inside out only to make it a 3-5% portfolio weighting? We're fortunate in that we're not weighted down like Buffett is. If a Munger-like approach can manage over time to collect from three to eight superior businesses then the dynamics of each would have significant impact on the overall portfolio. Key to this of course is avoiding mistakes in judgement - therefore, "We place a high premium on certainty." Certainty I think comes first by paying a low price and then purchasing the stable, consistent dominant business franchises which have distinct competitive advantages and for which Buffett and Munger are famous. We have seen what happens when one can load up on a dominant franchise as Buffett did with Coke and initially make it 35% of the total portfolio - it drove Berkshire ever higher for a decade. Likewise, the 40% weighting to American Express in the salad scare days drove the portfolio (and yes I read somewhere that he had to get an exception to policy for this but I can't remember where! Perhaps OID). Those were two of the ten or so decisions which Buffett made (in a Munger like fashion) that really define his investment life - 1) Closing the partnership at market high in 60s and going with just Berkshire Hathaway; 2) AXP in salad scare days; 3) Washington Post; 4) Coca Cola; 5) Geico; 6) General Re. Remove those six decisions and what would Berkshire be today?

I think the key to Munger is the "prepared mind" which sorry to say can not be derived from some magic investment formula. I just can't imagine Munger applying some formula to his universe. I think that the essence of Munger the investor is defined by what not to do, followed by a thorough multi-disciplinary attack on what remains, and then seizing the moment when it appears.

HB
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