Month: May 2010

Charlie Munger on being selective

It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced be—that they can occasionally find one.

And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

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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. So it’s just like the pari-mutuel system. 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.

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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.

And 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.

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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.

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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.

The Link between Inflation and Equity Returns

Several studies have indeed demonstrated that in the first stage of an inflationary cycle, equities perform relatively well because the first signs of inflation are often the consequence of an improving economic backdrop. There is a lag between a pick-up in inflation and the first monetary tightening. That period can last several months up to a year. In that period, equities are genuinely in a “sweet spot” as real bond yields become negative, hence reinforcing the TINA (There Is No Alternative) for equities. In the second phase however, equity returns decline as central bankers hike interest rates above nominal economic growth and inflation, leading to positive real interest rates. In that stage, equities lose their competitive edge over fixed income investments.

What can we conclude from these observations? In fact, one may conclude that a relatively benign inflation rate up to 4% is positive for equities. Beyond that level, equities tend to struggle. Also, we have seen that PE multiples (thus valuations) decrease in inflationary cycles. It is of paramount importance to look at the debt structure of companies, their pricing power, valuation and returns on tangible capital. It will become key to look for high-quality companies that are able to increase their prices beyond the inflation rate. Also, a complete absence of inflation or even deflation (the Japanese scenario) is very detrimental to corporate profits, but this is not our central scenario. Our general conclusion is that it is extremely hard to define hard and fast rules with respect to the link between inflation and equity returns. The response of individual companies will experience a very high dispersion and should therefore be taken into account in a bottom-up stock picking approach.

I have several links to comprehensive articles and research that analyse the impact of inflation on equities:

Stock Market or Market of Stocks

Over the past several years the money that has gone into ETFs has significantly increased. As a result the correlation between stocks from one sector and between stocks in general has ticked up. We live in market environment, where the impact of beta grows stronger, especially during corrections.

We like to think that it is a market of stocks and not a stock market; that equity selection matters. It actually does, but mainly on the way up and when earnings growth is scarce. In the era of ETFs, baskets of stocks are getting bought and sold simultaneously and often the weak rise with the strong and the strong fall with the weak.

Yes, of course if matters if a company grows its earnings by 200% y/y and its sales by 60% y/y. Eventually rising expectations for higher earnings will result in buying and price appreciation. Keep in mind that when the stock market declines, emotions rule decision making and all rationality is thrown out of the window. If you are an investor and the reason you bought still exists, the day to day volatility is just noise that needs to be ignored and corrections should be even welcomed as opportunities to add to a position. The question is, are you an investor or are you a trader and what is your time frame of market engagement? If you consider yourself a trader, price action should be your leading indicator and loss minimizing stops  need to be diligently honored in order to survive and prosper. Remember, there is one basic rule in the capital market jungle – fight only battles that you can win.