by Janet Lowe
This is the method of thinking that helps Munger and Buffett spot a company that has a franchise on a certain product, a so-called "moat" around its business. There are several examples of companies that have such a strong name brand that they seem invincible. Coca Cola has been such a company, though the challenges are relentless. Munger also uses the example of Wrigley's Chewing Gum.
"It's such a huge advantage to be by far the best-known gum company in the world. Just think of how hard it would be to replace that image. If you know you like Wrigley's Gum and you see it there for two bits, are you really going to reach for Glotz's Gum because it's 20 cents and put something you don't know in your mouth? It's not worth it for you to think about buying an alternative gum. So it's easy to understand why Wrigley's Gum has such a huge advantage."
Once you grasp the value of a company, then you have to decide how much the company is worth if you were buying it outright, or as in the case of the typical investor, simply buying a portion of the company on the stock market.
"The trouble with the Wrigley Gum-type investments is that everybody can see that they're wonderful businesses. So you look at it and you think, 'My God! The thing's at eight times book value or something. And everything else is at three times book value.' So you think, `I know it's wonderful, but is it wonderful enough to justify that big a premium?'"
The ability to answer such questions explains why some people are successful investors and others are not.
"On the other hand, if it weren't a little difficult, everybody would be rich," Munger insisted.
Observing business over time gives an investor greater perspective on this type of thinking. Munger said he remembers when the downtown department stores in many cities seemed invincible. They offered enormous selections, had large purchasing power, and owned the highest priced real estate in town, the corners where the streetcar lines crossed. However, as time passed, private cars became the prevalent mode of transportation. The streetcar lines were taken out, customers moved to the suburbs and shopping centers became the dominant shopping venues. Some simple changes in the way we live can completely alter the long-term value of a business.
Munger is passionately opposed to certain economic theories and business practices and enjoys the freedom his status and wealth give him to express those opinions. For example, he is perpetually miffed at investors and academics who promote the harsh form of the efficient market theory of investing:
"If you think psychology is badly taught in America, you should look at corporate finance. Modern portfolio theory? It's demented!" Munger proclaimed.
The concept is taught in mainstream business schools and takes the position that all information on publicly traded companies is spread rapidly throughout the investing universe, dispelling any advantage one investor has over another. Nobody can really beat the market because adjustments to news are worked into the price of a security so quickly.'
Munger recalled one efficient market theorist who over the years made a career of explaining how Buffett's success was merely the result of good luck. As Buffett's performance held steady and even improved, it became more difficult to explain Buffett as a mere anomaly. "... this theorist finally got all the way up to six sigmas-six standard deviations-of luck. But then, people started laughing at him because six sigmas of luck is a lot. So what did he do? He changed his theory. Now, he explains, Warren has six or seven sigmas of skill."
Refuting the claims of financial writer Michael Lewis, who also seemed to portray Buffett as a greedy manipulator whose success is mainly the result of happenstance, Munger says. "He's got the idea that Warren's success for 40 years is because he flipped coins for 40 years and it has come up heads 40 times. All I can say is, if he believes that, I've got a bridge I'd like to sell him."
There is no doubt whatsoever that Berkshire attained its high level of performance, in a large part, because of the commonsense notions shared between Munger and Buffett. For example, they ignore the popular financial indicator called Beta, which measures a stock's volatility in relation to the overall market. A company with a Beta that is higher than the market average is considered by many professional investors to be a high-risk proposition.
"This great emphasis on volatility in corporate finance we regard as nonsense ... ," said Munger. "Let me put it this way: as long as the odds are in our favor and we're not risking the whole company on one throw of the dice or anything close to it, we don't mind volatility in results. What we want are the favorable odds. We figure the volatility over time will take care of itself at Berkshire."
Both Munger and Buffett are indignant over the way the regulators allow stock options to be counted on the books so that they don't show up as an expense to the company. They mention the problem at nearly every annual meeting.
"It's fundamentally wrong not to have rational, honest accounting in big American corporations," said Munger. "And it's very important not to let little corruptions start because they become big corruptions-and then you have vested interests that fight to perpetuate them. Accounting for stock options in America is corrupt, and it's not a good idea to have corrupt accounting."
Buffett and Munger agree on most things, but they have a different opinion about who should be the decision maker when an unsolicited tender offer is made to a corporation. Buffett says his heart is with the shareholders, but Munger says there is a social interest in some cases, making it okay to make laws to govern such transactions.
"I totally agree that for the ordinary little family business that owns a theater, the shareholders ought to decide whether the theater is sold. But once you get into great big social institutions, that given certain circumstances, will go together in waves of acquisitions into huge agglomerations, that bothers me. So, I think that it's appropriate to have laws that prevent it," said Munger.'
If he were teaching finance, Munger said he would use the histories of 100 or so companies that did something right or something wrong.
"Finance properly taught should be taught from cases where the investment decisions are easy," said Munger. "And the one that I always cite is the early history of the National Cash Register Company. It was created by a very intelligent man who bought all the patents, had the best sales force, and the best production plants. He was a very intelligent man and a fanatic, all of whose passions were dedicated to the cash register business. And of course, the invention of the cash register was a godsend to retailing. You might even say that cash registers were the pharmaceuticals industry of a former age. If you read an early annual report when Patterson was the CEO of National Cash Register, an idiot could tell that here was a talented fanatic-very favorably located. Therefore, the investment decision was easy."
John Henry Patterson was an Ohio retailer who did not invent the cash register, but immediately saw its benefits and purchased the moneylosing company. In his zealousness, Patterson became the prototype for the contemporary business innovator. He virtually invented the concept of employee benefits (the low-cost company cafeteria, for one), sales force training and motivation, and was responsible for the first house organ, "The Factory News." During the great Dayton flood of 1913, Patterson halted production and devoted the company to saving the city. He gave food, shelter, supplied electrical power, and fresh water, and his company doctors and nurses tended the injured and ill. Factory workers built boats for flooded out residents. Nevertheless, Patterson was a bulldog competitor and once lost an antitrust suit, which later was overturned by a higher court. One of Patterson's most noteworthy achievements was hiring T.J. Watson, a piano salesman, who worked at NCR for years. After Patterson fired Watson, he went to work at ComputerTabulating-Recording Company, which Watson transformed into IBM, using many of the business skills he'd learned at NCR.
Patterson left a great business when he died, but he'd spent so much on social causes that his estate had very little money. Not that it mattered to him. Patterson was fond of saying "Shrouds don't have pockets." 9
Though few
companies last forever, all of them should be built to last a long time, says Munger. The approach to corporate control should be thought of as "financial engineering." Just as bridges and airplanes are constructed with a series of back-up systems and redundancies to meet extreme stresses, so too should corporations be built to withstand the pressures from competition, recessions, oil shocks, or other calamities. Excess leverage, or debt, makes the corporation especially vulnerable to such storms.
"It is a crime in America," stated Munger, "to build a weak bridge. How much nobler is it to build a weak company?"")
AMERICANS ARE OVERSOLD ON THE benefit they receive from money managers, and particularly, from mutual fund managers, and that bothers Munger enormously.
"It is, to me, just amazing what's happened in the mutual fund business," he said. "It just grows and grows and grows. And they get these fees just for maintaining shares in place-12-B-1 fees or whatever they call them. I am not charmed with the mechanics of that business."
Addressing a group of charitable foundation executives in Santa Monica, California, in 1998, Munger especially criticized Yale University for investing its endowment in the equivalent of a fund of mutual funds: "This is an amazing development. Few would have predicted that, long after Cornfeld's fall into disgrace, major universities would be leading foundations into Cornfeld's system."" Bernie Cornfeld in the 1970s created the ill-fated, fund-of-funds concept.
An eminence gris of no less stature than John Bogle, founder of the Vanguard Funds, has taken up Munger's cudgel. When Munger made his comment he was speaking to directors of nonprofit organizations and was attacking the practice of hiring consultants to hire money managers who in turn select mutual funds operated by other money managers. At each step, there is a commission to be paid, which skims off the money that can be used in the work of the charity.
"Mr. Munger goes on to point out," said Bogle, "the devastating impact of the cost of all this complexity on the return of foundations and endowments in a stock market with lower returns. Market returns-5 percent; total cost, 3 percent; net return, 2 percent."
And, said Bogle, "Please don't scoff at the use of the 5 percent return on stocks. The long-term real returns on stocks has been 7 percent, so Mr. Munger's hypothetical future figure is far from apocalyptic."12
Munger's recommendation to managers of the funds of not-for-profit foundations was simple: Save yourself a lot of time, money, and worry. Just put your endowments into index funds. Alternately, the foundations could follow Berkshire's lead and simply buy high quality stocks (if they are not highly overvalued in price) and hold on for the long term.13
It isn't even necessary to worry about diversification. "In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations, is securely rich," said Munger. "And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices."'-'
In fact, Munger went so far as to suggest that investors could have 90 percent of their wealth in a single company, if it was the right company. "Indeed, I hope the Mongers follow roughly this course. And I note that the Woodruff Foundations have, so far, proven extremely wise to retain an approximately 90 percent concentration in the founder's Coca Cola stock. It would be interesting to calculate just how all American foundations would have fared if they had never sold a share of founder's stock. Very many, I think, would now be much better off." 15
Although Munger asserted that the vast majority of professionally managed money, after taking into account the impact of fees and transaction costs would be better off in index funds, he ended by throwing out an alternate point of view:
Does that mean you should be in an index fund? Well, that depends on whether or not you can invest money way better than average or you can find someone who almost surely will invest money way better than average. And those are the questions that make life interesting.
If everyone put their money in index funds, Munger conceded, the prices of indexed stocks would be forced beyond intrinsic value, and the process would become meaningless.
It was this disenchantment with the management of money, in part, that led to Buffett and Munger's objection in the mid-1990s to the creation of mutual funds made up entirely of Berkshire Hathaway stock. Companies that wanted to establish the funds said it was a way to give average investors access to an exceptional investment.
Five Sigma Investment partners L.P. of Bala Cynwyd, Pennsylvania, had filed with the Securities and Exchange Commission to sell Berkshire through a vehicle called the Affordable Access Trust. The trust would require an initial deposit as small as $300. Berkshire shares at the time were trading for about $35,000 each. Another group, Nike Securities of Lisle, Illinois, planned a similar unit trust. 16
"Frankly, what we are doing is to make Berkshire available to average people," said Sam Katz, a principal at Five Sigma. "Just because someone is not wealthy doesn't mean they don't have the aptitude or sophistication for this business." 17
One broker involved in the deal declared, "Buffett and Munger turned out to be control freaks."'s
Berkshire submitted a 24-page memorandum to the SEC in December 1995, saying that the securities sale would mislead investors. The memorandum, which was prepared at Munger, Tolles, also was distributed to state regulators.
"I've been in one aspect or another of investment management for what, 44 years or so, and trying not to disappoint anyone," said Buffett. `And in the process of not disappointing anyone, one of the key factors is having them have the proper expectations and being knowledgeable about what they're getting and what they're not getting. Neither Mr. Munger nor I would function as effectively if we had tens of thousands of people who were in one way or another disappointed with us. That's not Berkshire."'9
In addition to registering a complaint with the SEC and then coming up with an alternative of their own, Munger sent a stinging letter to Five Sigma:
Warren Buffett does not regard the current market price of Berkshire stock as a price that makes new investments in Berkshire attractive. If he were asked by a friend or family member whether he advised a new purchase of Berkshire shares at the current price, Mr. Buffett would answer, No.20
To make the investment trusts less attractive, Berkshire took the unusual step of creating a B-class share, which would represent onethirtieth the value of the original shares, which now would be called A shares. The structure of the B shares, and the way in which they were presented, was unique. The deal was set up so that brokers could make very little commission money, thus discouraging them from pushing the shares onto their clients. Additionally, the underwriting syndicate for the shares included two discounter brokers, Schwab and Fidelity. By including discounters, initial shares would be more readily available to all investors.
Critics claimed that Buffett and Munger created the B shares because they could not tolerate losing control of Berkshire's shareholder policy. "This is a small problem that Mr. Buffett approached in a big way," said James K. Mulvey, an analyst with Dresdner Securities in New York.21
For starters Buffett and Munger planned to offer 100,000 B shares, but said they would keep adding to the offering until the public demand was met. The number of shares in the public offering increased four times, until ultimately 517,500 shares were sold at $1,110 per share, doubling Berkshire's shareholder base to 80,000 individuals. The offering added $600 million to Berkshire's capital.
Nike Securities went forward with its trust, but the Berkshire trust never became the phenomenon that the originators had hoped it would.
MICHAEL LEWIS, AMONG OTHERS, HAS accused Munger and Buffett of spouting high moral standards for the investment world, while not holding their own investments to the same requirements. They particularly poi
nt to the fact that Berkshire once invested in the stock of a company that does not serve the public good-a tobacco seller.
"We have set ourselves up, to some extent, as a moral censor of our own activities," Munger agreed, "but we have never had the attitude that when we buy a little piece of a company in an insurance portfolio, that we are a moral censor for the world.""
In April 1993, Berkshire took a sizable stake, approximately 5 percent, in UST, a leading maker of smokeless tobacco. The shares were trading at between $27 and $29 per share at the time. A 5 percent stake would have been worth more than $300 million. UST makes Skoal and Copenhagen, and also produces wine, including Chateau Ste. Michelle. At the same time, Berkshire sold its holdings in RJR Nabisco, which is a combined food and tobacco company.
To some it is splitting hairs, but to Munger, there is a big difference in buying stock in a corporation and owning the entire shebang. He follows different rules for each.
"If we're buying stock in major companies that are out there, (Buffett) doesn't make his judgment based on some moral overview of their whole business. We do that in judging and controlling our own behavior." 23
Munger said that though it once held tobacco company shares, Berkshire turned down a chance to buy a tobacco company outright.
"We don't want to be in the business of selling addictive drugs, with us being the controlling owners," Munger said. "It's not the way we do the game. We'll own shares, because if we don't own them, somebody else will. But we'll never have Berkshire in a controlling interest. 1124
That said, Munger admits that he and Buffett have made many investment errors. "If I were ordaining rules for running boards of directors, I'd require that three hours be spent examining stupid blunders including quantification of effects considering opportunity costs."