In honor of the now legendary Berkshire Hathaway annual meeting, I wanted to take a look at the investing styles of Warren Buffett and Charlie Munger. These two men have astounding records of investing outperformance that have resulted in both of them becoming billionaires. Naturally I think it is important to look at the early years when some of their best gains were realized.
Warren Buffett in the Early Years
When Warren Buffett started his original seven investment partnerships, he had just finished learning the tricks of investing from Ben Graham. In what became known as “cigar butt” investing, Buffett would buy struggling companies that were undervalued relative to their assets. This so called “cigar butt” investing was based on buying stocks at fractions of their net working capital. For working capital, and calculating it, you subtract the current liabilities from the current assets of the company. If you are wondering what that entails, it means that Buffett was buying a company’s assets for 60 cents on the dollar or better. Using this strategy, Buffett was able to build collections of these businesses that, in the aggregate, were completely undervalued relative to what they were worth. Eventually the market, and other investors would realize the stupid valuations placed on these businesses, and bid the stock prices up. Even if the market price never rose, the owner of the business could sell the business’s assets, and reap a 30 or 40% return. In order for this strategy to work, there has to be a passion, and the willingness to hustle. Warren read thousands of annual reports, and tracked down owners of microscopic corporations to buy the stock of companies that were extremely illiquid. For people who are willing to spend their lives doing this, the trade-offs are worth it, but for the average American, not so much. (If you want to read more about using working capital as an investing strategy, all of this information was written by Ben Graham in Security Analysis and The Intelligent Investor.)
Charlie Munger, Concentration, and Leverage
When you study the beginning of Charlie’s investing career, he followed a lot of the strategies that Warren Buffett told him about and practiced. While Warren Buffett and Charlie Munger shared certain strategies, Charlie Munger used different methods. By already examining some of the lessons we can learn from Charlie Munger’s investment partnership, we can expand of some of the ways he beat the market. One of the stories in The Snowball, written by Alice Schroeder, details how at one point, Charlie Munger engaged in arbitrage putting practically everything he owned in one stock. By buying British Power Columbia at $19, Charlie was setting himself up to win big when the Canadian government bought the company at $22. The reason why Charlie Munger leveraged himself to the hilt was because there was little chance that the deal would fall through. By taking intelligent risks, Charlie could make millions just on a $3 price movement. (This anecdote is on page 222.) If you can combine leverage with arbitrage like Charlie did, you can make a killing. When Charlie was just starting out, taking on large amounts of leverage was deemed acceptable by himself because he started young enough. Charlie also has the willingness to place huge concentration on his bets. If you have a particular insight into an opportunity, there can be huge rewards down the line if you structure the way you take advantage of it correctly. Eventually though, Charlie had the epiphany that it is best to buy great businesses. As time passed Charlie managed to convince Warren of this wisdom. This epiphany is the strategy that has been lauded by so many before me, and all I can do is add my voice to the chorus.
Comparing Warren Buffett and Charlie Munger
The achievement of Charlie Munger was convincing Warren Buffett that “sit on your ass” investing was superior than trying to figure out what a company was worth liquidated. When you go and look at some of the fifty year histories that Jeremy Siegel compiles the picture becomes clear. Watching Coca-Cola compound your money by 15% annually, or Philip Morris compound by 19% annually is infinitely superior to other strategies. While everyone else is tied to their computer watching stock quotes, you are literally sitting on your butt doing things you enjoy like lounging at the beach rather than stressing over a penny movement of a stock. When Warren Buffett and Charlie Munger are discussed, Warren has a better record, but it is Charlie’s strategy that I think people should copy.
The strategy of using Ben Graham’s net working capital has, in the words of Charlie Munger, “sailed.” With all the access to information investors have, any strategy like Graham’s where companies sell for less than the cash they have in the bank don’t work because investors today realize the stupid prices placed on those assets and buy them long before they reach that point. Arbitrage as well needs a lot of experience to be worked effectively in order to make money. Why mention this then, when I said investors should copy Charlie Munger’s strategy? Whenever the next depression happens may be a time when Warren Buffett and Ben Graham’s strategies can be applied. If and when that happens, you will have another tool that you can use. If you are intelligent in their use, you may achieve what Warren Buffett did, and have a better return than the strategies espoused by Charlie.