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- Remembering Charlie Munger
Dear Investors,
Charlie Munger passed away this week.
We remember him by sharing a few ideas that we learned from him.
Warren Buffett, 93 (left) & Charlie Munger, 99 (right)
This week Charlie Munger passed away at the age of 99. He was the vice-chairman of Berkshire Hathaway and business partner to Warren Buffett for 60 years. He is credited for moving Warren’s investment style away from cigar-butt investing.
When Warren first started out, he would buy companies that were in trouble and selling for less than what they were worth. He reasoned that they had a puff or two left in them, like a discarded cigar-butt found on the street.
Charlie Munger changed Warren’s thinking toward paying more and buying better quality companies. In the 1989 letter to shareholders, Warren said:
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.”
That was the first time, the famous quote was used, but the idea had been percolating for a while. In the 1981 shareholder’s letter Warren talked about preferring to own a small part of a wonderful business for its economic benefits, rather than controlling a business to report its account numbers. Clearly, the idea of wonderful businesses had already found its way to his mind.
Thought experiment
Let’s do a little thought experiment to see how these ideas play out in investing.
Imagine that the entire stock market consisted of two companies, Average and Extraordinary. The only difference between these companies was that the earnings at Extraordinary grew faster than those at Average.
Now let’s assume that the market always wants to keep the price-to-earnings ratio equal on these two companies.
PE ratio = share price / earnings per share
On day 1, both companies have the same PE ratio. A year later, both these companies have increased their earnings, but Extraordinary has increased its earnings more than Average.
What must happen?
Well, to keep the PE ratio the same, the price has to increase. But the price of Extraordinary has to go up more than the price of Average.
Over time, what we see is that if the market assigns the same PE ratio to both companies, the price of Extraordinary company must increase at a faster pace than the price of Average company. In other words, Extraordinary must deliver a better return than Average.
But as Charlie Munger always said “invert, always invert”.
Let’s invert the situation. The market does not rate all companies the same. So let’s imagine things backward. If we wanted Extraordinary and Average to give us the same return over time, how could we get that?
Simple, to get the same return over time, the starting price of Extraordinary would have to be higher than the starting price of Average. If the price were high enough, both companies would give exactly the same return. In this case, Extraordinary’s starting PE ratio would be higher than Average’s - it would be more expensive.
Here’s the key point - there exists a price at which even an extraordinary company gives you average returns. If you pay more than that price, you get substandard returns. If you pay less, you get superior returns. So the maximum price you would ever want to pay for an extraordinary company is the price at which its returns become equal to the average.
Guess what? Now you have a valuation framework. You know the following:
Extraordinary companies that can maintain their competitive advantage, will outperform average companies.
But the market rates these companies higher and assigns higher prices to them. That does not automatically make them too expensive. You have to judge their “expensiveness” in relation to the return that you can achieve from them over time.
In other words, it’s okay to pay more for a better quality business, but you can’t pay any price.
Assessing these three points is the job of every investor. You have to make judgements about an unknown future to determine where that maximum price is for a company. If you can buy the shares for less than that maximum price, you will earn superior returns.
This is easier said than done, but it is how we try to think about investing in extraordinary companies.
Final thoughts
Like many others, we stand on the shoulders of giants like Charlie Munger who figured out these ideas. They were unconventional at the time. But he was intellectually generous and shared these ideas with the World. Many of us are better off for it.
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