Win rate, safety margin, low valuation, good company
The following content is from Charlie Munger:
I want to talk not about emerging markets, securities arbitrage, etc., but solely about the topic of stock selection.
01 Improve Winning Percentage
The first question is: "What is the essence of the stock market?" This may immediately make you think of the "efficient market" theory, which has been popular since I stepped out of the business school.
Interestingly, one of the greatest economists in the world is a shareholder of Berkshire Hathaway. He wrote in textbooks that the stock market is very efficient, and no one can beat it. But his own funds kept flowing into Berkshire Hathaway and then kept growing.
So, just like the famous "Pascal's Wager" (this principle was proposed by Pascal, the gist is that if you believe in the existence of God, you will go to heaven after you die; even if God does not exist, you will not lose anything - Translator's note), Buffett hedged his bets.
Is the stock market really so efficient that no one can beat it? The efficient market theory is generally correct, that is, for a smart and disciplined stock picker, the market is very efficient, and beating the market is quite difficult.
In fact, the average result is just the average result. In theory, no one can beat the market. As I often say, an "Iron Rule" in life is: only 20% of people can make it to the top 15%. That's the rule of how things operate.
For those who go to the extreme of the efficient market theory, I gave them a nickname - "mentally deranged." This theory intersects with human intelligence, some people can use it to play with mathematical skills, which is why it is attractive to those with mathematical talent. The problem is that the basic assumptions may not necessarily align with reality.
Similarly, for someone holding a hammer, every problem looks like a nail. If you are used to using higher mathematics, why not use your mathematical tools for speculation?
The model I like is the simplification of the concept of the "common stock market," which is like a parimutuel system in horse racing (after deducting the house management fee, the jackpot is distributed based on the bets placed - Translator's note). A parimutuel system is equivalent to a market, where everyone comes in to place bets, and the odds change based on the bets. This is clearly the operating mode of the stock market.
Even a fool can see that a horse with lighter weight, good winning rates, and a favorable position is more likely to win compared to horses with poor race records and overweight. But look at the odds, the former is 3:2, and the latter is 100:1. Applying Pascal and Fermat's mathematical theories, what is the wisest way to bet is still unclear. Stock prices also change like this, so beating the system is very difficult In addition, the house collects a 17% commission from the total betting pool. This means you need to outsmart other bettors by deducting 17% from your own betting pool and then letting the remaining money work for you.
Can a person become a winner in horse racing by applying intelligence and wisdom in mathematics? Intelligence can bring some advantages, as many people know nothing about horse racing and simply bet on lucky numbers.
Therefore, if a person references the performance of various racehorses, is proficient in mathematics, and has a flexible mind, he has a significant advantage in the absence of frictional costs charged by the house (referring to fees and capital gains tax in stock market trading).
Unfortunately, in many cases, a smart, advantaged bettor only aims to reduce the average season's loss from 17% to 10%. Regardless, few people can win races after paying a 17% fee.
When I was young, I was a poker player, and I had a companion who did nothing but participate in harness racing. He enjoyed his life to the fullest.
My companion treated harness racing as his main profession, but he only placed occasional bets when he saw practical and mispriced opportunities. In this way, after paying all the house commissions - estimated to be around 17% - he lived a comfortable life.
You might say that such examples are not common. However, the market is not entirely efficient. Many people would have a chance to win if it weren't for this high 17% commission. It is efficient, but not completely so. With enough shrewdness and passion, some people will achieve better results than others.
The stock market is similar - just with much lower house commissions. If you remove trading costs - such as bid-ask spreads and commissions - and if your trading is not overly active, the trading costs are relatively low.
Therefore, with enough passion and training, some shrewd individuals will achieve above-average results. This is not easy to achieve, as most people's investment results are mediocre. But some people have talent and may achieve above-average results in low-cost operations.
So, how can you become one of these successful individuals - relatively speaking, rather than a loser? Take a look at the pari-mutuel betting system. Last night, I happened to have dinner with the chairman of Santa Anita racetrack. He mentioned that two or three bettors deposit some money with the racetrack for off-track betting.
After deducting all management fees, the racetrack starts distributing winnings - many of which are sent to Las Vegas - to those who have made a net profit after paying commissions. Even in such unpredictable horse racing, these individuals handle it with ease.
Humans are not naturally endowed with the ability to know everything, but those who are diligent are gifted by heaven with an ability - they observe and search for mispriced bets in the world, occasionally finding one Since heaven has given them this opportunity, smart people will invest heavily, but at other times they will remain idle. This is a very simple concept, and I agree with it very much - based on the experience of the betting pool system, such examples are everywhere.
However, few people operate in investment management this way, except for us - I am referring to Buffett and Munger. Although we are not a unique type of people, many people have some crazy ideas in their minds. They want to hire more business school students through doubled efforts to gradually know everything about all aspects, rather than waiting for a chance to strike hard. I think this is an extremely foolish approach.
What foresight do you need? I think not too much is needed. If you think about Berkshire Hathaway and the hundreds of billions of dollars it has accumulated, ten great insights can solve most problems.
This is also achieved by such a talented person - Warren, who is far above me in talent and extremely disciplined, after a lifetime of struggle. I don't mean to say that he only has these ten great insights, but most of the profits come from these ten great insights.
If your thinking is close to the winners of the betting pool system, your investment performance will be very significant. Just treat the market as a high-odds meaningless game, occasionally there will be some mispriced things. Perhaps you have limited intelligence and will not find many such opportunities in your lifetime, but if you really find a few, you should go all out.
Warren said in a speech at a business school, "I will give you a ticket with 20 small holes, you have 20 chances to punch holes, I can increase your lifelong financial wealth - these 20 holes represent all your investments in your life. Once you have punched all the holes on this card, it means your investment career is over."
He said, "According to this rule, you must carefully consider your actions and think twice before acting. Only in this way can you outperform others."
For Warren and me, this is a very clear concept. But in American business courses, few people mention this view because it goes beyond traditional wisdom.
For me, winners must selectively bet, this principle is obvious. I realized this principle very early on, and I don't understand why it is so difficult for many people to understand.
The reason why we make such foolish mistakes in investment management can be explained by a story: I once met a man selling fishing hooks, and I asked him, "Oh my, (fishing hooks) come in purple and green, do fish really get hooked?"
He said, "Sir, I'm not selling to fish." The situation of investment managers is like this seller of fishing hooks, they are also like those who sell salt to others, ignoring the fact that others do not lack salt, as long as the other party buys salt, they will sell salt. But this does not apply to clients who buy investment advice.
As an investment manager, if you invest in companies like Berkshire Hathaway, it is difficult to reach the current high level of salary - because you hold stocks like Walmart, Coca-Cola, etc., without using much brainpower, it will make clients richer and richer.
Before long, clients will be somewhat disgruntled: "Why should I give that guy 50% of the fee a year, holding this beautiful stock and doing nothing?" So, what makes sense to investors is not necessarily meaningful to managers, and in interpersonal affairs, the incentive mechanism of decision-makers determines behavior Among many companies, my favorite motivating case is FedEx. Its core operating system - also the key to making its products integrated - is to gather all planes at midnight and transfer all packages from one plane to another.
If there is any delay, the entire system will not be able to smoothly deliver the products to FedEx's customers.
But FedEx employees always messed up, never completing tasks on time. Managers tried everything - moral persuasion, threats, and so on, but to no avail.
Finally, someone came up with a good idea: reduce hourly wages but increase the pay for each shift - once all the work is done, they can go home. Ha, the old problem was solved in one night.
So, the right incentive measures are a very important lesson. FedEx once struggled to figure it out, perhaps now you understand this principle. Okay, we have realized that market efficiency is like a betting pool system - when betting on horse racing, betting based on preferences is more rewarding than risk betting, but it does not necessarily have a betting advantage.
In the stock market, the railway sector is performing poorly, but when its price reaches 1/3 of book value, it is a good buying opportunity. In contrast, IBM should be sold at a price 6 times its book value during its peak.
Just like a betting pool system, any fool can see that IBM's business prospects are better than the railway sector. However, if you calculate the probabilities of both sides and choose who is more cost-effective, the answer seems to become somewhat elusive. The stock market is very similar to a betting pool system, and it is difficult to beat it.
As an investor selecting common stocks, what methods should be adopted in the process of trying to beat the market? How can one achieve better-than-average results in the long term? A standard technique that fascinates many people is the so-called "sector rotation."
You speculate in your mind the timetable for oil stocks surpassing retail stocks, then wander around, delve into the hottest sectors of the market, and make more insightful decisions than others. Over time, you may be ahead. But I don't know anyone who has truly become rich by sector rotation, although it is possible. It's just that the wealthy people I know - they didn't get rich by this.
02 Finding a Margin of Safety and Optimizing Valuation Methods
The second basic method is the one used by Benjamin Graham, which both Buffett and I like very much. As a key point, Graham recommended this value concept to individual investors - how to price a company when buying it.
In many cases, this formula can be applied. If you multiply the stock price by the number of shares and the resulting number is not greater than 1/3 of the selling price, you have many advantages.
Even if a drunkard is running a boring industry, having the actual excess value per share in your hands is a great thing. With this large amount of excess value, you have a huge margin of safety.
But to some extent, he was operating this theory during the "shell shock" that engulfed the world in the 1930s - the worst economic contraction experienced by English-speaking countries in 600 years In Liverpool, England, wheat prices hit a 600-year low, causing a sense of "shell shock" around the world.
Benjamin Graham began using his Geiger counter to explore the ruins, discovering that some things were being sold at prices lower than their per-share working capital.
At that time, working capital essentially belonged to the shareholders. If employees were not useful, they would be laid off, and then the owners would pocket the working capital. This is how capitalism operates.
However, this calculation method is no longer effective—because once a company starts to contract, these important assets will no longer exist. Regulations and legal provisions in some civilized societies indicate that many assets belong to the employees, and once the company enters a decline phase, some assets on the balance sheet will no longer exist.
If you are a car dealership owner, the above situation does not apply. Your operations may lack careful planning or have other shortcomings. According to your way of doing business, the company may become increasingly bleak, and in the end, you can simply pack up your working capital and leave.
But IBM cannot do that. IBM has announced that due to the development of world technology and its deteriorating market position, they have decided to change their scale. I wonder if anyone has noticed what has disappeared from IBM's balance sheet. IBM is a typical example. Its managers are smart and disciplined, but technological changes have brought chaos, leading IBM to leave the wave after successfully "surfing" for 6 years.
This is a kind of decline to some extent—a vivid lesson in the dilemma of technology. (This is also one of the reasons why Buffett and Munger do not like technology, because it is not their strength and they cannot deal with the various strange things that may happen in it.)
In any case, I believe the main problem facing Benjamin Graham's philosophy is that gradually people around the world have learned this rule, and the obvious cheap stocks are no longer available. When you pick up the Geiger counter to detect on rubber, unfortunately, it does not make a "tick" sound.
This is the nature of those who hold hammers—as I said before, every problem in their eyes is like a nail—followers of Benjamin Graham respond by changing the scale on the Geiger counter.
In fact, they began to redefine cheap stocks from another perspective, constantly updating the definition, in order to continue Graham's philosophy, with good results. The effectiveness of Benjamin Graham's thinking system is evident in this.
Of course, the best part of Graham's system is the theory of "Mr. Market." Graham does not believe in the efficiency of the market; on the contrary, he sees it as a manic-depressive patient who visits every day. Mr. Market sometimes says, "I will sell to you at a price below its value." Sometimes it says, "I will buy at a price above its value." So you can choose whether to follow, sell some stocks, or just watch and wait For Graham, doing business with this crazy market gentleman is truly fortunate because he always provides you with so many choices. Graham's way of thinking is very important and deeply influences Buffett - he occasionally applies it to his own investments. However, if we blindly follow Graham's classic techniques, perhaps our investment performance would not be as good as it is now, because Graham did not stick to dogma.
Graham is not even willing to talk about management. His reason is that, just like the best professors teach for the general public, he tries to invent a system that everyone can use. He believes that not just anyone on the street can talk extensively about management and learning. He also has a theory: information in management is often distorted and can easily mislead the public.
If we act like Graham's followers, we will gradually gain the so-called "better foresight." We realize that some companies, even when sold at 2 to 3 times their book value, are still far below their intrinsic value because of their unlimited potential, and some managers or systems demonstrate extraordinary management skills.
Once we quantify how cheap it may be, which may surprise Graham, we start considering entering that business. By the way, most of Berkshire Hathaway's funds flow from these good companies. Our first $200 million or $300 million was obtained through constant exploration using the Geiger counter, but most of the other funds come from good companies. For example, Buffett's partnership company bought a large amount of shares in American Express and Disney when their stock prices plummeted.
Most investment managers are immersed in the game of various investment methods they are familiar with. At Berkshire Hathaway, no client can speculate against us, so we have a high degree of freedom. If we find cheap bets and are confident in our judgment, we act immediately.
But to be honest, I think (many fund managers) may not satisfy clients using existing systems. But if you have decided to invest in a pension fund for 40 years, encountering some twists and turns or a different investment path from others during the investment process, what can you do? As long as it ends well, that's all that matters. So, some minor fluctuations do not mean much.
However, in today's investment management, everyone not only wants to be a winner but also wants to win through conventional methods. This is a very unrealistic and crazy idea. This approach is like the Chinese tradition of foot binding, criticized by Nietzsche for those who take pride in being lame. This way will indeed make you a cripple. Fund managers may respond, "We have to do this because everyone measures us by this standard." If the enterprise is already established, then their actions are understandable.
But from the perspective of a rational consumer, the whole system is "mentally disordered," dragging many talented people into meaningless social activities. Berkshire Hathaway's system is completely normal. In this fiercely competitive world, when smart people confront other diligent wise men, they produce very valuable insights After brewing good foresight, it is meaningful to set off in an organized manner. The idea that one is an all-round talent anytime and anywhere is harmful and useless. Starting from a feasible plan, the likelihood of success is very high. How many of you have come up with 56 insights and are confident about it? Please raise your hands. And how many of you have 2 to 3 good ideas? Alright, the argument is over. (Munger imitates a lawyer's argument, showing a sense of humor - Translator's note)
03 Undervalued Good Companies
We need to make money from those efficiently operated companies. Sometimes we buy the entire company, but sometimes we only buy most of the company's stocks. Looking back, we have made a lot of money from excellent companies.
In the long run, the return on a stock is closely related to the development of the company. If a company's profit has been 6% of its capital for 40 years, then after holding it for 40 years, your return is no different from 6% - even if you initially bought it cheap. If the company has been making profits at 18% of its capital over two to three decades, even if the initial price was high, the return is more satisfactory.
So the trick is to invest in companies with better performance, which involves economies of scale, such as momentum effect.
How to implement it? One method is what I call "having foresight when they are growing up," aiming at the latecomers. For example, following Sam Walton after he first took Walmart public.
Many people use this method and have a lot of fun. If I were young, I might do the same. But for Berkshire Hathaway with a huge amount of capital, this method does not work because we cannot find investment targets that meet our scale parameters, so we have gradually developed our own unique way.
But I think "having foresight when they are growing up" is a wise way for those who try to operate through training, I just didn't adopt it.
Due to competitive factors, it is very difficult to implement "finding them when they are growing up." Berkshire Hathaway is taking this route. But can we continue?
For us, who is the next Coca-Cola? I don't know either, the answers to these questions are getting harder and harder. Fortunately, we have gained a lot in this regard - after entering an excellent company, we found that it also has outstanding management because management is crucial.
For example, Jack Welch came to General Electric, not the manager of Westinghouse, which made a big difference - and a world of difference. So, the role of management should not be underestimated.
Some things are foreseeable. I think it is easy for everyone to realize that Jack Welch is more insightful and has more effective management than his peers in other companies. Similarly, it is not difficult for us to understand that Disney has more development momentum, and Eisner and Weus are not ordinary managers Therefore, if you happen to enter an excellent company and also encounter a capable manager, this is a rare stroke of luck (hog heaven day, even pigs can go to heaven, metaphor for being very lucky).
If you are not fully prepared when opportunities knock on your door, you are making a serious mistake. Occasionally, you will find that some talented individuals can do things that ordinary technical personnel cannot do. I recommend Simon Marks, the second-generation leader of the century-old British company Marks & Spencer, as well as the American National Cash Register Company and Sam Walton, they belong to this type.
The appearance of these people is often not difficult to recognize. They have reasonable characteristics - passion, wisdom, just like the qualities they often show in social situations.
But generally speaking, betting on the quality of a company will yield better results than betting on the quality of management. In other words, if you can only choose one, bet on the potential of the company rather than the talent of the management. In some extraordinary moments, you may find a manager who stands out, shines brightly, and is even willing to follow him into what seems like an ordinary and unremarkable company.
There is also a simple effect that some investment managers rarely pay attention to, which is the tax effect. If you buy a stock with a compound annual growth rate of 15% and after 30 years, with a 35% tax, your annual return will reach 13.3%.
On the other hand, the same investment, but with a 35% tax on top of the 15% compound annual growth rate each year, your annual compound return rate will be 9.75%. The difference in return rates between the two is more than 3.5%. For investors holding stocks for 30 years, the 3.5% figure is astonishing.
If you invest in some outstanding companies for the long term, simply benefiting from the different tax treatment will make you earn a lot more money. Even if the annual investment return rate drops to 10%, and after paying a 35% tax at the end of the investment, you will still achieve a compound annual rate of 8.3% after 30 years. On the contrary, if you pay a 35% tax every year, on average, the annual compound return rate will drop to 6.5%.
So, even investing in common stocks of companies with a low dividend payout ratio, the after-tax returns relative to the historical average return level will increase by about 2% annually. Based on my experience of corporate mistakes, it can be concluded that extreme tax avoidance is a common cause of foolish mistakes, as some people make serious mistakes due to excessive consideration of taxes.
Warren and I don't drill for oil, we pay taxes. So far, we've done pretty well. From now on, whenever someone tries to sell you tax avoidance measures, my advice is to never listen.
In fact, whenever someone recommends something with a 200-page manual and requires a large commission, don't fall for it. If you follow this "Munger rule", you may occasionally make mistakes, but in the long run, you will be far ahead of others in your lifetime - and you will have fewer unpleasant experiences that may wear down your love for those around you.
If a person can make a few wise investment decisions and then sit back and wait for returns, they don't have to pay a large sum of money to brokers, nor will they hear so much nonsense Similarly, if this type of investment is effective, the government tax system will also add an additional 1 to 2 percentage points or more to your annual compound return.
Many people believe that by hiring investment advisors, paying them 1% of their salary, and letting them search for tax avoidance methods, they can gain an investment advantage. Does this really work? Is this philosophy dangerous? Of course.
Since everyone knows that investing in excellent companies is a viable method, sometimes it can lead to extremes. In the era of the "Nifty Fifty," everyone cherished excellent companies, so the P/E ratios of these companies began to rise to 50, 60, or even 70 times.
As IBM declined, other companies also fell. Excessive prices led to serious investment disasters, so you must always be vigilant against these dangers. Risks always exist, and nothing is taken for granted or easy. But if you can find fairly valued and outstanding companies, buy in at the right time and wait, this operation will be effective - especially for some individual investors.
04 Several Criteria and Cases for Good Stocks
In the stock market investment growth model, there is another branch: you may have found several companies in life that can significantly increase returns just by raising prices - but they don't do so, so they have the ability to reprice.
Disney did this. Taking your grandchildren to Disney is a very unique experience, although you only do it occasionally, many Americans love to go to Disney. When Disney found the opportunity to significantly raise prices, they took action immediately.
The wonderful record written by Eisner and Weus for Disney is a manifestation of their extraordinary wisdom, and the rest is attributed to the price increase measures of Disney World and Disneyland, as well as the hot sales of classic animated videotapes.
At Berkshire Hathaway, Warren and I also raised See's Candies, a well-known chocolate manufacturer in the United States, of course, we also invested in Coca-Cola - it also has pricing power and excellent management. So, its presidents Coizueta and Keough can do much more than just raising prices. This is great.
If you find some companies are undervalued, you have encountered several profitable opportunities. Some companies are priced below the standard that the public can afford, if you understand these, it's like picking up money on the street - provided that you have the courage to stick to your ideas. If you want to learn and draw lessons from the successful investment model of Berkshire Hathaway, you can see that we bought two newspapers twice, and these two newspapers eventually merged into one. So in a sense, we took a gamble.
One of the newspapers we bought - The Washington Post - was purchased at 20% of its value at the time. Following Ben Graham's classic approach, we bought when the price reached 1/5 of its value - at the time, the background was that this newspaper had both a top player in a match (obviously the eventual winner of the melee) and honest and smart management This is a real dream, they are an elite group of people - the Katharine Graham family. It's a dream - incredible like a dream. This goes back to 1973-1974, it seems to be a re-enactment of the investment boom of 1932, perhaps a market opportunity that comes once in 40 years. The return on investment is 50 times our initial cost, if it were someone else, I would never have dreamed of getting such a generous investment return in my lifetime like the Washington Post in 1973 and 1974.
I also want to talk about another model. Some projects of Gillette and Coca-Cola are priced low, while their global marketing advantages are obvious. Take Gillette for example, they have always been "surfing" in the field of new technology, of course, compared to the complex microchip standards, their technology is relatively simple. But in the eyes of their competitors, it is superior and hard to match. Gillette has always been far ahead in improving razors, with a market share of over 90% in many countries.
GEICO (Government Employees Insurance Company, a subsidiary of Berkshire Hathaway - translator's note) is a very interesting model, and one of the 100 models you must keep in mind. I have many friends who have been constantly playing in these failing companies throughout their lives, almost applying all the rules - I call it the "cancer therapy rule".
They look at all the chaos, calculate whether they can cut off everything else and leave only the healthy stuff, and then "revive" them. If they can indeed find it, they throw away the useless stuff.
If this method doesn't work, they liquidate the company's assets. GEICO had some very outstanding businesses, but due to being successful, GEICO did some stupid things. Because of their outstanding performance, they once thought they were invincible, and then experienced a serious setback. What they had to do was cut off the paralyzed businesses and return to their areas of expertise. This is a very simple model that never fails.
GEICO has made us a lot of money, although its content is somewhat mixed, overall, it is a good company. GEICO has introduced some extraordinary and talented talents, and they have started to make bold cuts. This is the model you are looking for.
Mission of Investment Managers: Enhancing Value for Clients
Finally, I will talk about investment management. It's an interesting industry - because in terms of net worth, the entire investment management industry has not brought any value enhancement to clients, that's the nature of its operation. Of course, the plumbing industry is not like this, nor is the medical industry.
If you want to enter the investment management industry, you will face this special situation, where most investment managers operate using "psychological denial" - like a chiropractor, this is a standard way to deal with the limitations of investment managers. But if you want to be exceptional, I suggest avoiding this "psychological denial" pattern I believe that in the field of investment management, only a small number of elite individuals can truly enhance value. However, intelligence alone is not enough; one must also undergo some practical training - seizing every opportunity to provide above-average returns for your clients.
I am referring to investment managers dedicated to selecting common stocks, not other fields. Certainly, there are many experts in areas like currencies who have achieved good performance in large-scale operations. But the environment I am in is different, so the discussion is limited to the selection of American stocks.
I think it is very challenging to enhance value for investment management clients, but it is not impossible.
Over the years, at various cocktail parties, we often encounter questions like: "How can I establish a stable system for financial stability and retirement savings?" I always try to avoid these questions.
The answer is: "Spend less than you earn, make sure there is a surplus, and then put it in a tax-deferred account. Over time, it will have some effect. It's so simple and clear that everyone can understand it at a glance."