Mental Models #1 | Art of Stock Picking

Rule One: You need a latticework of mental models in your head

This article is the first in a series that I shall publish focusing on what the great Charlie Mungers called ‘mental models’:

• Mental Models #1 - The need for a lattice of mental models, Charlie Munger

• Mental Models #2 - Commercial democratization as a mental model

• Mental Models #3 - Incrementally better isn’t enough, be fundamentally different

• Mental Models #4 - Ideas have no value

• Mental Models #5 - coming soon

• Mental Models #6 - coming soon

There are more to follow in the weeks ahead. Don’t miss them, sign up and we’ll send them directly into your inbox:

The starting point for this journey has to be his speech given in 1994 to students at The University of Southern California. Here he introduces the concept of mental models so articulately.

The Art of Stock Picking Speech (abridged)

The subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom.

“You've got to hang experience on a latticework of models in your head.”

Charlie Munger

Before you're going to be a great stock picker, you need some general education. So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you through a few basic notions.

The first rule is that you can't really know anything if you just remember isolated facts. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to hang experience on a latticework of models in your head.

Models

The first rule is that you've got to have multiple models because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does. It's like the old saying, "To the man with only a hammer, every problem looks like a nail." That's a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.

The models have to come from multiple disciplines because all the wisdom of the world is not to be found in one little academic department. So you've got to have models across a fair array of disciplines.

So let's briefly review what kind of models and techniques constitute this basic knowledge that everybody has to have before they proceed to being really good at a narrow art like stock picking.

First there's mathematics. Obviously, you've got to be able to handle numbers and basic arithmetic. The useful model, after compound interest, is the elementary math of permutations and combinations - very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters. It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.

The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat / Pascal. It uses a very crude, shortcut type of approximation. So you have to learn in a very usable way this very elementary math and use it routinely in life - just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer. If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else.

Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention. And it's not that hard to understand. But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of [an asset]. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.

In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries - which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art. And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, "This is asinine." So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process. "And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.

He had another rule, from psychology, which, if you're interested in wisdom, ought to be part of your repertoire. His rule for all the Braun Company's communications was called the five W's - you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it twice.

You might ask why that is so important? Well, if you always tell people why, they'll understand it better, they'll consider it more important, and they'll be more likely to comply. Even if it's obvious, it's wise to stick in the why.

Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. Now we come to another somewhat less reliable form of human wisdom microeconomics. And here, I find it quite useful to think of a free market economy or partly free market economy as sort of the equivalent of an ecosystem. Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world - and get very good because they specialize frequently find good economics that they wouldn't get any other way. And once we get into microeconomics, we get into the concept of advantages of scale.

Now we're getting closer to investment analysis because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important. For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently. Advantages of scale allow greater specialization within the firm. Therefore, each person can be better at what he does. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, "To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #I or #2 or out." That was a very tough-minded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth.

As you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality - which is again grounded in human nature. And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else's in-basket. But, of course, it isn't. It's not done until AT&T delivers what it's supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies. They also tend to become somewhat corrupt. In other words, if I've got a department and you've got a department and we kind of share power running this thing, there's sort of an unwritten rule: "If you won't bother me, I won't bother you and we're both happy. "So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They're too slow to make decisions and nimbler people run circles around them. The constant curse of scale is that it leads to big, dumb bureaucracy.

And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who'd come up by some career path - I don't know exactly what it was, but it could have been refrigerators or something - and all of a sudden, he's loaning money to real estate developers building hotels. And in due time, they lost all those billions of dollars.

CBS provides an interesting example of another rule of psychology namely, Pavlovian association. If people tell you what you really don't want to hear what's unpleasant there's an almost automatic reaction of antipathy. Television was dominated by one network - CBS in its early days. And Paley was a god. But he didn't like to hear what he didn't like to hear. And people soon learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt although it was a great business. So the idiocy that crept into the system was carried along by this huge tide. It was a Mad Hatter's tea party the last ten years under Bill Paley. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss.

On the subject of advantages of economies of scale, I find chain stores quite interesting. A chain store can be a fantastic enterprise. It's quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart - and he did it with more fanaticism and better employee manipulation. So he just blew right by them all. Sears had layers and layers of people it didn't need. It was very bureaucratic. It was slow to think. And there was an established way of thinking. If you poked your head up with a new thought, the system kind of turned against you. It was everything in the way of a dysfunctional big bureaucracy that you would expect. In all fairness, there was also much that was good about it. But it just wasn't as lean and mean and shrewd and effective as Sam Walton. And, in due time, all its advantages of scale were not enough to prevent Sears from losing heavily to Wal-Mart and other similar retailers.

Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well. Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth. If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure. Yet, in other fields like cereals, for example almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it. Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it. And maybe the cereal makers by and large have learned to be less crazy about fighting for market share - because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it. In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.

For example, if you look around at bottler markets, you'll find 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. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening.

The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does. For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones." And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it. What was he thinking? He was thinking, "It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business." And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners. That's such an obvious concept - that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers.

Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line. It's such a simple idea. It's so basic. And yet it's so often forgotten

Then there's another model from microeconomics which I find very interesting. When technology moves as fast as it does in a civilization like ours, and when you're an early bird, there's a model that I call "surfing" - when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows.... But people get long runs when they're right on the edge of the wave - whether it's Microsoft or Intel or all kinds of people, including National Cash Register in the early days.

The cash register was one of the great contributions to civilization. It's a wonderful story. Patterson was a small retail merchant who didn't make any money. One day, somebody sold him a crude cash register which he put into his retail operation. And it instantly changed from losing money to earning a profit because it made it so much harder for the employees to steal.... But Patterson, having the kind of mind that he did, didn't think, "Oh, good for my retail business." He thought, "I'm going into the cash register business. "And, of course, he created National Cash Register. And he "surfed". He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic about everything important as the technology developed. I have in my files an early National Cash Register Company report in which Patterson described his methods and objectives. And a well-educated orangutan could see that buying into partnership with Patterson in those early days, given his notions about the cash register business, was a total 100% cinch. And, of course, that's exactly what an investor should be looking for. In a long life, you can expect to profit heavily from at least a few of those opportunities if you develop the wisdom and will to seize them.

Berkshire Hathaway, by and large, does not invest in people that are "surfing" on complicated technology. Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies. Again, that is a very, very powerful idea. Every person is going to have a circle of competence. If you play games where other people have the aptitudes and you don't, you're going to lose. And that's as close to certain as any prediction that you can make. You have to figure out where you've got an edge. And you've got to play within your own circle of competence. If you want to be the best tennis player in the world, you may start out trying and soon find out that it's hopeless - that other people blow right by you. However, people who could never win a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence - which results partly from what they were born with and partly from what they slowly develop through work. So some edges can be acquired.

Stock picking

I don't want to get into emerging markets, bond arbitrage and so forth. I'm talking about nothing but plain vanilla stock picking. That, believe me, is complicated enough. And I'm talking about common stock picking.

The first question is, "What is the nature of the stock market?" It's rather interesting because one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy. The efficient market theory is obviously roughly right. Indeed, the average result has to be the average result. By definition, everybody can't beat the market. As I always say, the iron rule of life is that only 20% of the people can be in the top fifth. That's just the way it is. So the answer is that it's partly efficient and partly inefficient. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality. Again, to the man with a hammer, every problem looks like a nail. If you're good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?

The model I like to sort of simplify the notion of what goes on in a market for common stocks is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate is way more likely to win than a horse with a terrible record and extra weight and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system. And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.

Intelligence should give some edge, because lots of people who don't know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take. Unfortunately, what a shrewd horseplayer's edge does in most cases is to reduce his average loss over a season of betting.

The stock market is the same way except that the house handle is so much lower. If you take transaction costs - the spread between the bid and the ask plus the commissions and if you don't trade too actively, you're talking about fairly low transaction costs. In a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner - in a relative sense - instead of a loser? They bet big when they have the odds. And the rest of the time, they don't. It's just that simple. That is a very simple concept. Yet, in investment management, practically nobody operates that way. We operate that way - I'm talking about Buffett and Munger. And we're not alone in the world. But a huge majority of people have some other crazy construct in their heads. Instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time. How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. You're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple. When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all." He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better." To me, it's obvious that the winner has to bet very selectively. It's been obvious to me since very early in life. I don't know why it's not obvious to very many other people.

I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, "My God, they're purple and green. Do fish really take these lures?" And he said, "Mister, I don't sell to fish." Investment managers are in the position of that fishing tackle salesman. But that isn't what ordinarily works for the buyer of investment advice. If you invested Berkshire Hathaway-style, it would be hard to get paid as an investment manager as well as they're currently paid - because you'd be holding a block of Wal-Mart and a block of Coca-Cola and a block of something else. You'd just sit there. And the client would be getting rich. And, after a while, the client would think, "Why am I paying this guy half a percent a year on my wonderful passive holdings?" So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker.

From all business, my favorite case on incentives is Federal Express. The heart and soul of their system which creates the integrity of the product is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. And it was always screwed up. They could never get it done on time. They tried everything moral suasion, threats, you name it. And nothing worked. Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift and when it's all done, they can all go home. Well, their problems cleared up overnight. So getting the incentives right is a very, very important lesson. It was not obvious to Federal Express what the solution was. But maybe now, it will hereafter more often be obvious to you.

In the stock market, some railroad that's beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn't so clear anymore what was going to work best for a buyer choosing between the stocks. So it's a lot like a pari-mutuel system. And, therefore, it gets very hard to beat. What style should the investor use as a picker of common stocks in order to try to beat the market - in other words, to get an above average long-term result?

A standard technique that appeals to a lot of people is called "sector rotation". You simply figure out when oils are going to outperform retailers, etc. You just kind of flit around being in the hot sector of the market making better choices than other people. And presumably, over a long period of time, you get ahead. However, I know of no really rich sector rotator. Maybe some people can do it. I'm not saying they can't. All I know is that all the people I know who got rich and I know a lot of them did not do it that way.

The second basic approach is the one that Ben Graham used much admired by Warren and me. As one factor, Graham had this concept of value to a private owner what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety - as he put it - by having this big excess value going for you. But he was, by and large, operating when the world was in shell shock from the 1930s - which was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the owners' pockets. That was the way capitalism then worked.

Nowadays, of course, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of the civilization, so much is owed to the employees that, the minute the enterprise goes into reverse, some of the assets on the balance sheet aren't there anymore. Now, that might not be true if you run a little auto dealership yourself. You may be able to run it in such a way that there's no health plan and this and that so that if the business gets lousy, you can take your working capital and go home. But IBM can't, or at least didn't. Just look at what disappeared from its balance sheet when it decided that it had to change size both because the world had changed technologically and because its market position had deteriorated. And in terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after "surfing" successfully for 60 years.

At any rate, the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn't click. But such is the nature of people who have a hammer - to whom, as I mentioned, every problem looks like a nail that the Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well.

So the Ben Graham intellectual system was a very good one. Of course, the best part of it all was his concept of "Mr. Market". Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, "I'll sell you some of my interest for way less than you think it's worth." And other days, "Mr. Market" comes by and says, "I'll buy your interest at a price that's way higher than you think it's worth. "And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it's been very useful to Buffett, for instance, over his whole adult lifetime.

However, if we'd stayed with classic Graham the way Ben Graham did it, we would never have had the record we have. And that's because Graham wasn't trying to do what we did. For example, Graham didn't want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn't feel that the man in the street could run around and talk to managements and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Therefore, it was very difficult. And that is still true, of course human nature being what it is.

So having started out as Grahamites which, by the way, worked fine we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. And, by the way, the bulk of the billions in Berkshire Hathaway have come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses. And even some of the early money was made by being temporarily present in great businesses. Buffett Partnership, for example, owned American Express and Disney when they got pounded down.

Most investment managers are in a game where the clients expect them to know a lot about a lot of things. We didn't have any clients who could fire us at Berkshire Hathaway. So we didn't have to be governed by any such construct. And we came to this notion of finding a mispriced bet and loading up when we were very confident that we were right. So we're way less diversified. And I think our system is miles better.

However, in all fairness, I don't think a lot of money managers could successfully sell their services if they used our system. Investment managers would say, "We have to be that way. That's how we're measured." And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system's "bonkers" and draws a lot of talented people into socially useless activity.

The Berkshire system is not "bonkers". It's so damned elementary that even bright people are going to have limited, really valuable insights in a very competitive world when they're fighting against other very bright, hardworking people. And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times.

The big money's been made in the high quality businesses. And most of the other people who've 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 than 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% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result. So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.

How do you get into these great companies?

One method is what I'd call the method of finding them small get 'em when they're little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it's a very beguiling idea. If I were a young man, I might actually go into it. But it doesn't work for Berkshire Hathaway anymore because we've got too much money. We can't find anything that fits our size parameter that way. Besides, we're set in our ways. But I regard finding them small as a perfectly intelligent approach for somebody to try with discipline. It's just not something that I've done.

Finding 'em big obviously is very hard because of the competition. So far, Berkshire's managed to do it. But can we continue to do it? What's the next Coca-Cola investment for us? Well, the answer to that is I don't know. I think it gets harder for us all the time. And ideally and we've done a lot of this you get into a great business which also has a great manager because management matters. So you do get an occasional opportunity to get into a wonderful business that's being run by a wonderful manager.

If you don't load up when you get those opportunities, it's a big mistake. Occasionally, you'll find a human being who's so talented that he can do things that ordinary skilled mortals can't. I would argue that Simon Marks who was second generation in Marks & Spencer of England was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man. These people do come along and in many cases, they're not all that hard to identify.

However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely. you find a manager who's so good that you're wise to follow him into what looks like a mediocre business.

Another very simple effect I very seldom see discussed, either by investment managers or anybody else, is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% capital gains tax at the very end of the holding period, the way that works out is that after taxes you’ve generated a compound annual growth rate of 13.3%. In contrast, if you generated the same 15% annual return by exiting one position and entering another every year, then the tax liability would accrue annually and a 35% haircut on a 15% return results in a net 9.75% compound growth rate. So the difference there is over 3.5%, and what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that taxes work.

Occasionally, you'll be wrong if you adopt "Munger's Rule". However, over a lifetime, you'll be a long way ahead - and you will miss a lot of unhappy experiences that might otherwise reduce your love for your fellow man. There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded. And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf'? Lots of luck.

Are there any dangers in this philosophy? Yes. Everything in life has dangers. Since it's so obvious that investing in great companies works, it gets horribly overdone from time to time. In the "Nifty-Fifty" days, everybody could tell which companies were the great ones. So they got up to 50, 60 and 70 times earnings. And just as IBM fell off the wave, other companies did, too. Thus, a large investment disaster resulted from too high prices. And you've got to be aware of that danger. So there are risks. Nothing is automatic and easy. But if you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed.

Within the growth stock model, there's a sub-position: There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer. That existed in Disney. It's such a unique experience to take your grandchild to Disneyland. You're not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies.

At Berkshire Hathaway, Warren and I raised the prices of See's Candy a little faster than others might have. And, of course, we invested in Coca-Cola - which had some untapped pricing power. It was perfect. You will get a few opportunities to profit from finding underpricing.

If you look at Berkshire's investments where a lot of the money's been made and you look for the models, you can see that we twice bought into two newspaper towns which have since become one newspaper towns. So we made a bet to some extent. In one of those, The Washington Post, we bought it at about 20% of the value to a private owner. So we bought it on a Ben Graham style basis at one fifth of obvious value and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They're very high class people - the Katharine Graham family. That's why it was a dream an absolute, damn dream. Of course, that came about back in '73 - 74. And that was almost like 1932. That was probably a once in-40-years type denouement in the markets. That investment's up about 50 times over our cost. If I were you, I wouldn't count on getting any investment in your lifetime quite as good as The Washington Post was in '73 and '74.

But it doesn't have to be that good to take care of you. Let me mention another model. Of course, Gillette and Coke make fairly low-priced items and have a tremendous marketing advantage all over the world. And in Gillette's case, they keep surfing along new technology which is fairly simple by the standards of microchips. But it's hard for competitors to do. So they've been able to stay constantly near the edge of improvements in shaving. There are whole countries where Gillette has more than 90% of the shaving market.

GEICO is a very interesting model. It's another one of the 100 or so models you ought to have in your head. I've had many friends in fix up game over a long lifetime. And they practically all use the following formula - I call it the cancer surgery formula: They figure out if there' s anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn't work, they liquidate the business. But it frequently does work. And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses. All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated over and over again. And, in GEICO's case, it was a wonderful business combined with a bunch of foolishness that could easily be cut out. That is a model you want to look for. And you may find one or two or three in a long lifetime that are very good. And you may find 20 or 30 that are good enough to be quite useful.

Finally, I'd like to once again talk about investment management. That is a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That's the way it has to work. Of course, that isn't true of plumbing and it isn't true of medicine. If you're going to make your careers in the investment management business, you face a very peculiar situation. And most investment managers handle it with psychological denial. That is the standard method of handling the limitations of the investment management process. But if you want to live the best sort of life, I would urge each of you not to use the psychological denial mode.