Book Reviews, Value Investing

Book Review of Poor Charlie’s Almanack

This is an excellent book! Highly recommended. There’s some interesting and funny stuff about Charlie Munger that I didn’t know (especially Buffett’s story about Charlie in Pg. 49). Wrote some of the quotes below. Charlie’s quotes are those that are not attributed. I think I’m more of a Charlie Munger than a Warren Buffett.

On Investing:

  1. Buffett: “Investing is all about laying cash out now to get cash back in the future.  The timing, certainty and amount of this are what you need to evaluate… If you need a spreadsheet or a calculator to get to an answer, you should probably pass.  The number should scream at you from the paper”.
    [My note: It is vitally important to invest in a business that keeps throwing off free cash flow. With dividend-paying stock, you get some assurance that some of that FCF will come back to you as cash. However if you buy stocks for capital gains, you are relying on the mood of Mr Market to prove you right. That’s why for capital gains, you need to buy companies with sustainable competitive advantage that will grow and grow and become a leader of its industry/sector. That will force Mr Market to recognise its worth. If you buy a fair business at a great price, Mr Market may never ever recognise that mis-pricing (you need activist market participants to correct that, which may not happen for a long long time, and during that time, lots of negative things can happen to a fair business compared to a great business).]
  2. Holding Cash
    1. Li Lu: “In making investments, I have always believed that you must act with discipline whenever you see something you truly like…. Once in a while, you will find a ‘fat pitch’ that is slow, straight, and right in the middle of your sweet spot. Then you swing hard. This way, no matter what natural ability you start with, you will substantially increase your hitting average. One common problem for investors is that they tend to swing too often…. However, the opposite problem is equally harmful to long-term results: You discover a ‘fat pitch’ but are unable to swing with the full weight of your capital.
    2. “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash — and I don’t want to go back.”
    3. Buffett: “The one thing I will tell you is the worst investment you can have is cash… Cash is going to become worth less over time. But good businesses are going to become worth more over time… We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. You always want to have enough so that nobody else can determine your future essentially” [My note: market plunging and you can’t act, margin calls, etc.]
  3. Charlie’s investment process
    1. Business
      1. Analyses a ton of things including the current and prospective regulatory climate; state of labour, supplier, and customer relations; potential impact of changes in technology; competitive strengths and vulnerabilities; pricing power; scalability; environmental issues; and the presence of hidden exposures.
      2. Assess competitive advantage – products, markets, trademarks, employees, distribution channels, societal trends, etc. – and the durability of that advantage.
      3. Consider “competitive destruction” forces that over the long term lay siege to most companies. Identify and buy only those businesses with a good chance of beating these tough odds. [My note: this is an interesting point. Might be good to start putting together a table of companies and the reasons why they failed.]
      4. Goes through all risks of the investment failing. “There is no such thing as a riskless investment, look for those with few risks that are easily understandable.”
    2. Valuation
      1. Recast financial statement figures to fit his own view of reality, including actual free or “owners” cash being produced, inventory and other working capital assets, fixed assets, and frequently overstated intangible assets.
      2. Calculate the intrinsic value of the whole business, with allowance for potential dilution, etc., to determine an approximate value per share.
    3. Liability
      1. Completes an assessment of the true impact, current and future, of the cost of stock options, pension plans, and retiree medical benefits.
      2. Scrutinizes the liability side of the balance sheet (e.g. insurance float can be more properly viewed as an asset)
    4. Management
      1. Assesses a company’s management, are they able, trustworthy, owner-oriented (e.g. how do they deploy cash? overcompensate themselves? pursue ego-oriented growth for growth’s sake?)
    5. Ignore insignificant detail in the analysis.
    6. Proper timing is important. Apply a “prior to pulling the trigger” checklist, especially useful in evaluating “close calls”
      1. What are the current price, volume, and trading considerations?
      2. What disclosure timing or other sensitivities exist?
      3. Do contingent exit strategies exist?
      4. Are better uses of capital currently or potentially available?
      5. Is sufficient liquid capital currently on hand or must it be borrowed?
      6. What is the opportunity cost of that capital?
    7. When all circumstances are just right, make a large, decisive bet. Do not take “initial positions”.
  4. “A great business at a fair price is superior to a fair business at a great price.”. My notes:
    1. A great business grows and grows and forces Mr Market to recognize its value. A fair business can be subject to Mr Market’s moods for a long time.
    2. Great businesses seldom trade at fair prices or below, hence you need to grab such opportunities when they present themselves.
    3. “If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you buy a few great companies, then you can sit on your ass. That’s a good thing.”
    4. “We’re partial to putting out large amounts of money where we won’t have to make another decision.”
  5. Diversification
    1. “If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience.”
    2. “Our game is to recognize a big idea when it comes along, when one doesn’t come along very often. Opportunity comes to the prepared mind.”
  6. “Really good investment opportunities aren’t going to come along too often and won’t last too long, so you’ve got to be ready to act. Have a prepared mind.”
  7. Short Selling
    1. “Being short and seeing a promoter take the stock up is very irritating. It’s not worth it to have that much irritation in your life.”
  8. Cost of Capital
    1. Buffett: “Charlie and I don’t know our cost of capital… We measure everything against our alternatives.”
    2. “… people make decisions based on opportunity costs – in other words, its your alternatives that matter. That’s how we make all of our decisions.”

On Thinking:

  1. “Personally, I’ve gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically conclusions in various ways — which, by and large, are useful — but which often malfunction? One approach is rationality… And the other is to evaluate the psychological factors that cause subconscious conclusions — many of which are wrong.”
  2. Mental Models
    1. “You must know the big ideas in the big disciplines and use them routinely….. What you need is a latticework of mental models in your head. And, with that system, things gradually get to fit together in a way that enhances cognition.”. Instead of making stand-alone assessment of a company’s financial information, Charlie also conducts a comprehensive analysis of the larger, integrated “ecosystem” in which it operates.
    2. Einstein: “A scientific theory should be as simple as possible, but no simpler.”
  3. How to Think
    1. “I’m afraid that’s the way it is. If there are twenty factors and they interact some, you’ll just have to learn to handle it — because that’s the way the world is. But you won’t find it that hard if you go at it Darwin-like, step by step with curious persistence. You’ll be amazed at how good you can get.”
    2. “The most important thing to keep in mind is the idea that especially big forces often come out of these one hundred models. When several models combine, you get lollapalooza effects; this is when two, three, or four forces are all operating in the same direction. And, frequently, you don’t get simple addition.”
    3. “Most commonly, the forces coming out of these one hundred models are conflicting to some extent. And you get huge, miserable tradeoffs. But if you can’t think in terms of tradeoffs and recognize tradeoffs in what you’re dealing with, you’re a horse’s patoot…. You have to recognize how these things combine… So you must have the models, and you must see the relatedness and the effects from the relatedness.”

On Life

  1. “A lot of successes in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc.”
  2. “Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts.”
  3. “What’s the best way to get a good spouse? The best single way is to deserve a good spouse..”

Other Interesting Stuff

  1. Charlie’s first wife was Nancy Huggins whom he married while he is in the military. They subsequently divorced in 1953. This reminded me of how Buffett and his wife separated amicably, and Ben Graham also separated from his wife. This seems to be a price that really successful people for being so engrossed in their interests and work.
  2. “What matters most: passion or competence that was inborn? Berkshire is full of people who have a peculiar passion for their own business. I would argue passion is more important than brain power.”
  3. “In the past, when Berkshire has gotten cheap, we’ve found other even cheaper stocks to buy. I’d always prefer this. It’s no fun to have the company so lacking in repute that we can make money for some shareholders by buying out others.”

Nothing to Adds

  1. Don’t go for open outcry auctions because human psychology of fear of losing causes you to overpay. Don’t go for closed bid auctions because they invite a possibility for big mispricing errors (e.g. winner’s curse of paying double what the 2nd guy bidded).

Funny Stuff

  1. Buffett in the Foreword wrote that Munger improved Ben Franklin’s thinking in many respects, save for some, one of which is below on his “Advice on the Choice of a Mistress” 🙂
  2. Buffett’s story about Charlie on Pg. 49 is absolutely hilarious!

Other Stuff

  1. Stock Options
    1. “A stock option is both an expense and dilution”
    2. Buffett: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
  2. Asbestos
    1. “… lawyers are stealing money from people who are hurt and giving it to people who aren’t entitled.”
  3. Buffett: “Henry Singleton has the best operating and capital deployment record in American business..” (co-founder of Teledyne)
  4. To learn the great concepts, it helps to tie them into the lives and personalities of the people who developed them (e.g. you learn economics better if you make Adam Smith your friend). Make friends with the eminent dead who had the right ideas.

Recommended Books

  1. Deep Simplicity: Bringing Order to Chaos and Complexity
  2. James Bowell’s biography of Samuel Johnson on transcending envy.

Talk One: Harvard School Commencement Speech (Jun e 13, 1986)

  1. Don’t take drugs or alcohol to change your mood/perception.
  2. Don’t be envious.
  3. Don’t be resentful.
  4. Be reliable.
  5. Learn everything that you can from your own experience, maximizing what you learn from the good and bad experience of others, living and dead.
  6. Learn from the best work done before yours.
  7. Never stay down when defeated.
  8. Invert. Understand why people and things fail, and avoid them.
  9. Maximize objectivity, criticize your own ideas, be vurious, and have perseverance.
  10. Aim high.

Talk Two: A Lesson on Elementary Worldly Wisdom as It Relates to investment Management and Business (The University of Southern California Marshall School of Business, April 14, 1994)

  1. You have to array your experience – both vicarious and direct – on a latticework of models.
  2. Models
    1. Mathematics
      • Basic arithmetic
      • Compound interest
      • Math of permutations and combinations
      • Decision trees
    2. Accounting
      • Accounting and its limitations
    3. Psychology
      • If you tell people why, they will understand it better, and will consider it more important, and will be more likely to comply. Carl Braun had a rule that all communications in his company has to have 5 Ws (who, what, where, when, why). If you don’t do it, you would get fired after two times.
    4. Engineering quality control
      • Tradeoff exist between the cost and the likelihood of things breaking
    5. Statistics
      • Able to do rough calculation using the Gaussian distribution because events and huge aspects of reality end up distributed that way.
    6. Engineering
      • Backup system
      • Breakpoints
    7. Physics
      • Critical mass
    8. Biology/physiology
      • People are programmed by our genetic makeup to be much the same.
    9. Psychology
      • Psychology of misjudgment
    10. Microeconomics
      • A free market economy is equivalent to an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche.
      • Patents, trademarks, exclusive franchises
      • Discriminate between when technology is going to help you and when it’s going to kill you. Determine how much of the cost savings is going to the bottom line and how much is going to flow through to the customer (e.g. are you producing a commodity product? or are you the sole producer?)
      • Competitive destruction due to new technology. The ‘early birds’ get to surf for a long, long time, after which they need to get into a different business or they’re dead.
    11. Microeconomics: Advantages of scale
      1. Human nature: Cost reductions along the experience curve. Greater volume causes people to improve their ability and efficiency because human beings try to improve and are motivated by incentives.
      2. Geometry: If you build a circular tank, as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube.
      3. Resources: Big companies selling huge volume (e.g. P&G) can afford expensive network TV advertising that small companies cannot.
      4. Informational: Large companies have an informational advantage (e.g. Wrigley can be known in a remote place compared to an unknown brand) that allows it to command a premium.
      5. Psychology: People are influenced by what others do. If everyone is drinking Coca-Cola all around the world because of Coca-Cola’s worldwide distribution setup, people will just follow suit. The wide distribution setup is a huge advantage that is very hard to get.
      6. Snowball effect: In some business the very nature of things is to cascade toward the overwhelming dominance of one firm, e.g. daily newspapers. This is because the scale builds upon itself; when a newspaper gets most of the circulation, it gets most of the advertising, and once it has most of the advertising and circulation, nobody will want the smaller papers with less information. [my note: like social networking, its a network effect.]
      7. Specialization: Advantages of scale allow greater specialization within the firm, so each person can be better at what he does. E.g. specialists at Wal-Mart HQ that know a lot about refrigerators, etc. to perform the buying compared to some proprietor of a little store.
      8. Business: Huge purchasing power. Also a large chain store can have ‘little laboratories’ of stores to conduct experiments.
      9. Process: Established systems that forces everyone to do what works.
    12. Microeconomics: Disadvantages of scale
      1. Ecosystem: Susceptible to being dislodged by competitors that go for a narrower specialization. E.g. Berkshire had a travel magazine for business travel, this was killed by a competitor that created a magazine targeted solely at corporate travel departments. They gave very targeted information, became more efficient, and didn’t need to waste resources in giving general information. E.g. Saturday Evening Post vs. Motocross.
      2. Human nature: Bureaucracy with layers of management and associated costs, work pushing, slow decision-making, no shareholder focus (e.g. Sears vs. Wal-Mart).
      3. Tendency for dysfunctional behavior: E.g. Westinghouse loaned billions of dollars to real estate developers building hotels and lost them.
      4. Pavlovian association: Ex-CBS CEO Bill Paley had an automatic reaction of antipathy towards people that tell him unpleasant things that he didn’t want to hear, so he lived in a cocoon where people only told him what he liked to hear.
  3. Puzzle on Dynamics of Market Competition
    1. Many markets get down to 2-6 big competitors. In some of those markets, nobody makes any money, but in others, everybody does very well. Why is the competition in some markets rational so that shareholders do well, while in other markets there’s destructive competition that destroys shareholder wealth?
    2. E.g. net amount of money made by shareholders of airlines since Kitty Hawk is a substantial negative figure. Intense competition ravaged shareholder wealth.
    3. E.g. in cereals, big players make ~40% on your capital, medium-grade cereal maker can make ~15%.
    4. A main factor can be because there is a brand identity factor in cereals that doesn’t exist in airlines.
    5. [My thought: It depends on how obviously a good is the same across all competitors, i.e. how obvious is it a commodity. Airline seats are obvious, all the seats are the same, the planes are pretty much the same from competitor to competitor, and all of them take you from one place to another. Whereas for cereals, they may not all be the same. When it comes to food, you might think that Kellogg’s cereals might have used better raw materials, or the process is cleaner, or you are willing to pay a little more for a brand that has been around for a long time (which makes you trust it). Same for petrol, you are not sure whether the petrol sold by the different companies are the same so you tend to stick to one brand because you might be afraid of ‘spoiling’ your car if you change. Petrol companies on their part will try to create and maintain that doubt in your mind by their advertising. When there is product differentiation, companies can occupy their own strata in the market (e.g. premium, low-cost), or be occupy their own individual sphere in the market. This allows for an equilibrium where all players can make money.]
    6. There are many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises.
  4. Nature of the Stock Market
    1. The stock market is like a pari-mutuel system at the race track. Everybody goes there and bets, and the odds change based on what’s bet. A clear good horse pays very little, and a bad horse pays high odds. Because of this, it is not clear which is the best bet.
    2. Charlie knew someone who made a substantial living doing nothing but bet harness races, and he would think about harness races and bet only occasionally when he saw some mispriced bet available.
    3. Work hard to look for a mispriced bet, bet big when the world gives you that opportunity. And the rest of the time, you don’t.
  5. Investment Style
    1. Sector rotation (e.g. oil, retail, etc.) may work, but he knows of no really rich sector rotator.
    2. Ben Graham’s bargains are hard to find now. Accounting nowadays is also not realistic – when the business starts to fail, significant assets will not be there (e.g. money owed to employees, health plans, pension plans, etc.)
    3. Most of Berkshire’s money has come from the great businesses (momentums implicit in their position, unusual managerial skill, etc.). Most of the people who have made a lot of money have done so in high-quality businesses.
      • Over the long term, it’s hard for a stock to earn a much better return that 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% return on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result. So the trick is getting into great companies.
      • Get into great companies by finding them when they are small.
      • In addition, sit-on-your-ass investing means you are paying less to brokers, and paying less taxes. The tax savings itself is equivalent to an extra 1-3% annually compounded. E.g. if you buy something that compounds at 15% per annum, hold for 30 years then pay 35% tax at the end, your returns after tax is 13.3% per annum. If you pay tax every year, you get only 9.75% per annum.
  6. The Right Structure for Investment Management
    1. Buffett and Munger do not have any clients who could fire them at Berkshire.
    2. That is why they can do their approach of finding a mispriced bet and loading up when they are very confident of being right, even though that could cause huge volatility and bad short-term results.
  7. Averaged out, betting on the quality of a business is better than betting on the quality of management.
  8. On-going

Talk Four: Practical Thought About Practical Thought (An Informal Talk, July 20, 1996)

  1. Five notions helpful in solving problems
    1. Decide big “no-brainer” questions first.
    2. Use math to sort out the messy, practical life.
    3. It is not enough to think problems through forward. Think also in reverse (i.e. invert the problem, think of what not to do, think of how things could fail).
    4. Think in a multidisciplinary manner using elementary academic wisdom.
    5. Really big effects (lollapalooza effects) will often come only from large combination of factors.
  2. On-going

Benjamin Franklin, Advice to a Young Man on the Choice of a Mistress (1745)

My dear Friend,

I know of no Medicine fit to diminish the violent natural Inclinations you mention; and if I did, I think I should not communicate it to you. Marriage is the proper Remedy. It is the most natural State of Man, and therefore the State in which you are most likely to find solid Happiness. Your Reasons against entering into it at present, appear to me not well-founded. The circumstantial Advantages you have in View by postponing it, are not only uncertain, but they are small in comparison with that of the Thing itself, the being married and settled. It is the Man and Woman united that make the compleat human Being. Separate, she wants his Force of Body and Strength of Reason; he, her Softness, Sensibility and acute Discernment. Together they are more likely to succeed in the World. A single Man has not nearly the Value he would have in that State of Union. He is an incomplete Animal. He resembles the odd Half of a Pair of Scissars. If you get a prudent healthy Wife, your Industry in your Profession, with her good Economy, will be a Fortune sufficient.

But if you will not take this Counsel, and persist in thinking a Commerce with the Sex inevitable, then I repeat my former Advice, that in all your Amours you should prefer old Women to young ones. You call this a Paradox, and demand my Reasons. They are these:

1. Because as they have more Knowledge of the World and their Minds are better stor’d with Observations, their Conversation is more improving and more lastingly agreable.

2. Because when Women cease to be handsome, they study to be good. To maintain their Influence over Men, they supply the Diminution of Beauty by an Augmentation of Utility. They learn to do a 1000 Services small and great, and are the most tender and useful of all Friends when you are sick. Thus they continue amiable. And hence there is hardly such a thing to be found as an old Woman who is not a good Woman.

3. Because there is no hazard of Children, which irregularly produc’d may be attended with much Inconvenience.

4. Because thro’ more Experience, they are more prudent and discreet in conducting an Intrigue to prevent Suspicion. The Commerce with them is therefore safer with regard to your Reputation. And with regard to theirs, if the Affair should happen to be known, considerate People might be rather inclin’d to excuse an old Woman who would kindly take care of a young Man, form his Manners by her good Counsels, and prevent his ruining his Health and Fortune among mercenary Prostitutes.

5. Because in every Animal that walks upright, the Deficiency of the Fluids that fill the Muscles appears first in the highest Part: The Face first grows lank and wrinkled; then the Neck; then the Breast and Arms; the lower Parts continuing to the last as plump as ever: So that covering all above with a Basket, and regarding2 only what is below the Girdle, it is impossible of two Women to know an old from a young one. And as in the dark all Cats are grey, the Pleasure of corporal Enjoyment with an old Woman is at least equal, and frequently superior, every Knack being by Practice capable of Improvement.

6. Because the Sin is less. The debauching a Virgin may be her Ruin, and make her for Life unhappy.

7. Because the Compunction is less. The having made a young Girl miserable may give you frequent bitter Reflections; none of which can attend the making an old Woman happy.

8thly and Lastly They are so grateful!!

Thus much for my Paradox. But still I advise you to marry directly; being sincerely

Your affectionate friend,

B. Franklin




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