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

38. Berkshire Annual Meeting 2005: Final Part III: Points 17-27 for Wisdom & Fun (of Learning)

Wisdom & Fun 17.  No Need For Perfect Wisdom: Just a bit better than average over a long period of time.

Avoiding Mental Mistakes

The first step is to recognize the traps. Charlie, in Poor Charlie’s Almanack, talks about various traps, so read that book.

Our personalities are such that we’re probably less prone to falling into these traps, but it still happens – just less than before.

Munger: You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.

-15-

Buffett: It reminds me of the story about the two guys being chased by the bear and one guy says to the other, “I don’t have to outrun the bear. I just have to outrun you!” (Laughter)

Poor Charlie’s Almanack

Munger: Peter Kaufman did it. He came up with the idea and Warren got excited about it. It’s a ridiculous name [the title]. (Laughter)

If you assimilate everything that’s in that simple book, you’ll be far ahead in the game.

Wisdom & Fun 18.  If You Want To  learn a whole lot about life and making money: Rad Poor Charlie’s Almanack

Buffett: It’s a sensational book. You’ll learn a whole lot about life – and making money.

Learning to be a Good Investor

When I was seven years old, I first took an interest in stocks. My dad was in the business, so I’d go with him to the office and I saw interesting things. [When I was a little older,] I went to the library and read every book on markets and investing.

When I was 11, I bought my first stock – three shares. I was following charts. When I was 19, I read The Intelligent Investor and it changed my whole framework.

My advice is to read a lot. There are no secrets in the business that only the priesthood knows. It’s all right there.

It requires qualities of temperament way more than qualities of intellect.

Once you have a 125 IQ, much more doesn’t matter. Look for opportunities that fit your framework. Try to learn every day, but you can’t act every day. It’s important to enjoy the game, just as it is to enjoy bridge or baseball [if you’re going to play those games seriously].

Corporate Managers Should Learn Investing (and the Madness of Most Acquisition Activity)

Munger: I think corporate managers should learn to be better investors because it would make them better managers.

Buffett: Charlie makes a good point. Managers should learn about investing. I have friends who are CEOs and they outsource their investing to a financial advisor because they don’t feel comfortable analyzing Coke and Gillette and picking one stock vs. the other. Yet when an investment banker shows up with fancy slides and a slick presentation, an hour later the CEO is willing to do a $3 billion acquisition. It’s extraordinary the willingness of corporate CEOs to make decisions about buying companies for billions of dollars when they aren’t willing to make an investment for $10,000 in their personal account. It’s basically the same thing.

Money Management is a Low Calling – and an Ominous Indicator

Munger: I think money management is a low calling relative to being a surgeon. I don’t like the percentage of our GDP and brainpower and professional effort that’s in money management. I don’t think it’s a good thing for our country, and don’t expect it to end well.

The present era has no comparable precedent in the history of capitalism when so many people are trading pieces of paper. We have a higher proportion of the intelligent sections of society involved in buying and selling bits of paper and trying to make money doing it. There are more people doing this than at any time in history. A lot of this reminds me of Sodom and Gomorrah.

Buffett: When we’ve seen baby versions of this in the past, there have been future [very negative] implications [for the stock market].

Munger: When you get so much nonsense going on, it feeds on itself and creates a frenzy. [When this has happened historically,] there have been serious implications.

Wisdom & Fun 19. Buy Businesses With Untapped Pricing Power

Untapped Pricing Power – The Measure of a Great Business

We like buying businesses with some untapped pricing power. For example, when we bought See’s for $25 million, I asked myself, “If we raised prices by 10 cents per pound, would sales fall off a cliff?” The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices.

A good example is newspapers. The local daily paper controlled the market and every year they raised the [advertising] rates and circulation prices – it was almost a big yawn. They didn’t worry about losing big advertisers like Sears, JC Penney or Wal-Mart, or losing subscribers. They increased prices whether the price of newsprint went up or down.

Now, they agonize over price increases because they worry about driving people to other mediums. That world has changed.

You can learn a lot about the durable economics of a business by watching price behavior. The beer industry is able to raise prices, but it’s getting tougher.

COMMENTS ON ECONOMIC MATTERS

Market Views

Regardless of the market, I will keep buying businesses. We like low prices.

Wisdom & Fun 20. If You Don’t Do Macro-Forecasting But Recognize Value: You’d Do Fine

We’re not good at forecasting markets. Charlie and I spend no time thinking about where the market’s going. We do know when we’re getting good value [when we’re buying a stock or business].

There are always going to be some good and bad things happening.

I’ve seen more people lose more money by getting focused too much on one factor. We’ve never not bought something due to macroeconomic concerns.

Market Calls and Current View

Very infrequently you can say something intelligent about the market as a whole – when circumstances are so extreme that you predict the next 5-10 years with some degree of certainty. This was the case in 1969 and 1974. But most of the time, we’re in some in-between zone.

Obviously you can get more for your money now than in 1999 when I wrote that Fortune article (“Mr. Buffett on the Stock Market”; Fortune subscribers can click here to read it). I knew I’d be right.

If I had to make a choice today between long-term bonds yielding 4.5% vs. equities over the next 20 years, I’d prefer equities. But people who expect 6-7% after-tax or double digits [pre-tax] and think they can do it or hire someone else to do it will likely be disappointed.

I don’t think we’re in bubble times or bargain times.

I think you’ll get a chance to do something screamingly intelligent within a few years, maybe much sooner, relative to current choices.

Wisdom & Fun 21: Best businesses can maintain their earnings without continued reinvestment

The Best Business

The best businesses can maintain their earnings without continued reinvestment, whereas in the worst you have to keep pouring money into a money-losing business.

The best business is being the best surgeon in town. You don’t have to do any reinvestment – the investment was the education. The surgeon will retain his earnings power, regardless of inflation.

Likely Housing Bubble

Americans feel very good about home ownership – for many people, it’s been their best-behaving investment. If it’s a bubble and if it’s pricked, it could affect some Berkshire businesses, but it would also let us put a lot of money to work [referring to a likely crisis that would depress stock prices and let them invest some of the $40+ billion cash hoard].

We’ve not made our money betting on macro stuff like foreign exchange; instead, it’s from buying cheap stocks like PetroChina.

25 years ago, we saw the same thing [a real estate bubble] with Nebraska farmland. People fled cash, saying “cash is trash.” A farm 30 miles north of here sold for $2,000/acre in 1980; I bought it later for $600/acre. People went crazy and the consequences were huge. Many banks failed, even ones that had survived the Great Depression.

I don’t know where we are with housing – people may behave differently because they live in it. But when you get prices increasing at a far greater rate than construction costs or inflation [there can be problems].

Munger: In parts of California and in the Washington DC suburbs, there’s a bubble.

Buffett: I sold a house in Laguna Beach, CA for $3.5 million. The house was only worth about $500,000, so the land was being valued at $3 million. It was only a fraction of an acre, so the land was being valued at $60 million per acre. That’s a pretty fancy price for almost any land.

Munger: One of the Directors of Wesco told me that a modest house next to his recently sold for $27 million. There are some very extraordinary housing price bubbles going on and the consequences could be serious.

More on the Housing Bubble (and Why Foreigners Invest in the U.S.)

The financing terms have become easier and easier as prices have risen, which is contrary to normal [and prudent] practices. But the financing process has become so disintermediated that the mortgage buyer doesn’t care. The easier financing has led to a boom in prices.

The Nebraska farm bubble was fueled by banks that historically had been conservative but went crazy. They said that a farm was an asset-appreciation investment, not an income investment – in other words, they were playing the greater fool game.

The rest of the world is saving. They’re investing $2 billion/day in the U.S. Some say they have so much confidence in the U.S. that they want to invest, but this is silly. They invest because they have to.

Wisdom & Fun 21: Easy financing is fueling big price increases in houses.

Munger: It’s obvious that easy financing [for houses] is fueling big price increases.

Buffett: Consider the following fanciful illustration. Let’s say we had a fixed population in Omaha and no new houses were built, but each year everyone sold their house to their neighbor and moved. In year one, the price was $100,000. In year two, the price jumped to $150,000, but Fannie and Freddie guaranteed the mortgage and sold it to Asian investors. This is an influx of $50,000 to the family income. In year three, the price jumps to $200,000 and the same thing happens.

Obviously, it is transparent what’s happening here, so it wouldn’t really happen, but you can have accidental behavior that leads to certain aspects of this.

Munger: There are Ponzi effects in any economy, and you can see that here.

Bearish on REITs

Munger: In a corporation like Berkshire, a subchapter C, owning real estate is very disadvantageous.

Investing in real estate is having a bubble of its own. My friends who own real estate are selling their worst assets and getting better prices than they’d imagined.

Wisdom & Fun 22. You May Love REITS But Not Its Accounting

Buffett: I have less than 1% of my net worth outside Berkshire and when the Nasdaq hit its high, I had nearly all of it in REITs, which were selling at a discount to their liquidation values. REITs are quite attractive now, especially compared with 5-6 years ago when they were very unpopular.

It’s better to pay attention to something being scorned than championed.

Munger: And REIT accounting is phony.

Buffett: Other than that, we love REITs. (Laughter)

 

Wisdom & Fun 23. Car Industry Is Not Easy

GM and Ford

[GM CEO] Rick Waggoner and [Ford Chairman] Bill Ford have both been handed, by past managers, extremely difficult hands to play. They’re not the consequences of their own doing, but they have inherited a legacy cost structure, with contracts put in place decades ago, that make it very difficult for them to be competitive in today’s world.

GM and Ford don’t sign long-term contracts to pay high amounts for steel, but that’s what they’ve done with annuity and healthcare payments to employees. The result is such expenses are far higher than that of competitors, so it’s not a fair fight.

GM once had 50% market share, and it’s fallen to 25%. Even if it was still 50%, they’d still be in trouble.

I’m not sure what I’d do if I was elected CEO of GM. It reminds me of what Bill Buckley said when asked what he would do if he actually won his race for New York mayor back in 1965 and he said, “The first thing I’d do is ask for a recount.” (Laughter) Well, that’s what I’d do at GM.

The UAW says, “We have a contract and we have a deal.” GM has set aside $90 billion for pensions and another $20 billion or so for healthcare, yet has a market cap of only $14 billion. That’s not sustainable…. Something will have to give.

If a company had to pay an extra $2,000 per car more for steel, everyone would realize there was a crisis and demand a quick solution, but that’s not happening.

Part of the problem arose because [the actions of previous managements] bore no accounting consequences. Back in the 1960s, companies didn’t have to account for pension costs on an accrual basis, and didn’t have to do so for healthcare costs until the late 80s or early 90s. But those costs are very real…

Wisdom & Fun 23. If You Jump From The 42nd Floor, Whilst Going Through The 20th Floor, You’re Still Enjoying The Breeze But It Does Not Mean You Don’t Have A Probem

Munger: Warren just gave a very optimistic prognosis in my view. Just because the full consequences haven’t yet hit, doesn’t mean there isn’t a huge problem. It’s as if someone jumped out of a window on the 42nd floor. As you go by the 20th floor, you’re still OK, but that doesn’t mean you don’t have a real problem. (Laughter)

If I was the President of the U.S., Governor of Michigan or the CEO of GM, I wouldn’t wait. I’d address the problem right now because no one’s coming to save you.

Pharmaceutical stocks

That industry is in a state of flux right now. It’s historically earned very good returns on invested capital, but it could well be that the world will unfold differently in the future than in the past. I’m not sure I can give you a good answer on that.

Munger: We just throw some decisions into the “too hard” file and go onto others.

Buffett: We get paid not for jumping over 7-foot bars but for finding 1-foot bars that we can step over.

Impact of Rising Commodity Prices on Margins

Our carpet business has been hit by rising commodity prices. Sometimes you can get into temporary situations in which you can’t raise prices fast enough to keep up with rising input costs. But the main impact of the rising price of oil – it’s an extra $200 million per day – is borne by American consumers.

Corporate Profit Margins Likely to Fall

Corporate profits are at an all-time high as a percentage of GDP. I’d bet that they go down in the next few years. Corporate taxes [as a percent of total taxes] are at an all-time low and there’s likely to be reversion to the mean.

Bearish on Gold

We’re not enthused about gold. People say it’s a hedge against inflation, but that’s also true of oil, land, Coca-Cola, See’s Candies, etc. I’d much prefer to own land in Nebraska or an apartment house or an index fund as a store of value. We’d rather own an asset that will be useful even if the currency drops to 10 cents on the dollar. People will always need to drink and eat [referring to Coke and See’s]. We wouldn’t trade ownership of businesses for a hunk of yellow metal.

Munger: If you have the opportunities of Berkshire, an investment in gold is dumb.

More Bearishness on Gold

Gold would be way down my list as a store of value. I’d much rather own 100 acres of land in Nebraska or an apartment house or an index fund.

The Dow went from 66 to 11,000 or 12,000 during the last century, and you got paid a lot of dividends along the way. Gold went from $20 in 1900 to $400 in 2000, plus you’d have to pay insurance and storage costs, so it’s not a good store of value.

I’m not advocating paper money – it’s good to worry about this. But I’d rather sell one pound of candy. That will retain its value even if the currency is seashells.

Gold has done very badly [as an investment] in the past and I see no reason why it will work well in the future. All that happens is that it is taken out of the ground in South Africa and put back in the ground in Fort Knox. (Laughter)

Munger: Gold was good to have if you were a well-to-do Jewish family in Vienna in 1935 because of the situation [just before the Nazis took over]. But if you’re in our position, gold has no interest.

NYSE’s Merger with Archipelago

I personally think it would be better if the NYSE remained as a neutral, not-for-big-profit institution. The exchange has done a very good job over the centuries. It’s one of the most important institutions in the world.

Wisdom & Fun 24. The enemy of investment success is activity.

The enemy of investment success is activity. The exchange of yesterday will be better for the American investor. I know the American investor will not be better off if volume doubles on the NYSE, and I know the NYSE will be trying to figure out how to do that if it is trying to maximize its own earnings per share.

Trading is the frictional cost of capitalism. GM or IBM will not earn more money if their stock turns over more actively, but a for-profit NYSE will.

Munger: I feel the same, only more strongly. I think we have lost our way when people like the [board of] governors and the CEO of the NYSE fail to realize they have a duty to the rest of us to act as exemplars. I don’t think you want to turn the stock exchange of the country into an even larger casino than it is already.

You do not want your first-grade school teacher to be fornicating on the floor or drinking booze in the classroom; similarly you do not want your stock exchange to be setting the wrong moral example. I am appalled.

Buffett: I wish I’d gone to first grade where he did. (Laughter)

Asbestos

Munger: There’s been terrible behavior by doctors, terrible behavior by lawyers, gutless behavior by courts, and even more gutless behavior by politicians, who [he said something disparaging about them].

You keep hoping that it will get so bad that things will change, that reform will happen. And it can happen: for example, the Workman’s Comp system in California. With the Schwarzenegger revolution in California, it’s been partly – maybe 15% – corrected. If it gets bad enough, it’s possible that it could be fixed.

It’s crazy that judges give money to people who smoked two packs of cigarettes a day for their entire lives, are dying, and have one little spot on their lungs.

Even asbestos will eventually go away, but who knows how much damage will be done before the storm passes.

But the behavior is so terrible It’s that kind of behavior that makes me talk about [the U.S. being at] the apex of its civilization.

Inflation

The talk of deflation was total nonsense.

You would think that the trade deficit, which has resulted in a weaker currency, would have led to higher inflation.

The price of oil has risen far more in dollars than in euros.

So, inflation matters. It’s always there and is something we think about. But See’s Candies will do fine in an inflationary environment.

Munger: So far, the weak dollar has acted to restrain inflation.

Buffett: Yes. For example, we’re paying less for shoes, few of which are made in the U.S. anymore.

Interest Rates and Inflation

We don’t want to be long the long bond [e.g., he thinks there’s risk of rising interest rates].

But if you’d told me two years ago what the macro conditions would be today, I’d have been very surprised by where interest rates are today [i.e., he thought they’d be higher].

Munger: There won’t be an automatic correlation between interest rates and inflation – there will be weird things.

ADVICE ON LIFE AND OTHER

The Future of the United States

Overall, I’m an enormous bull on the United States. In 1790, we had a population of 3.9 million people vs. 290 million in China and 190 million in Europe. We’ve all had roughly the same conditions since then, yet 215 years later, we have 30% of the world’s GDP. This is one of the great all-time success stories.

Munger: I believe that we are at or near the apex of a great civilization.

Buffett: I don’t feel that way. You’ll know who’s right in 20 or 30 years.

America vs. the Rest of the World

What we do is no secret. The relative importance of America will diminish. The rest of the world is catching on and adopting our best practices. But our castle will grow. It’s good for us if the rest of the world does well, and they’re growing from a lower base. I don’t think their success comes out of our hide.

Munger: In 50-100 years, if we’re a poor third to some countries in Asia, I wouldn’t be surprised. If I had to bet, the part of the world that will do best will be Asia.

Comments on Social Security

Wisdom & Fun 25. I don’t want to do anything to hurt the bottom 10-20% of the population.

I don’t want to do anything to hurt the bottom 10-20% of the population. I’ve seen people who fear for the last years of their lives [that they won’t have enough money].

We’re worrying about a problem in 25 years, that’s a fraction of our current $500 billion trade deficit. We’re spending 4.5% of our GDP on Social Security now; if we have to increase it to 6% in 50 years, this is not a worry.

There are some things we should do, however: means test it, lift the $90,000 cut-off [there are no Social Security taxes above this amount each year] or eliminate it, and increase the retirement age. 2005 is a lot different from 1935 [in terms on longevity].

Munger: That’s the perspective of the Democrat up here, so you might be surprised to hear from the Republican that I think the Republicans are out of their cotton-pickin’ minds to be taking on this issue at this time. The thought that more of our GDP will be going to the elderly over time is not anathema to me.

Social Security is very successful. Apart from disability – a small part – there’s almost no fraud; it’s hard to fake being dead. (Laughter) It rewards work, it’s low cost. It’s one of the most successful government programs ever.

For the current administration, which needs to face down North Korea and Iran, deal with Iraq, etc., to waste political capital on this twaddle…

On Tough Decisions

I honestly can’t think of any [investment] decision I’ve agonized with over a long period of time.

Wisdom & Fun 26. A good public school system is a lot like virginity: easy to preserve, but not to restore.

Public Education

A good public school system is a lot like virginity: easy to preserve, but not to restore. To succeed, well-to-do people need to be involved. I admire the fact that people like John Walton, Bill Gates and Ted Forstmann have gotten involved with this issue.

Next to the nuclear/chemical/biological weapon problem, the #1 problem we face is making sure our educational system is providing a good education to all children – and it’s not. Dealing with the problem is complicated, as there are thousands of school districts and many unions as well.

A big problem is that in many places, the rich have opted out. I imagine that if I used the local golf courses, I’d care a lot about how they were managed and maintained – it’s the same with schools. There’s a two-tiered system right now.

I’m a big believer in public schools.

Wisdom & Fun 27. No Child Left Behind Should Not Mean All Children Are  Left Behind

Munger: I met a guy whose wife teaches 8th grade in the local schools. He told me that, due to requirements of No Child Left Behind, for the numerous students who can’t read, she records the books herself so that these students can listen to the books and follow along in class. This is [the best of] No Child Left Behind in a sense, but it’s also a failure. It’s very hard for a civilization to fix failure when 8th graders can’t read.

It’s a very serious failure that we’ve allowed this to happen.

Buffett: Bill Ruane [of Ruane, Cunniff, managers of the Sequoia Fund] has an extraordinary program that teaches kids to read. It’s been going on for 10 years and the kids are enthusiastic.

A major reason for the success of the United States is the equality of opportunities compared to the rest of the world. It’s a bad situation when some kids have great families, caring teachers, good schools, etc., but less advantaged kids have teachers that just push their students through the system, in schools where other students are doing bad things…

This [failure of the educational system] shouldn’t be allowed in a country with almost $40,000 of GDP per capita.

Humor

[When he was asked if, now that Bill Gates is on his board, a Berkshire-Microsoft merger might be in the offing, Buffett replied:] I keep hinting, but it doesn’t work.