Charlie Munger's 3 Categories of Investment: In, Out & Too Tough Investment Wisdom

30. DJCO 2016 – Annual Meeting – Part III – Lesson 7 – 12

Lesson 7-12: Software Business Is Like The Rest Of Capitalism

Question: What do you think about the attractiveness of the software business versus industrial franchises?

Answer: Software based businesses, some of them have become some of the most profitable businesses on earth.  Other software companies are failing and shrinking.  So it’s like the rest of capitalism.  It has its good spots and its bad spots.  And as I’ve said, the one we’re pursuing will be sticky if we succeed in it.

Question: Other competing businesses in the journal tech space are growing faster.  Why is that? And they seem to be selling for higher multiples.  Would you ever consider selling Daily Journal Technologies at a high multiple?

Answer: Well, nobody has offered us a high multiple.  It’s a peculiar part of the software business involving a lot of agony now for a payoff way later.  You can’t judge it as a normal business.  It’s venture capital.  It just happens to be located in a publicly traded company.  If venture capital works, it could gradually evolve into a pretty huge business.  But of course, everybody’s trying to evolve into a pretty huge business, and only a few succeed.  But we’re not like a normal software business.  And those little companies were not acquisitions like Berkshire Hathaway makes acquisitions, those were not established companies that were sure to succeed and relatively fool proof.  If we were going to make our venture capital type assault on this kind of peculiar part of the software market, we needed momentum from other sales forces and service operations and so forth.  So we just bought them.  But don’t judge those things by the standards of normal corporate acquisitions.  Those are part of venture capital.

Lesson 8: For CEO Compensation, We Just Try To Do Whatever Makes Sense Under The Circumstances.

Question: If you were to design CEO compensation for an insurance company or bank, how would you do that?

Answer: Well both Berkshire and the Daily Journal have our own way of doing things and we don’t follow anybody else’s.  We just try to do whatever makes sense under the circumstances.

Lesson 9: What’s The Trend? BYD is in a position, on purpose, to benefit from this electrification trend in the world. 

Question: What’s your expectations about BYD for the next 10 years?

Answer: Well, we allow questions on all subjects, and I suppose that one is a legitimate question.  BYD has 220,000 employees.  That is a big company.  That too was venture capital when we went into it.  That company has done amazing things.  The man who created that company was like the eighth son of a peasant.  He went to engineering school, got a PHD, and started off by borrowing $300,000 from the Bank of China.  And going into the small batteries for cell phones and so forth which was totally dominated by high-tech Japanese firms.  And he succeed in grabbing about a third of that market from a standing start of zero.  And he won the intellectual property rights of the litigation.  And that litigation happened in Japan.  He was a very remarkable man doing an almost insanely ambitious thing.  And out of that, he has 200 and some thousand employees and a huge lithium battery plant.  Last month he sold 10,000 electric cars in China which is more than Tesla sold.  And of course nobody’s hardly heard of BYD.

It’s an interesting company.  Berkshire doesn’t do this kind of venture Capital stuff.  And I hope the Daily Journal will work out half as well as I expect BYD to work out.

BYD is in a position, on purpose, to benefit from this electrification trend in the world.  It’s been very helpful to them that people are dying on the streets of Beijing because they can’t breathe the air.  They have to go to electric cars in Beijing.  And BYD is ahead in terms of efficient manufacturing.

They’re very well located.  That’s a very interesting venture capital investment.  Now was it an accident?  Sort of.  Berkshire departed from its standard methods and did that one.  I would say that I only wish our prospects were as good as BYD’s.  And by the way, they might be, but it’s not the way to bet.

Lesson 10: If You Have A Rich Uncle Willing To Sell You A Business at 10% of What It Is Worth, Don’t Talk About Discount Rate. Read On For Gems On Discount Rates

Question: When you value a company, what discount rate should we use?  Warren Buffett has used a risk free rate and sometimes makes some adjustments.  And I’ve read that you use an opportunity cost approach of your next best investment.  Which one of these are correct?

Answer: Well, they’re both correct.  Obviously it’s relevant what the return you get on a government bonds is.  That affects the value of other assets (in the general climate).  And obviously your opportunity cost  should govern your own investment decision making.  If you happen to have rich Uncle who will sell you a business for 10% of what it is worth, you don’t want to think about some other investment.  Your opportunity cost is so great that you forget about everything else.  And most people don’t pay enough attention to opportunity costs.

Bridge players know about opportunity costs.  Poker players know about opportunity costs.

Question: When you arrive at the valuation number using the discount rate, does that mean that between the two rates…

Answer: We don’t use numeric formulas that way.  We take into account a whole lot of factors.  It’s a multifactor thing and there’s a trade-off between factors, and it’s just like a bridge hand.  You have to think of a lot of different things at once.  There’s never going to be a formula that will make you rich just by going through some numerical process.  If that were true, every mathematical nerd that gets A’s in algebra would be rich. (laughter)  That’s not the way it works.

You’ve got to be comfortable thinking about a lot of different things at once, and correctly thinking about a lot of different things at once.  You don’t have a formula that will help you… and all that stuff is relevant.  Opportunity cost of course is crucial.  And of course the risk free rate is part of a factor that determines how attractive some common stock is.

Question: Do you use the same discount rate for different businesses.  For example, an IBM or a Coca-Cola?

The answer is, no, of course not.  Different businesses get different treatments.  They all are viewed in terms of value and you weigh one against another.  But of course we’ll pay more for a good business than a lousy one.

We don’t really want any lousy businesses anymore.  We use to make money by (buying) lousy businesses and kind of wringing money out of them.  That is a painful difficult way to make money if you’re already rich. (laughter) We don’t do much of it any more.  Sometimes we do it by accident because one of our businesses turns (on us)… and we deal with those businesses the best we can, but we’re not looking for new ones.

Lesson 11: Multiple Models, Many Different Models – That’s The Way Aha Aha.

Question: I have a mental models question for you.  You talk about these quick, cut to the chase, algorithms that you use, do you arrive at that fluency only after having gone through your entire mental model checklist over a long period of time?  Or is it simply a matter of, for example, knowing you’re looking at a social situation and so the psychology checklist might be appropriate.

Answer: Well, if you’re talking about multiple models, that means you’re thinking about many different models.  That’s the nature of reality particularly if you are an investor with a wide variety of human activities, and there’s no way to make that easy.

Look, you all are in the business, do you find it easy? (laughter) Anybody who finds it easy is wrong.  You’re living in a delusion.  It’s not easy.  You occasionally will get an easy one.  But not very many.  Mostly it’s hard.

How many people find it hard to make those investments right now?  (Most people raise their hands)  Yeah, yeah, it’s an intelligent group of people.  (laughter)  We collect them.

Lesson 12: Most of you are not going to get five opportunities to marry some wonderful person. So, If You Find The Right One, Go For It. The Same Goes For Investments.

Question: You talk about making an effort to reduce standard errors and doing so by not taking part in auction processes.  In terms of your daily habits or life habits, what you do that most people don’t, to reduce standard errors.

Answer: Well, there are two things Warren and I have done, and Rick Guerin has done too.  One is that we spend a lot of time thinking.  Our schedules are not that crowded.  And we’re constantly…We look like academics more than we do like businessmen.  So our system has been to sift life for a few opportunities and seize a few of them.  And we don’t mind long periods in which nothing happens.

And Warren is exactly the same way.  Warren’s sitting on top of an empire, and you go to his schedule sometimes and there’s a haircut! (laughter) “Oh, there’s a haircut today.”  That’s what created one of the most successful business records in history.  He has a lot of time to think.

And that brings me to the subject of multi-tasking.  All of you people have got very good at multi-tasking, and that would be fine if you were the chief nurse in a hospital, but as an investor, I think you’re on the wrong road.  Multi-tasking will not give you the highest quality of thought that man is capable of doing.  Juggling two or three balls at once where people come at you on their schedule, not yours, is not an ideal thinking environment.

But I do think that the constant search for wisdom, and the constant search for the right kind of temperamental reaction towards opportunity, I think that will never be obsolete.  And you can apply that to your personal life too.  Most of you are not going to get five opportunities to marry some wonderful person.  Heck, most of you aren’t going to get one.  (laughter) You’re just going to have to make do with an ordinary result.