Berkshire Hathaway Inc. has been called the world’s most remarkable compound interest machine. The company’s fundamental formula – buying quality companies at a discount – has been widely praised and frequently copied. Warren Buffett gets most of the credit and enjoys most of the limelight generated by Berkshire’s astonishing success. Much less is known about Charlie Munger, the company’s media-shy Vice Chairman, who has had a massive influence on its long-term fortunes.
Since 1965, when an investment group headed by Mr. Buffett acquired the company, Berkshire has demonstrated explosive growth. The company has a notoriously high price in its stock (more than $275,00 for one Class A share in the first three quarters of 20191). And even though it has faltered slightly in relation to earlier years, Berkshire’s track record remains unparalleled. As a recent article in Forbes2 reported:
“AQR Capital Management crunched the numbers for all the U.S. stocks and mutual funds that have traded for at least 40 years since 1929. Buffett’s performance tops them all. For the 40-year stretch from 1976 to 2017 his Sharpe ratio, excess return relative to risk, was almost double that of the overall market.”
The company accomplished this by investing its capital in an increasing number of prosperous enterprises and without dangerous amounts of borrowing.
Learning machines & mental models
Warren Buffett has never underestimated the role Charlie Munger played in their success. He once observed, famously: “Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.”
While both Buffett and Munger are self-described “learning machines,” it is perhaps the latter whose thirst for knowledge is the most extreme.
Charlie Munger is a collector of what he calls “mental models” about the workings of the world. He uses them to attack problems before arriving at a solution. Munger is known, above all, for his fluent, multidisciplinary mind.
That is the inescapable conclusion we have drawn from a biography entitled Damn Right!3: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger.
Originally trained as a meteorologist, he graduated from Harvard with a law degree. Throughout his career, he has drawn heavily from the study of psychology, economics, physics, biology, and history, among others, in developing his system of multiple “mental models.”
An excellent example of a mental model is Pareto’s Principle, or the power law, as it’s referred to in statistics. The principle mainly observes that a minimal number of critical variables have a greater impact on the result of a process than the rest of the variables combined.
Accordingly, Charlie Munger and Warren Buffett don’t just buy any stock. They have a system to evaluate whether or not a company is undervalued relative to the market. They’re looking for a few gems that will provide outsized returns. If you examine the Berkshire Hathaway portfolio, most of the profits are derived from a very small section.
Rationality in an irrational world
Another profoundly enlightening quote from Charlie Munger is: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
Put another way: it’s better to limit the downside of any decision by avoiding mistakes than it is to be brilliant. Consider that even the brightest people tend to be outstanding in only specific disciplines, which means that they are still exposed to pervasive and powerful biases in most areas.
Behavioural finance attests to this. Loss aversion says we respond about twice as harshly to losses than we do to gains. Confirmation bias says we tend to favour evidence that supports an existing point-of-view.
Charlie Munger’s point is that by building a toolkit of mental models that account for our biases, we can significantly reduce the chance of judgment errors and, therefore, losses.
Munger also once said: “I think Warren and I know the edge of our competency better than other people do.”
Limiting the downside requires the humility to recognise our need to keep on continually learning, researching and questioning, even within our fields of expertise. And the discipline to do it effectively.
We like to think Charlie Munger’s lesson applies to all of us.