written by
Renjit Philip

Investment lessons from “Poor” Charlie Munger!

Invesment Book excerpt 7 min read , October 16, 2022
ca. 2002 --- Charlie Munger --- Image by © Alan Levenson/Corbis
ca. 2002 --- Charlie Munger --- Image by © Alan Levenson/Corbis | Photographer: Alan Levenson | Copyright: © Corbis. All Rights Reserved.

Poor Charlie Munger:

I read the book Poor Charlie's Almanack in the fall of 2020. It cost me more than a few dollars to get it shipped from the US to Dubai. I remember wiping it clean using Clorox wipes when I got it (don't judge me, it was the middle of the pandemic!). I felt I needed to read this book that kept getting referred to in multiple podcasts. I found that podcasts and books were helpful distractions during the pandemic.

The book is nearly 2.5 kg in weight, is an unwieldy 25x26 cm size, and has over 570 pages. It is, however, a goldmine of life lessons and mental models for decision-making and investing. I have extracted my learning here solely from an investment perspective.

Book: Poor Charlie’s Almanack

Poor Charlie's Almanack.

Where did this name come from?

I gathered that Benjamin Franklin wrote a book full of his life lessons called Poor Richards' Almanack, and Charlie Munger is a massive admirer. Hence this title.

Who is Charlie Munger, you ask?

Charlie Munger is the American Billionaire investor and vice chairman of Berkshire Hathaway. Warren Buffet's closest friend, partner, and right-hand man. He is an alumnus of Harvard University and the California Institute of Technology. He was born on Jan 1st, 1924.

What impact did he have on Warren Buffet?

As described in the epic biography (Snowball), Warren Buffet was heavily influenced by Benjamin Graham in his initial years. It was all about getting a bargain deal and beating down acquisition prices. In short, buy low, sell high. Munger influenced his thinking on buying great businesses that generate cash, have excellent management, and have a defensible moat. Not necessarily only about buying at a low price.

Let us dive straight into my learnings from the book.

1) Mental models are essential to learning:

Pick up the fundamental truths or axioms of multiple disciplines, including psychology. Think of a pilot who has to use several skills to fly a plane. Think of the checklist they use: Physics of flight, Chemistry of fuel, Math of flight, and Engineering of the Airframe and the engine. It would be best if you relied on all your learning in situations where you have to decide on investing. Munger insight: Don't think valuing a business is only about annual reports, balance sheets, and P&L statements.

Benjamin Franklin on a USD 100 bill. Photographer: Nathan Dumlao | Source: Unsplash

2) Invert, always invert:

Figure out what you don't want to happen and avoid that at all costs—an excellent way to create business risk management plans. This incidentally is a great way to avoid investing mistakes. One of the critical measures I took away from this is context-driven investment diversification. Depending on the economic situation, a mix of assets yields the optimum return and safety. The definition of optimum will change depending on the person investing and their risk appetite and monetary needs. What worked in a low-interest rate, low-inflation economy will not work in a high-interest rate, high-inflation economy (one that we are getting into).

3) Lollapalooza effect:

This is a term that Munger has coined for models and factors that combine to create, amplify, and reinforce each other. The lesson Munger wants us to pick is that we need to look at first-order effects and then dive deeper into the second and third-order effects of models and factors interacting with each other. Don't just stop at the first-order effect. Example: In the stock market, if you consider the force of rising interest rates, typically, it should bring the stock of a company that relies on borrowing to fund its operation to go down. However, when you layer on the human psychology of the traders, then you see a different behavior of the indices.

4) Stay within a well-defined circle of competence while investing:

Understanding the business well gives you an understanding of the business model and how they make money. For years, Berkshire avoided investing in tech firms because Buffet and Munger could not justify the valuations and saw firsthand the dot com bust. Years later, they deeply “understood” Apple's business model and are heavily invested in it. One might say that Apple has become a cash-generating business, almost like a tech "utility," and that is when it found favor with Munger and Warren.

5) Identify and reconcile disconfirming evidence:

Munger keeps reminding us that- Above all, never fool yourself; remember that you are the easiest person to fool. Find people who oppose your point of view, understand why they have differing points of view, and see if it makes sense. If their arguments hold water, you must be ready to change or even drop your investment thesis.

6) Unleash the power of compounding:

Munger and Buffet are fans of compounding. Businesses that generate free cash and then channel that cash back into the company to grow at a compounded rate. Compounding is not a concept we understand easily, or a subject taught at school. “Compound interest is the eighth wonder of the world," -said Einstein, and Munger urges us never to interrupt it unnecessarily. The power of compounding keeps appearing in Munger's speeches and the Almanack.

7) Profit is not always Selling price minus Cost price:

Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake. Investment managers and traders have to show annual returns, so there has to be a "sell" order to realize the profits. We do not have to do that as long-term owners of a business. A shareholder can be a long-term owner of a business.

The thing is, the Wall Street trader approach does not work for long-term patient wealth creators. Retail investors often do not consider the transactional costs and the effect of taxes, which brings down their net returns. One of Munger's favorite investment approaches is "patience."

8) Allocation - proper capital allocation is an investor's number one job.

Remember that the highest and best use is always measured by the subsequent best use (opportunity cost). That is self-explanatory, but many of us do not think of the following best investment and the risk involved in the next best investment opportunity while evaluating an investment. When presented with an investment, always ask- what is the alternative investment avenue open before you? What additional risk are you taking on, and for what incremental return?

9) Pricing:

A great business at a fair price is superior to a fair company at a great price.

Suppose you come across a business that has sound fundamentals and is run by an excellent management team. In that case, it is worth paying a premium for it. And a "dog" business will not create supernormal returns even if you bought it at a throw-away price.

Find businesses that have pricing power and have not yet exercised it. These are near-monopolies in their categories or have tremendous brand strength and are rare.

10) Multiple mental models:

Charlie recommends a multi-mental model approach to business analysis and assessment. He recommends mixing, for example, the study of economics with human psychology. And he counsels us from being too wedded to one theory or skill. A man with a hammer sees everything as a nail.

11) Spend time to find out a business's "moat" – the sustainable defensibility of its profit-making machine.

Why are you investing in that business if you can't find one? Many companies market with an undifferentiated “me-too” product or a service. The question is, does their brand command a premium position in the customer’s minds? Will the business sustain its pricing power, or will a cheaper competitor undercut it?

12) Softer evaluation metrics:

When you don't have financials to evaluate a business, Charlie and Warren use these yardsticks:

  • Can we trust management?
  • Can it harm our reputation?
  • What can go wrong?
  • Do we understand the business?
  • Does it require capital infusions to keep going?
  • What is the expected cash flow?
  • Finally, is the price appropriate?

13) Cognitive Awareness:

Finally, before pressing that "buy" button on your investment app, check if you are making cognitive errors while investing. Are we following the herd, following authority blindly? Did we consider opposing schools of thought? Did you think of all the downside risks? Imagine if you could pause and ask yourself this question before getting swayed by the Reddit investor or the Meme coin shill.

To reinforce this point, Munger quotes the legendary physicist Richard Feynman who said, "The first principle is that you must not fool yourself—and you are the easiest person to fool."

The Almanack has several applicable models that I found helpful. One that I wish I had known when I started out investing more than twenty years back. It is a book well worth investing your time and money in.

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