Buffett & Munger | Learn From The Best
30 Key Ingredients In Their Recipe For Successful Investing
If investing wisdom could be bottled, these two gentlemen would sell more than Coca Cola! Unfortunately we can’t bottle it, but they have been generous over the years and shared their recipe for success.
I identify the 32 key ingredients for you and I have set it out thematically which is far more useful.
In amongst the themes, I have included pearls of wisdom in the form of quotes made by either Charlie Munger (died at 99) or Warren Buffett (aged 94). That’s nearly two centuries worth of accumulated knowledge. Some of the quotations on the same topic, but perhaps made several years apart, have been concatenated where they reinforce each other.
I have also included quotes from John Maynard Keynes to demonstrate that none of these ideas are new, most pre-date Berkshire Hathaway. Munger and Buffett are merely expert at applying them.
If these ideas have stood the test of time for 100 years, they will undoubtedly serve you well in the years to come.
Enjoy!
Circle of Competence: To a man with a hammer, everything looks like a nail. But different businesses require a different tool set and so know your strengths. You don’t have to be an expert on every company, or even very many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
“Never invest in a business you cannot understand. Risk comes from not knowing what you are doing. There is nothing wrong with a ‘know nothing’ investor who realizes it. The problem is when you are a ‘know nothing’ investor but you think you know something.”
Invert, Always Invert: Most investors are myopic and see an investment only through the lens of what the upside looks like with little or no consideration given to the possible downside. Formulate an investment strategy based around what might go wrong. Ask yourself, “If I wanted to lose money, what would I have to do?” and then, through that lens, it is easy to avoid doing those things.
Use Screeners Wisely: On the subject of inverting, most people try to find wonderful companies by screening for winners based on arbitrary metrics that they believe are indicative of success. The better approach is to invert, filter out companies that do not meet your requirements. Remove companies outside of your circle of competence. Remove companies with poor management track record. Remove companies with poor balance sheets. Remove companies in declining industries. And so on and so forth. You will be surprised how few companies there are left to invest in. That’s how you find your winners.
Margin of Safety: Leave room for error. This means, don’t try to drive a 9,800 pound truck over a bridge that says it’s capacity is 10,000 pounds. Go down the road and find one that says, capacity 15,000 pounds. Invest the same way. If you find a business that trades for less than intrinsic value, that is your margin of safety. Don’t be down on a business just because the market is down on its share price.
“If a business does well, the stock eventually follows.”
The Law of Large Numbers: A company with a single customer can double in size with only one more. It isn’t so easy to double if you are a company that already has millions of customers. Invest in a business with a long road ahead rather than looking in your rear view mirror at the road already traveled.
“In the business world, the rear-view mirror is always clearer than the windshield but the investor of today does not profit from yesterday’s growth. If past history was all that is needed to play the game of money, the richest people would be librarians.”
Read: Many great business people and investors came before us and the knowledge that they accumulated over a lifetime is often preserved in books. Choose the right role models.
“Spend each day trying to be a little wiser than you were when you woke up. The man who doesn’t read good books has no advantage over the man who can't read them. What we learn from history is that most people don’t learn from history. Tell me who your heroes are and I’ll tell you who you’ll turn out to be. ”
Be Patient: Wait for the right opportunity to materialize. Don’t invest for the sake of investing. A sometimes-forgotten advantage that favors long-term investors is that over time the weeds wither away and the flowers bloom. Most amateur investors do it the wrong way around: their winners go up 25% and they cash in a small profit while holding on to the losers hoping that they will recover. That’s like watering the weeds and cutting out the flowers. You want to let the winners run. Let your winners pay for your losers. Don't sell your winners to double down on losers. It takes just a few winners to work wonders, but this too requires patience.
“An investor should act as though he had a lifetime decision card with just twenty punches on it. You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing. Successful investing requires discipline, patience, and a long-term perspective. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”
Swing Hard: The best hitters in baseball history waited for good pitches. The rest of the time they don't swing at all. So, having been patient, wise people bet heavily when the world offers them a great opportunity. They bet big when they have the odds in their favour (See Lou Simpson case study). You don't need to buy every company. Instead, wait for the right opportunity to come along.
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble. Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
As time goes on, I get more and more convinced that the right method in investments is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitles to put full confidence” John Maynard Keynes
Don’t Be Married To An Idea:
It's okay to change your mind. If an investment isn’t working out, the first cut is often the cheapest.
“The most important thing to do if you find yourself in a hole is to stop digging. Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. It's not the strongest species that survive, nor the most intelligent, but the ones most responsive to change.”
“When my information changes, I alter my conclusions. What do you do, sir?” John Maynard Keynes
Some Mistakes Are Better Than Others: Not every investment decision will be a good one. Everyone makes mistakes. Err on the side of caution because a mistake that sees you not invest in a company that subsequently turns out to be wonderful (Amazon was always a regret for Buffett and Munger), is far better than a mistake that sees you invest in a company that crashes and burns. The former will cost you nothing but regret, the latter will result in a substantial loss of capital.
“Rule #1: Never lose money. Rule #2: Never forget Rule #1. In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. Remember our escapes from near-disasters at USAir and Salomon? I certainly do.”
Opportunity Cost: The decision to do x is a decision not to do y.
“Investing $1,000 in Apple is the decision not to invest that $1,000 in Microsoft. Investing is not just about finding good companies, it is about finding the best place to put your money.”
Invest, Don’t Speculate: Half of all coin-flippers will win their first toss; none of those winners has any expectation of profit if he continues to play the game. Invest because you believe that the fundamentals of a business are sound, not because the stock is fashionable and you believe that the buying activity of others will push the share price higher. In recent years we have invented the concept of a meme-stock; that is a share that is generating social media attention to the point that each wave of new investors fuels the gains of the previous wave. People then suffer from confirmation bias which pushes the price still higher. This is no different to the way in which a Ponzi scheme works. It is a recipe for disaster because you are building a house on sand and it will eventually topple over.
“I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It's not brilliance. It's just avoiding stupidity.”
“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choices most nearly correspond to those most preferred by the competitors as a whole. So each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third derivative where we devote our intelligence to anticipating what average opinion expects the average opinion to be.”
The Keynsian Beauty Contest, John Maynard Keynes
Independent Thinking: Think for yourself. Don’t just go along with the crowd. The stock investor is neither right nor wrong because others agree or disagree with him.
“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well. Beware the investment activity that produces applause; the greatest opportunities are usually greeted by yawns. When promised quick profits, respond with a quick NO. Speculation is most dangerous when it looks easiest. The most dangerous words in business are: Everybody else is doing it.”
“The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive” John Maynard Keynes
Simplicity: In investing you aren't rewarded just for making more complex investments. Keep it simple. The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective. There seems to be some perverse human characteristic that likes to make easy things difficult.
After many years of buying and supervising a great variety of businesses, I have not learned how to solve difficult business problems. I have learned to avoid them. It is not necessary to do extraordinary things to get extraordinary results. I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
Certainty: One factor often overlooked in evaluating an investment is how much conviction one has in the probability of success or certainty of a favourable outcome. The benchmark should always be something about which you are already relatively certain. If you only invest in something which provides a greater degree of certainty than that which you already possess, then this results in an incremental march where you will tend towards absolute certainty. This reduces your risk and will improve your aggregate returns.
“If somebody shows us a business, the first thing that goes through our head is would we rather own this business than more Coca-Cola? Would we rather own it than more Gillette? It’s crazy not to compare it to things that you’re very certain of. There are very few businesses that we’ll find where we’re as certain about the future as we are at companies such as those. And therefore, we will want companies where the certainty gets close to that. And then we’ll want to figure that we’re better off than just buying more of those. If every management, before they bought a business in some unrelated deal that they might not have even heard of a short time before it was being promoted to them, if they said, ‘Is this better than buying in our own stock? Is this better than buying Coca-Cola stock or something’, there’ would be a lot fewer deals done. But they tend not to measure it against what we regard as close to perfection as we can get… You simply look around for the thing that you feel the surest about, and that promises the greatest return weighted for that certainty.”
Second Order Thinking: Just because electric vehicles are fashionable does not mean that investing in an EV manufacturer is a good idea. It may be better to invest in a battery manufacturer or a business providing charging infrastructure for example. American Express has made more money out of the airline industry than any airline has ever made! Think outside the box.
The Multiplicative Effect: When there are multiple growth drivers in play, they don’t add together, they multiply. It isn’t a question of 3+3=6, it’s 3x3=9. The more tailwinds a business has behind it, the better. Conversely, headwinds can have the opposite effect. A business capitalized at an eye watering multiple of sales or earnings will find this acting as a drag on shareholder returns for many years (see Microsoft case study).
Manage Expectations and Control Your Emotions: Unrealistic expectations drive poor decisions. If you expect every stock to double within a year you’ll be disappointed and perhaps sell too early or transact too frequently. Investing is all about having the correct temperament. It isn’t something that can be learned, you either have it or you don’t. Most people don’t which is why most people achieve mediocre investment results.
“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ. Success in investing doesn’t correlate with IQ … what you need is the temperament to control the urges that get other people into trouble in investing. The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”
Its About The Woods, Not individual Trees: Focus on the big picture. Day to day fluctuations are meaningless, so too are weekly, monthly, quarterly or any short term numbers.
“Do not take yearly results too seriously. Instead, focus on four or five-year averages.”
“Day to day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even absurd, influence on the market. Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market. Most people are concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.” John Maynard Keynes
Price Matters: The right stock at too high a price makes for a poor investment. However, just because it looks cheap doesn’t make it a good investment either. Don’t fall into a value trap. Price is what you pay, value is what you get. They should never be confused. You are looking for value.
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments. The only thing that matters in investing is determining the intrinsic value of a business and paying a fair price. It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price. ”
Watch For Bear Traps: Don’t buy simply because the price has dipped from a historically higher level. Just because it was there once before doesn’t mean it will get back there again. Don’t be guided by price action.
“A stock that is down 90% was a stock that had fallen 80% and then halved again! The market is there to serve you, not to instruct you.”
A Poor Business is usually a Poor Investment: A business with poor fundamentals is unlikely to be capable of being turned around and becoming a favourable investment.
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Look for Moats: A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company being the low cost producter (GEICO, Costco) or possessing a powerful world-wide brand (Coca Cola, Gilette, American Express) is essential for sustained success.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The best businesses are the ones that can deliver high quality goods or services at a very low cost."
“Basically, the single most important decision in evaluating a business is pricing power. If you have the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price a tenth of a cent, you have a terrible business. I’ve been in both and I know the difference.”
Look for Fortresses: A solid company is financially secure. Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Revenue is great, but cash is the lifeblood of any business and too much debt is a ticking time-bomb. Sooner or later the economy will hit a bump in the road and those with too much debt are usually the first to fall.
“Only when the tide goes out do you discover who’s been swimming naked.”
Market Declines Create Opportunities: If you expect to be a net investor over the medium to long term, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise.
“Long term investors ought to rejoice when markets decline. It allows them to deploy funds more advantageously. So smile when you read a headline that says 'INVESTORS LOSE AS MARKET FALLS'. Edit this in your mind to 'Disinvestors lose as market falls, but investors gain.' Journalists often forget this truism: there is a buyer for every seller and what hurts one necessarily helps the other.
Market declines don’t bother me. Indeed, I enjoy such price declines if I have funds available to increase positions. Remember that the stock market is a manic depressive. The most common cause of low prices is pessimism; sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that's the enemy of the rational buyer. The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Beware Of Other People’s Numbers: Consider incentives. Brokers are incentivized to encourage you to buy and sell stocks. Managers are incentivized to inflate the stock price. Always consider the incentives that drive people. Look beneath the surface.
“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
Ensure Interests Are Aligned: Unless the interests of shareholders and the interests of shareholders are properly aligned, one side will emerge disappointed and it is rarely the management that loses. Many managers suggest that egregious stock based compensation and over-priced stock repurchases to offset dilution is being done to align interests: It’s not. It is being done to enrich the managers at the expense of the shareholders. If the senior management are not investing in the company that they manage with their own money, then why should you?
“Invest with people who are eating their own cooking. There are many Berkshire Hathaway centimillionaires and, yes, billionaires who have never studied our financial figures. They simply know that Charlie and I – along with our families and close friends – continue to have very significant investments in Berkshire, and they trust us to treat their money as we do our own. And that is a promise we can make... We will have a significant part of our net worth in Berkshire shares, bought with our own money.”
Capital Allocation Is Key: A dollar of retained earnings reinvested at an accretive rate of return is worth far more to an investor than the payment of a dividend paid out of taxed corporate earnings, taxed a second time as income and then subject to frictional transaction costs of reinvestment. Dividends are a last resort mechanism for returning capital to shareholders where there are no opportunties available to the CEO to allocate that capital elsewhere for the benefit of shareholders. Organic growth, acquisitive growth, creating a war-chest for future investment, repayment of debt and accretive stock buy-backs (see Henry Singleton case study) should all be considered first. In its 60 year history Berkshire Hathaway only paid a dividend once before realizing that it had been a foolish decision. The dividend was ten cents per share on 3rd January 1967, a mere 0.54% yield on the then $17.87 stock price. The company paid a total of $101,755 in dividend payments on that day. It may surprise you to learn that had Berkshire not paid that solitary dividend but instead retained the earnings and reinvested the money back in the business it would be worth well over $3 billion today! (See Nifty 50 vs Berkshire at the bottom of this article).
“Our shareholders will continue to save and prosper by us retaining earnings and compounding growth on gross pre-tax dollars.”
Opportunity Cost Analysis: To buy one stock is to forfeit the opportunity to have capital allocated to something else.
“I would argue one filter that’s useful in investing is the simple idea of opportunity costs. If you have one opportunity available in large quantity, and you like it better than 98% of the other things you see, you can screen out the other 98% because you already know something better… People who have very good opportunities, using the concept of opportunity costs, can make better decisions about what to buy. With this attitude, you get a concentrated portfolio, which we don’t mind. That practice of ours, which is so simple, is not widely copied. I do not know why…”
Compounding: If you doubled a penny every day for 30 days, the amount on day 30 would be $5,368,709.12. Every time you transact, you incur the friction of transaction costs and usually a tax liability. These are a loss of capital and act as a bleed on your returns, reducing both the amount that you have to reinvest and the rate at which it compounds. “Buy a stock the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market. I never attempt to make money on the stock market. I buy on the assumption that they'd close the market the next day and not reopen it for 10 years. If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.
“All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies. Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic. The stock market transfers money from the active to the patient. Our favorite holding period is forever. Time is the friend of the wonderful company, the enemy of the mediocre. The first rule of compounding: Never interrupt it unnecessarily."
“If farming were to be organised like the stock market, a farmer would sell his farm in the morning when it was raining, only to buy it back in the afternoon when the sun came out.” John Maynard Keynes
Believe In Yourself: Have confidence in your own ability as an active investor or else don’t do it. You will not understand everything and should not be distracted by macro economic influences which wax and wane over time. A good company is a good company and it will stand the test of time. Be prepared to do the leg work of detailed research, due diligence and analytics.
“If you're not willing to act on your beliefs, then they are just opinions and not worth much. If you're not a little confused by what's going on, you're not paying attention.”
