MungersWorldlyWisdom
“A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”.
Charles Munger
1994
I'm going
to play a minor trick on you today ‑ because the subject of my talk is
the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about
worldly wisdom ‑ a much broader topic that interests me because I think
all too little of it is delivered by modern educational systems, at least in an
effective way.
And therefore, the talk is sort of along the lines that some behaviorist
psychologists call Grandma's rule after the wisdom of Grandma when she said
that you have to eat the carrots before you get the dessert.
The carrot part of this talk is about the general subject of worldly wisdom
which is a pretty good way to start.
After all, the theory of modern education is that you need a general education before you specialize.
And I think to some extent, before you're going to be a great stock
picker, you need some general education.
So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you through
a few basic notions.
What is elementary, worldly wisdom?
Well, the first rule is that you can't really know anything if you just
remember isolated facts and try and bang 'em
back. If the facts don't hang together
on a latticework of theory, you don't have them in a usable form.
You've got to have models in your
head. And you've got to array your
experience ‑ both vicarious and direct ‑ on this latticework of
models. You may have noticed students
who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a
latticework of models in your head.
What are the models? Well, the first
rule is that you've got to have multiple models
‑ because if you just have one or two that you're using, the nature of
human psychology is such that you'll torture
reality so that it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor
who, of course, is the great boob in medicine.
It's like the old saying, "To the man with only a hammer, every problem
looks like a nail." And of course,
that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous
way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.
And the models have to come from multiple disciplines ‑ because all the
wisdom of the world is not to be found in one little academic department. That's why poetry professors, by and large,
are so unwise in a worldly sense. They
don't have enough models in their heads.
So you've got to have models across a fair array of disciplines.
You may say, "My God, this is already getting way too tough." But, fortunately, it isn't that tough ‑ because 80 or 90 important models will
carry about 90% of the freight in making you a worldly ‑ wise
person. And, of those, only a mere handful really carry very heavy freight.
So let's briefly review what kind of models and techniques constitute this
basic knowledge that everybody has to have before they proceed to being really
good at a narrow art like stock picking.
First there's mathematics. Obviously,
you've got to be able to handle numbers and quantities ‑ basic
arithmetic. And the great useful model,
after compound interest, is the elementary math of permutations and
combinations. And that was taught in my
day in the sophomore year in high school.
I suppose by now in great private schools, it's probably down to the
eighth grade or so.
It's very simple algebra. It was all
worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.
It's not that hard to learn. What is
hard is to get so you use it routinely almost everyday
of your life. The Fermat/Pascal system
is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.
Many educational institutions ‑ although not nearly enough ‑ have
realized this. At
By and large, as it works out, people can't naturally and automatically do
this. If you understand elementary
psychology, the reason they can't is really quite simple: The basic neural
network of the brain is there through broad genetic and cultural
evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut ‑ type
of approximation. It's got elements of
Fermat/Pascal in it. However, it's not
good.
So you have to learn in a very usable way this very elementary math and use it
routinely in life ‑ just the way if you want to become a golfer, you
can't use the natural swing that broad evolution gave you. You have to learn
to have a certain grip and swing in a different way to
realize your full potential as a golfer.
If you don't get this elementary, but mildly unnatural, mathematics of
elementary probability into your repertoire, then you go through a long life
like a one‑legged man in an ass‑kicking contest. You're giving a huge advantage to everybody else.
One of the advantages of a fellow like Buffett, whom
I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary
math of permutations and combinations....
Obviously, you have to know accounting.
It's the language of practical business life. It was a very
useful thing to deliver to civilization.
I've heard it came to civilization through
And it's not that hard to understand.
But you have to know enough about it to understand its limitations ‑
because although accounting is the starting place, it's only a crude
approximation. And it's not very hard to
understand its limitations. For example,
everyone can see that you have to more or less just guess at the useful life of
a jet airplane or anything like that.
Just because you express the depreciation rate in neat numbers doesn't
make it anything you really know.
In terms of the limitations of accounting, one of my favorite stories involves
a very great businessman named Carl Braun who created the CF Braun Engineering
Company. It designed and built oil
refineries ‑ which is very hard to do.
And Braun would get them to come in on time and not blow up and have
efficiencies and so forth. This is a
major art.
And Braun, being the thorough Teutonic type that he was, had a number of
quirks. And one of them was that he took
a look at standard accounting and the way it was applied to building oil
refineries and he said, "This is asinine."
So he threw all of his accountants out and he took his engineers and said,
"Now, we'll devise our own system
of accounting to handle this process."
And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented
man who demonstrated both the importance of accounting and the importance of
knowing its limitations.
He had another rule, from psychology, which, if you're interested in wisdom,
ought to be part of your repertoire ‑ like the elementary mathematics of
permutations and combinations.
His rule for all the Braun Company's communications was called the five W's ‑
you had to tell who was going to do what, where, when and why. And
if you wrote a letter or directive in the Braun Company telling somebody to do
something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it
twice.
You might ask why that is so important? Well, again that's a rule of psychology. Just as you think better if you array
knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people
why, they'll understand it better, they'll consider it more important, and
they'll be more likely to comply. Even
if they don't understand your reason, they'll be more likely to comply.
So there's an iron rule that just as you want to start getting worldly wisdom
by asking why, why, why, in communicating with other people about everything,
you want to include why, why, why. Even
if it's obvious, it's wise to stick in the why.
Which models are the most reliable? Well,
obviously, the models that come from hard science and engineering are the most
reliable models on this Earth. And
engineering quality control ‑ at least the guts of it that matters to you
and me and people who are not professional engineers ‑ is very much based
on the elementary mathematics of Fermat and Pascal:
It costs so much and you get so much less likelihood of it breaking if you
spend this much. It's all elementary
high school mathematics. And an
elaboration of that is what Deming brought to
I don't think it's necessary for most people to be terribly facile in
statistics. For example, I'm not sure
that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal
distribution looks like and I know that events and huge aspects of reality end
up distributed that way. So I can do a
rough calculation.
But if you ask me to work out something involving a Gaussian distribution to
ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play
pretty well without mastering Pascal.
And by the way, that works well enough.
But you have to understand that bell‑shaped curve at least roughly
as well as I do.
And, of course, the engineering idea of a backup system is a very powerful
idea. The engineering idea of
breakpoints ‑ that's a very powerful model, too. The notion of a critical mass ‑ that
comes out of physics ‑ is a very powerful model.
All of these things have great utility in looking at ordinary reality. And all of this cost-benefit analysis ‑
hell, that's all elementary high school algebra, too. It's just been dolled up a little bit with
fancy lingo.
I suppose the next most reliable models are from biology/ physiology because,
after all, all of us are programmed by our genetic makeup to be much the same.
And then when you get into psychology, of course, it gets very much more
complicated. But it's an ungodly
important subject if you're going to have any worldly wisdom.
And you can demonstrate that point quite simply: There's not a person in this room viewing the
work of a very ordinary professional magician who doesn't see a lot of things
happening that aren't happening and not see a lot of things happening that are
happening.
And the reason why is that the perceptual apparatus of man has shortcuts in
it. The brain cannot have unlimited
circuitry. So someone who knows how to
take advantage of those shortcuts and cause the brain to miscalculate in
certain ways can cause you to see things that aren't there.
Now you get into the cognitive function as distinguished from the perceptual
function. And there, you are equally ‑
more than equally in fact ‑ likely to be misled. Again, your brain has a shortage of circuitry
and so forth ‑ and it's taking all kinds of little automatic shortcuts.
So when circumstances combine in certain ways ‑ or more commonly, your
fellow man starts acting like the magician and manipulates you on purpose by
causing your cognitive dysfunction ‑ you're a patsy.
And so just as a man working with a tool has to know its limitations, a man
working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used
to control and motivate other people....
So the most useful and practical part of psychology ‑ which I personally
think can be taught to any intelligent person in a week ‑ is ungodly
important. And nobody taught it to me by
the way. I had to learn it later in
life, one piece at a time. And it was
fairly laborious. It's so elementary
though that, when it was all over, I felt like a fool.
And yeah, I'd been educated at Cal Tech and the
The elementary part of psychology ‑ the psychology of misjudgment, as I
call it ‑ is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly
complicated. But the guts
of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to pay heed to
it. In fact, I've done it several times
during the last two or three years in a very important way. You never get totally over making silly
mistakes.
There's another saying that comes from Pascal which I've always considered one
of the really accurate observations in the history of thought. Pascal said in essence, "The mind of man
at one and the same time is both the glory and the shame of the universe."
And that's exactly right. It has this
enormous power. However, it also has
these standard misfunctions that often cause it to
reach wrong conclusions. It also makes
man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological
manipulation, what human beings will do is quite interesting.
Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really
govern the interests involved,
rationally considered? And second, what
are the subconscious influences where
the brain at a subconscious level is automatically doing these things ‑
which by and large are useful, but which often misfunction.
One approach is rationality ‑ the way you'd work out a bridge problem: by
evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the
psychological factors that cause subconscious conclusions ‑ many of which
are wrong.
Now we come to another somewhat less reliable form of human wisdom ‑
microeconomics. And here, I find it
quite useful to think of a free market economy ‑ or partly free market
economy ‑ as sort of the equivalent of an ecosystem....
This is a very unfashionable way of thinking because early in the days after
Darwin came along, people like the robber barons assumed that the doctrine of
the survival of the fittest authenticated them as deserving power ‑ you
know, "I'm the richest. Therefore,
I'm the best. God's in his heaven,
etc."
And that reaction of the robber barons was so irritating to people that it made
it unfashionable to think of an economy as an ecosystem. But the truth is that it is a lot like an
ecosystem. And you get many of the same
results.
Just as in an ecosystem, people who narrowly specialize can get terribly good
at occupying some little niche. Just as
animals flourish in niches, similarly, people who specialize in the business
world ‑ and get very good because they specialize ‑ frequently find
good economics that they wouldn't get any other way.
And once we get into microeconomics, we get into the concept of advantages of
scale. Now we're getting closer to
investment analysis ‑ because in terms of which businesses succeed and
which businesses fail, advantages of scale are ungodly important.
For example, one great advantage of scale taught in all of the business schools
of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and
more volume enables human beings, who are trying to improve and are motivated
by the incentives of capitalism, to do it more and more efficiently.
The very nature of things is that if you get a whole lot of volume through your
joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses
succeed and fail....
Let's go through a list ‑ albeit an incomplete one ‑ of possible
advantages of scale. Some come from
simple geometry. If you're building a
great spherical tank, obviously as you build it bigger, the amount of steel you
use in the surface goes up with the square and the cubic volume goes up with
the cube. So as you increase the
dimensions, you can hold a lot more volume per unit area of steel.
And there are all kinds of things like that where the simple geometry ‑
the simple reality ‑ gives you an advantage of scale.
For example, you can get advantages of scale from TV advertising. When TV advertising first arrived ‑
when talking color pictures first came into our living rooms ‑ it was an
unbelievably powerful thing. And in the
early days, we had three networks that had whatever it was ‑ say 90% of
the audience.
Well, if you were Proctor & Gamble, you could afford to use this new method
of advertising. You could afford the
very expensive cost of network television because you were selling so many cans
and bottles. Some little guy
couldn't. And there was no way of buying
it in part. Therefore, he couldn't use
it. In effect, if you didn't have a big
volume, you couldn't use network TV advertising which was the most effective
technique.
So when TV came in, the branded companies that were already big got a huge tail
wind. Indeed, they prospered and
prospered and prospered until some of them got fat and foolish, which happens
with prosperity ‑ at least to some people....
And your advantage of scale can be an informational advantage. If I go to some remote place, I may see
Wrigley chewing gum alongside Glotz's chewing
gum. Well, I know that Wrigley is a
satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30
cents, am I going to take something I don't know and put it in my mouth ‑
which is a pretty personal place, after all ‑ for a lousy dime?
So, in effect, Wrigley , simply by being so well
known, has advantages of scale ‑ what you might call an informational
advantage.
Another advantage of scale comes from psychology. The psychologists use the term “social
proof”. We are all influenced ‑
subconsciously and to some extent consciously ‑ by what we see others do
and approve. Therefore, if everybody's
buying something, we think it's better. We don't like to be the one guy who's out of
step.
Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally
think, "Gee, I don't know much about this.
They know more than I do.
Therefore, why shouldn't I follow them?"
The social proof phenomenon which comes right out of psychology gives huge
advantages to scale ‑ for example, with very wide distribution, which of
course is hard to get. One advantage of
Coca-Cola is that it's available almost
everywhere in the world.
Well, suppose you have a little soft drink.
Exactly how do you make it available all over the Earth? The worldwide distribution setup ‑
which is slowly won by a big enterprise ‑ gets to be a huge advantage.... And if you think
about it, once you get enough advantages of that type, it can become very hard
for anybody to dislodge you.
There's another kind of advantage to
scale. In some businesses, the very
nature of things is to sort of cascade toward the overwhelming dominance of one
firm.
The most obvious one is daily newspapers.
There's practically no city left in the
And again, that's a scale thing. Once I
get most of the circulation, I get most of the advertising. And once I get most of the advertising and
circulation, why would anyone want the thinner paper with less information in
it? So it tends to cascade to a winner‑take‑all
situation. And that's a separate form of
the advantages of scale phenomenon.
Similarly, all these huge advantages of scale allow greater specialization
within the firm. Therefore, each person
can be better at what he does.
And these advantages of scale are so great, for example, that when Jack Welch
came into General Electric, he just said, "To hell with it. We're either going to be # 1 or #2 in every
field we're in or we're going to be out.
I don't care how many people I have to fire and what I have to
sell. We're going to be #I or #2 or
out."
That was a very tough‑minded thing to do, but I think it was a very
correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for
a civilization either, because I think that General Electric is stronger for
having Jack Welch there.
And there are also disadvantages of scale.
For example, we ‑ by which I mean Berkshire Hathaway ‑ are
the largest shareholder in
We'd have a travel magazine for business travel. So somebody would create one which was
addressed solely at corporate travel departments. Like an ecosystem, you're getting a narrower
and narrower specialization.
Well, they got much more efficient. They
could tell more to the guys who ran corporate travel departments. Plus, they didn't have to waste the ink and
paper mailing out stuff that corporate travel departments weren't interested in
reading. It was a more efficient
system. And they beat our brains out as
we relied on our broader magazine.
That's what happened to The Saturday
Evening Post and all those things.
They're gone. What we have now is
Motorcross ‑ which is read by a bunch of nuts
who like to participate in tournaments where they turn somersaults on their
motorcycles. But they care about
it. For them, it's the principle purpose
of life. A magazine called Motorcross is a total necessity to those people. Arid its profit margins would make you
salivate.
Just think of how narrowcast that kind of publishing is. So occasionally, scaling
down and intensifying gives you the big advantage. Bigger is not always better.
The great defect of scale, of course, which makes the game interesting ‑
so that the big people don't always win ‑ is that as you get big, you get
the bureaucracy. And with the
bureaucracy comes the territoriality ‑ which is again grounded in human
nature.
And the incentives are perverse. For
example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the
shareholder or anything else? And in a
bureaucracy, you think the work is done when it goes out of your in-basket into
somebody else's in-basket. But, of
course, it isn't. It's not done until
AT&T delivers what it's supposed to deliver. So you get big, fat, dumb, unmotivated
bureaucracies.
They also tend to become somewhat corrupt.
In other words, if I've got a department and you've got a department and
we kind of share power running this thing, there's
sort of an unwritten rule: "If you won't bother me, I won't bother you and
we're both happy." So you get
layers of management and associated costs that nobody needs. Then, while people are justifying all these
layers, it takes forever to get anything done.
They're too slow to make decisions and nimbler people run circles around
them.
The constant curse of scale is that it leads to big, dumb bureaucracy ‑
which, of course, reaches its highest and worst form in government where the
incentives are really awful. That
doesn't mean we don't need governments ‑ because we do. But it's a terrible problem to get big
bureaucracies to behave.
So people go to stratagems. They create
little decentralized units and fancy motivation and training programs. For example, for a big company, General
Electric has fought bureaucracy with amazing skill. But that's because they have a combination of
a genius and a fanatic running it. And
they put him in young enough so he gets a long run. Of course, that's Jack Welch.
But bureaucracy is terrible.... And as things get very powerful and very big,
you can get some really dysfunctional behavior.
Look at Westinghouse. They blew
billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who'd come up by some
career path ‑ I don't know exactly what it was, but it could have been
refrigerators or something ‑ and all of a sudden, he's loaning money to
real estate developers building hotels.
It's a very unequal contest. And
in due time, they lost all those billions of dollars.
CBS provides an interesting example of another rule of psychology ‑
namely, Pavlovian association. If people tell you what you really don't want
to hear what's unpleasant ‑ there's an almost automatic reaction of
antipathy. You have to train yourself
out of it. It isn't foredestined
that you have to be this way. But you
will tend to be this way if you don't think about it.
Television was dominated by one network ‑ CBS in its early days. And Paley was a
god. But he didn't like to hear what he
didn't like to hear. And people soon
learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little
cocoon of unreality and everything else was corrupt ‑ although it was a
great business.
So the idiocy that crept into the system was carried along by this huge
tide. It was a Mad Hatter's tea party
the last ten years under Bill Paley.
And that is not the only example by any means.
You can get severe misfunction in the high
ranks of business. And of course, if
you're investing, it can make a lot of difference. If you take all the acquisitions that CBS
made under Paley, after the acquisition of the
network itself, with all his advisors ‑ his investment bankers,
management consultants and so forth who were getting paid very handsomely ‑
it was absolutely terrible.
For example, he gave something like 20% of CBS to the Dumont Company for a
television set manufacturer which was destined to go broke. I think it lasted all of two or three years
or something like that. So very soon
after he'd issued all of that stock,
So life is an everlasting battle between those two forces ‑ to get these
advantages of scale on one side and a tendency to get a lot like the U.S.
Agriculture Department on the other side ‑ where they just sit around and
so forth. I don't know exactly what they
do. However, I do know that they do very
little useful work.
On the subject of advantages of economies of scale, I find chain stores quite
interesting. Just think about it. The concept of a chain store was a
fascinating invention. You get this huge
purchasing power ‑ which means that you have lower merchandise
costs. You get a whole bunch of little
laboratories out there in which you can conduct experiments. And you get specialization.
If one little guy is trying to buy across 27 different merchandise categories
influenced by traveling salesmen, he's going to make a lot of poor
decisions. But if your buying is done in
headquarters for a huge bunch of stores, you can get very bright people that
know a lot about refrigerators and so forth to do the buying.
The reverse is demonstrated by the little store where one guy is doing all the
buying. It's like the old story about
the little store with salt all over its walls.
And a stranger comes in and says to the storeowner, "You must sell
a lot of salt." And he replies, "No, I don't. But you should see the guy who sells me salt."
So there are huge purchasing advantages.
And then there are the slick systems of forcing everyone to do what
works. So a chain store can be a
fantastic enterprise.
It's quite interesting to think about Wal-Mart starting from a single store in
He played the chain store game harder and better than anyone else. Walton invented practically nothing.
But he copied everything anybody else ever did that was smart ‑
and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.
He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great
record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout,
knockout ‑ 42 times.
Walton, being as shrewd as he was, basically broke other small town merchants
in the early days. With his more
efficient system, he might not have been able to tackle some titan head-on at
the time. But with his better system, he
could destroy those small town merchants.
And he went around doing it time after time after time. Then, as he got bigger, he started destroying
the big boys.
Well, that was a very, very shrewd strategy.
You can say, "Is this a nice way to behave?" Well, capitalism is a pretty brutal
place. But I personally think that the
world is better for having
Wal-Mart. I mean you can idealize small
town life. But I've spent a fair amount
of time in small towns. And let me tell
you ‑ you shouldn't get too idealistic about all those businesses he
destroyed.
Plus, a lot of people who work at Wal-Mart are very high grade, bouncy people
who are raising nice children. I have no
feeling that an inferior culture destroyed a superior culture. I think that is nothing more than nostalgia
and delusion. But, at any rate, it's an
interesting model of how the scale of things and fanaticism combine to be very
powerful.
And it's also an interesting model on the other side ‑ how with all its
great advantages, the disadvantages of bureaucracy did such terrible damage to
Sears, Roebuck. Sears had layers and
layers of people it didn't need. It was
very bureaucratic. It was slow to
think. And there was an established way
of thinking. If you poked your head up
with a new thought, the system kind of turned against you. It was everything in the way of a
dysfunctional big bureaucracy that you would expect.
In all fairness, there was also much that was good about it. But it just wasn't as lean and mean and
shrewd and effective as Sam Walton. And,
in due time, all its advantages of scale were not enough to prevent Sears from
losing heavily to Wal-Mart and other similar retailers.
Here's a model that we've had trouble with.
Maybe you'll be able to figure it out better. Many markets get down to two or three big
competitors ‑ or five or six. And
in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.
Over the years, we've tried to figure out why the competition in some markets
gets sort of rational from the investor's point of view so that the
shareholders do well, and in other markets, there's destructive competition
that destroys shareholder wealth.
If it's a pure commodity like airline seats, you can understand why no one
makes any money. As we sit here, just
think of what airlines have given to the world ‑ safe travel,
greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made
by the shareholders of airlines since
Yet, in other fields ‑ like cereals, for example ‑ almost all the
big boys make out. If you're some kind
of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make
40%. But why are cereals so profitable ‑
despite the fact that it looks to me like they're competing like crazy with
promotions, coupons and everything else?
I don't fully understand it.
Obviously, there's a brand identity factor in cereals that doesn't exist in
airlines. That must be the main factor
that accounts for it.
And maybe the cereal makers by and large have learned to be less crazy about
fighting for market share ‑ because if you get even one person who's
hell-bent on gaining market share.... For example, if I were Kellogg and I
decided that I had to have 60% of the market, I think
I could take most of the profit out of cereals.
I'd ruin Kellogg in the process.
But I think I could do it.
In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model
for predicting how that's going to happen.
For example, if you look around at bottler markets, you'll find many markets
where bottlers of Pepsi and Coke both make a lot of money and many others where
they destroy most of the profitability of the two franchises. That must get down to the peculiarities of
individual adjustment to market capitalism.
I think you'd have to know the people involved to fully understand what
was happening.
In microeconomics, of course, you've got the concept of patents, trademarks,
exclusive franchises and so forth.
Patents are quite interesting.
When I was young, I think more money went into patents than came
out. Judges tended to throw them out ‑
based on arguments about what was really invented and what relied on prior
art. That isn't altogether clear.
But they changed that. They didn't
change the laws. They just changed the
administration ‑ so that it all goes to one patent court. And that court is now very much more
pro-patent. So I think people are now
starting to make a lot of money out of owning patents.
Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a
big operation if it's well known.
The exclusive franchise can also be wonderful.
If there were only three television channels awarded in a big city and
you owned one of them, there were only so many hours a day that you could be
on. So you had a natural position in an
oligopoly in the pre-cable days.
And if you get the franchise for the only food stand in an airport, you have a
captive clientele and you have a small monopoly of a sort.
The great lesson in microeconomics is to discriminate between when technology
is going to help you and when it's
going to kill you. And most people do
not get this straight in their heads.
But a fellow like Buffett does.
For example, when we were in the textile business, which is a terrible
commodity business, we were making low-end textiles ‑ which are a real
commodity product. And one day, the
people came to
And
What was he thinking? He was thinking,
"It's a lousy business. We're
earning substandard returns and keeping it open just to be nice to the elderly
workers. But we're not going to put huge
amounts of new capital into a lousy business."
And he knew that the huge productivity increases that would come from a better
machine introduced into the production of a commodity product would all go to
the benefit of the buyers of the textiles.
Nothing was going to stick to our ribs as owners.
That's such an obvious concept ‑ that there are all kinds of wonderful
new inventions that give you nothing as owners except the opportunity to spend
a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements
are going to flow through to the customers.
Conversely, if you own the only newspaper in
In all cases, the people who sell the machinery ‑ and, by and large, even
the internal bureaucrats urging you to buy the equipment ‑ show you
projections with the amount you'll save at current prices with the new
technology. However, they don't do the
second step of the analysis which is to determine how much is going stay home
and how much is just going to flow through to the customer. I've never seen a single projection
incorporating that second step in my life.
And I see them all the time.
Rather, they always read: "This capital outlay will save you so much
money that it will pay for itself in three years."
So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow
you've earned a return of only about 4% per annum. That's the textile business.
And it isn't that the machines weren't better.
It's just that the savings didn't go to you. The cost reductions came through all
right. But the benefit of the cost
reductions didn't go to the guy who bought the equipment. It's such a simple idea. It's so basic. And yet it's so often forgotten.
Then there's another model from microeconomics which I find very
interesting. When technology moves as
fast as it does in a civilization like ours, you get a phenomenon which I call
competitive destruction. You know, you have
the finest buggy whip factory and all of a sudden in comes
this little horseless carriage. And
before too many years go by, your buggy whip business is dead. You either get into a different business or
you're dead ‑ you're destroyed. It
happens again and again and again.
And when these new businesses come in, there are huge advantages for the early birds. And when you're an early bird, there's a
model that I call "surfing" ‑ when a surfer gets up and catches
the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired
in shallows....
But people get long runs when they're right on the edge of the wave ‑
whether it's Microsoft or Intel or all kinds of people, including National Cash
Register in the early days.
The cash register was one of the great contributions to civilization. It's a wonderful story. Patterson was a small retail merchant who
didn't make any money. One day, somebody
sold him a crude cash register which he put into his retail operation. And it instantly changed from losing money to
earning a profit because it made it so much harder for the employees to
steal....
But Patterson, having the kind of mind that he did, didn't think, "Oh,
good for my retail business." He thought, "I'm going into the cash
register business." And, of course,
he created National Cash Register.
And he "surfed". He got the
best distribution system, the biggest collection of patents and the best of
everything. He was a fanatic about
everything important as the technology developed. I have in my files an early National Cash
Register Company report in which Patterson described his methods and
objectives. And a well-educated
orangutan could see that buying into partnership with Patterson in those early
days, given his notions about the cash register business, was a total 100%
cinch.
And, of course, that's exactly what an investor should be looking for. In a long life, you can expect to profit
heavily from at least a few of those opportunities if you develop the wisdom
and will to seize them. At any rate,
"surfing" is a very powerful model.
However, Berkshire Hathaway , by and large, does not
invest in these people that are "surfing" on complicated
technology. After all, we're cranky and
idiosyncratic ‑ as you may have noticed.
And Warren and I don't feel like we have any great advantage in the high-tech
sector. In fact, we feel like we're at a
big disadvantage in trying to understand the nature of technical developments
in software, computer chips or what have you.
So we tend to avoid that stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea.
Every person is going to have a circle of competence. And it's going to be very hard to advance
that circle. If I had
to make my living as a musician.... I can't even think of a level low enough to describe where I would be sorted out
to if music were the measuring standard of the civilization.
So you have to figure out what your own aptitudes are. If you play games where other people have the
aptitudes and you don't, you're going to lose.
And that's as close to certain as any prediction that you can make. You have to figure out where you've got an edge. And you've got to play within your own circle of competence.
If you want to be the best tennis player in the world, you may start out trying
and soon find out that it's hopeless ‑ that other people blow right by
you. However, if you want to become the
best plumbing contractor in
So some edges can be acquired. And the
game of life to some extent for most of us is trying to be something like a
good plumbing contractor in
Some of you may find opportunities "surfing" along in the new
high-tech fields ‑ the Intels, the Microsofts and so on.
The fact that we don't think we're very good at it and have pretty well
stayed out of it doesn't mean that it's irrational for you to do it.
Well, so much for the basic microeconomics models, a little
bit of psychology, a little bit of mathematics, helping create what I call the
general substructure of worldly wisdom.
Now, if you want to go on from carrots to dessert, I'll turn to stock
picking ‑ trying to draw on this general worldly wisdom as we go.
I don't want to get into emerging markets, bond arbitrage and so forth. I'm talking about nothing but plain vanilla
stock picking. That, believe me, is
complicated enough. And I'm talking
about common stock picking.
The first question is, "What is the nature of the stock market?" And that gets you directly to this efficient
market theory that got to be the rage ‑ a total rage ‑ long after I graduated from law school.
And it's rather interesting because one of the greatest economists of the world
is a substantial shareholder in Berkshire Hathaway and has been for a long
time. His textbook always taught that
the stock market was perfectly efficient and that nobody could beat it. But his own
money went into
Is the stock market so efficient that people can't beat it? Well, the efficient market theory is
obviously roughly right ‑
meaning that markets are quite efficient
and it's quite hard for anybody to
beat the market by significant margins as a stock picker by just being
intelligent and working in a disciplined way.
Indeed, the average result has to be the average result. By definition, everybody can't beat the market.
As I always say, the iron rule of life is that only 20% of the people
can be in the top fifth. That's just the
way it is. So the answer is that it's
partly efficient and partly inefficient.
And, by the way, I have a name for people who went to the extreme efficient
market theory ‑ which is "bonkers". It was an intellectually consistent theory
that enabled them to do pretty mathematics.
So I understand its seductiveness to people with large mathematical
gifts. It just had a difficulty in that
the fundamental assumption did not tie properly to reality.
Again, to the man with a hammer, every problem looks like a nail. If you're good at manipulating higher
mathematics in a consistent way, why not make an assumption which enables you
to use your tool?
The model I like ‑ to sort of simplify the notion of what goes on in a
market for common stocks ‑ is the pari-mutuel system at the
racetrack. If you stop to think about
it, a pari-mutuel system is a market. Everybody goes there and bets and the
odds change based on what's bet. That's
what happens in the stock market.
Any damn fool can see that a horse carrying a light weight with a wonderful win
rate and a good post position etc., etc. is way more likely to win than a horse
with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse
pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically
the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that
it's very hard to beat the system.
And then the track is taking 17% off the top.
So not only do you have to outwit all the other
betters, but you've got to outwit them by such a big margin that on average,
you can afford to take 17% of your gross bets off the top and give it to the
house before the rest of your money can be put to work.
Given those mathematics, is it possible to beat the horses only using one's
intelligence? Intelligence should give
some edge, because lots of people who don't know anything go out and bet lucky
numbers and so forth. Therefore,
somebody who really thinks about nothing but horse performance and is shrewd
and mathematical could have a very considerable edge, in the absence of the
frictional cost caused by the house take.
Unfortunately, what a shrewd horseplayer's edge does in most cases is to reduce
his average loss over a season of betting from the 17% that he would lose if he
got the average result to maybe 10%.
However, there are actually a few people who can beat the game after
paying the full 17%.
I used to play poker when I was young with a guy who made a substantial living
doing nothing but bet harness races.... Now, harness racing is a relatively
inefficient market. You don't have the
depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about
harness races as his main profession.
And he would bet only occasionally when he saw some mispriced
bet available. And by doing that, after
paying the full handle to the house ‑ which I presume was around 17% ‑
he made a substantial living.
You have to say that's rare. However,
the market was not perfectly efficient.
And if it weren't for that big 17% handle, lots of people would
regularly be beating lots of other people at the horse races. It's efficient, yes. But it's not perfectly efficient. And with enough shrewdness and fanaticism,
some people will get better results than others.
The stock market is the same way ‑ except that the house handle is so
much lower. If you take transaction
costs ‑ the spread between the bid and the ask
plus the commissions ‑ and if you don't trade too actively, you're
talking about fairly low transaction costs.
So that with enough fanaticism and enough discipline,
some of the shrewd people are going to get way better results than average in
the nature of things.
It is not a bit easy. And, of course,
50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost
operation, they will get better than average results in stock picking.
How do you get to be one of those who is a winner ‑ in a relative sense ‑
instead of a loser?
Here again, look at the pari-mutuel system.
I had dinner last night by absolute accident with the president of Santa
Anita. He says that there are two or
three betters who have a credit arrangement with them, now that they have
off-track betting, who are actually beating the house. They're sending money out net after the full
handle ‑ a lot of it to
And the one thing that all those winning betters in the whole history of people
who've beaten the pari-mutuel system have is quite simple. They bet very seldom.
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.
That is a very simple concept. And to me
it's obviously right ‑ based on experience not only from the pari-mutuel
system, but everywhere else.
And yet, in investment management, practically nobody operates that way. We operate that way ‑ I'm talking about
Buffett and Munger. And we're not alone in the world. But a huge majority of people have some other
crazy construct in their heads. And
instead of waiting for a near cinch and loading up, they apparently ascribe to
the theory that if they work a little harder or hire more business school
students, they'll come to know everything about everything all the time.
To me,
that's totally insane. The way to win is to work, work, work, work and hope to have a
few insights.
How many insights do you need? Well, I'd
argue: that you don't need many in a lifetime.
If you look at Berkshire Hathaway and all of its accumulated billions,
the top ten insights account for most of it.
And that's with a very brilliant man ‑
So you can get very remarkable investment results if you think more like a
winning pari-mutuel player. Just think
of it as a heavy odds against game full of craziness
with an occasional mispriced something or other. And you're probably not going to be smart
enough to find thousands in a lifetime.
And when you get a few, you really load up. It's just that simple.
When
He says, "Under those rules, you'd really think carefully about what you
did and you'd be forced to load up on what you'd really thought about. So you'd do so much better."
Again, this is a concept that seems perfectly obvious to me. And to
To me, it's obvious that the winner has to bet very selectively. It's been obvious to me since very early in
life. I don't know why it's not obvious
to very many other people.
I think the reason why we got into such idiocy in investment management is best
illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, "My God, they're purple and
green. Do fish really take these
lures?" And he said, "Mister,
I don't sell to fish."
Investment managers are in the position of that fishing tackle salesman. They're like the guy who was selling salt to
the guy who already had too much salt. And as long as the guy will buy salt, why they'll sell salt. But that isn't what ordinarily works for the buyer of investment advice.
If you invested
So what makes sense for the investor is different from what makes sense for the
manager. And, as usual in human affairs,
what determines the behavior are incentives for the
decision maker.
From all business, my favorite case on incentives is Federal Express. The heart and soul of their system ‑
which creates the integrity of the product ‑ is having all their
airplanes come to one place in the middle of the night and shift all the
packages from plane to plane. If there
are delays, the whole operation can't deliver a product full of integrity to
Federal Express customers.
And it was always screwed up. They could
never get it done on time. They tried
everything ‑ moral suasion, threats, you name it. And nothing worked.
Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift ‑ and when it's all done, they can all go home. Well, their problems cleared up overnight.
So getting the incentives right is a very, very important lesson. It was not obvious to Federal Express what
the solution was. But maybe now, it will
hereafter more often be obvious to you.
All right, we've now recognized that the market is efficient as a pari-mutuel
system is efficient with the favorite more likely than the long shot to do well
in racing, but not necessarily give any betting advantage to those that bet on
the favorite.
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.
What style should the investor use as a picker of common stocks in order to try
to beat the market ‑ in other words, to get an above average long-term
result? A standard technique that
appeals to a lot of people is called "sector rotation". You simply figure out when oils are going to
outperform retailers, etc., etc., etc. You just kind of flit around being in the hot sector of the market
making better choices than other people.
And presumably, over a long period of time, you get ahead.
However, I know of no really rich sector rotator. Maybe some people can do it. I'm not saying they can't. All I know is that all the people I know who
got rich ‑ and I know a lot of them ‑ did not do it that way.
The second basic approach is the one that Ben Graham used ‑ much admired
by Warren and me. As one factor, Graham
had this concept of value to a private owner ‑ what the whole enterprise
would sell for if it were available. And
that was calculable in many cases.
Then, if you could take the stock price and multiply it by the number of shares
and get something that was one third or less of sellout value, he would say
that you've got a lot of edge going for you.
Even with an elderly alcoholic running a stodgy business, this significant
excess of real value per share working for you means that all kinds of good
things can happen to you. You had a huge margin of safety ‑ as he put
it ‑ by having this big excess value going for you.
But he was, by and large, operating when the world was in shell shock from the
1930s ‑ which was the worst contraction in the English-speaking world in
about 600 years. Wheat in
And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you
just sacked them all, took the working capital and stuck it in the owners'
pockets. That was the way capitalism
then worked.
Nowadays, of course, the accounting is not realistic because the minute the business
starts contracting, significant assets are not there. Under social norms and the new legal rules of
the civilization, so much is owed to the employees that, the minute the
enterprise goes into reverse, some of the assets on
the balance sheet aren't there anymore.
Now, that might not be true if you run a little auto dealership yourself. You may be able to run it in such a way that
there's no health plan and this and that so that if the business gets lousy,
you can take your working capital and go home.
But IBM can't, or at least didn't.
Just look at what disappeared from its balance sheet when it decided
that it had to change size both because the world had changed technologically
and because its market position had deteriorated.
And in terms of blowing it, IBM is some example. Those were brilliant, disciplined
people. But there was enough turmoil in
technological change that IBM got bounced off the wave after "surfing"
successfully for 60 years. And that was
some collapse ‑ an object lesson in the difficulties of technology and
one of the reasons why Buffett and Munger don't like technology very much. We don't think we're any good at it, and
strange things can happen.
At any rate, the trouble with what I call the classic Ben Graham concept is
that gradually the world wised up and those real obvious bargains
disappeared. You could run your Geiger
counter over the rubble and it wouldn't click.
But such is the nature of people who have a hammer ‑ to whom, as I
mentioned, every problem looks like a nail that the Ben Graham followers
responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in
a different way. And they kept changing
the definition so that they could keep doing what they'd always done. And it still
worked pretty well. So the Ben
Graham intellectual system was a very good one.
Of course, the best part of it all was his concept of "Mr.
Market". Instead of thinking the
market was efficient, he treated it as a
manic-depressive who comes by every day.
And some days he says, "I'll sell you some of my interest for way
less than you think it's worth." And other days,
"Mr. Market" comes by and says, "I'll buy your interest at a
price that's way higher than you think it's
worth." And you get the option of deciding whether you want to
buy more, sell part of what you already have or do nothing at all.
To Graham, it was a blessing to be in business with a manic-depressive who gave
you this series of options all the time.
That was a very significant mental construct. And it's been very useful to Buffett, for instance, over his whole adult lifetime.
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.
And even some of the early money was made by being temporarily present in great
businesses. Buffett
Partnership, for example, owned American Express and Disney when they got
pounded down.
Most investment managers are in a game where the clients expect them to know a
lot about a lot of things. We didn't
have any clients who could fire us at Berkshire Hathaway. So we didn't have to be governed by any such
construct. And we came to this notion of
finding a mispriced bet and loading up when we were
very confident that we were right. So
we're way less diversified. And I think
our system is miles better.
However, in all fairness, I don't think a lot of money managers could
successfully sell their services if they used our system. But if you're investing for 40 years in some
pension fund, what difference does it make if the path from start to finish is
a little more bumpy or a little different than everybody else's so long as it's
all going to work out well in the end?
So what if there's a little extra volatility.
In investment management today, everybody wants not only to win, but to have a
yearly outcome path that never diverges very much from a standard path except
on the upside. Well, that is a very
artificial, crazy construct. That's the
equivalent in investment management to the custom of binding the feet of
Chinese women. It's the equivalent of
what Nietzsche meant when he criticized the man who had a lame leg and was
proud of it.
That is really hobbling yourself. Now, investment managers would say, "We have to be that way. That's how we're measured." And they may
be right in terms of the way the business is now constructed. But from the viewpoint of a rational
consumer, the whole system's "bonkers" and draws a lot of talented
people into socially useless activity.
And the
And it makes sense to load up on the very few good insights you have instead of
pretending to know everything about everything at all times. You're much more likely to do well if you
start out to do something feasible instead
of something that isn't feasible. Isn't
that perfectly obvious?
How many of you have 56 brilliant ideas in which you have equal
confidence? Raise your hands,
please. How many of you have two or
three insights that you have some confidence in? I rest my case.
I'd say that Berkshire Hathaway's system is adapting to the nature of the
investment problem as it really is.
We've really made the money out of high quality businesses. In some cases, we bought the whole
business. And in some cases, we just
bought a big block of stock. But when
you analyze what happened, the big money's been made in the high quality
businesses. And most of the other people
who've made a lot of money have done so in high quality businesses.
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.
But it doesn't work for Berkshire Hathaway anymore because we've got too much
money. We can't find anything that fits
our size parameter that way. Besides,
we're set in our ways. But I regard
finding them small as a perfectly intelligent approach for somebody to try with
discipline. It's just not something that
I've done.
Finding 'em big obviously is very hard because of the
competition. So far,
And ideally ‑ and we've done a lot of this ‑ you get into a great
business which also has a great manager because management matters. For example, it's made a great difference to
General Electric that Jack Welch came in instead of the guy who took over
Westinghouse ‑ a very great difference.
So management matters, too.
And some of it is predictable. I do not
think it takes a genius to understand that Jack Welch was a more insightful
person and a better manager than his peers in other companies. Nor do I think it took tremendous genius to
understand that Disney had basic momentums in place which are very powerful and
that Eisner and Wells were very unusual managers.
So you do get an occasional opportunity to get into a wonderful business that's
being run by a wonderful manager. And,
of course, that's hog heaven day. If you
don't load up when you get those opportunities, it's a big mistake.
Occasionally, you'll find a human being who's so talented that he can do things
that ordinary skilled mortals can't. I
would argue that Simon Marks ‑ who was second generation in Marks &
Spencer of
These people do come along ‑ and in many cases, they're not all that hard
to identify. If they've got a reasonable
hand ‑ with the fanaticism and intelligence and so on that these people
generally bring to the party ‑ then management can matter much.
However, averaged out, betting on the quality of a business is better than
betting on the quality of management. In
other words, if you have to choose one, bet on the business momentum, not the
brilliance of the manager.
But, very rarely.
you find a manager who's so good that you're
wise to follow him into what looks like a mediocre business.
Another very simple effect I very seldom see discussed either by investment
managers or anybody else is the effect of taxes. If you're going to buy something which
compounds for 30 years at 15% per annum and you pay one 35% tax at the very
end, the way that works out is that after taxes, you keep 13.3% per annum.
In contrast, if you bought the same investment, but had to pay taxes every year
of 35% out of the 15% that you earned, then your return would be 15% minus 35%
of 15% ‑ or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long
holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in
great companies, you can get a huge edge from nothing but the way that income
taxes work.
Even with a 10% per annum investment, paying a 35% tax at the end gives you
8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year
instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per
annum if you only achieve an average return by historical standards from common
stock investments in companies with tiny dividend payout ratios.
But in terms of business mistakes that I've seen over a long lifetime, I would
say that trying to minimize taxes too much is one of the great standard causes
of really dumb mistakes. I see terrible mistakes from people being
overly motivated by tax considerations.
Warren and I personally don't drill oil wells.
We pay our taxes. And we've done
pretty well, so far. Anytime somebody
offers you a tax shelter from here on in life, my advice would be don't buy it.
In fact, any time anybody offers you anything
with a big commission and a 200-page prospectus, don't buy it. Occasionally, you'll be wrong if you adopt
"Munger's Rule". However, over a lifetime, you'll be a long
way ahead ‑ and you will miss a lot of unhappy experiences that might
otherwise reduce your love for your fellow man.
There are huge advantages for an
individual to get into a position where you make a few great investments and
just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system
gives you an extra 1, 2 or 3 percentage points per annum compounded.
And you think that most of you are going to get that much advantage by hiring
investment counselors and paying them 1% to run around, incurring a lot of
taxes on your behalf'? Lots of luck.
Are there any dangers in this philosophy?
Yes. Everything in life has
dangers. Since it's so obvious that
investing in great companies works, it gets horribly overdone from time to
time. In the "Nifty-Fifty"
days, everybody could tell which companies were the great ones. So they got up to 50, 60 and 70 times
earnings. And just as IBM fell off the
wave, other companies did, too. Thus, a
large investment disaster resulted from too high prices. And you've got to be aware of that danger....
So there are risks. Nothing is automatic
and easy. But if you can find some
fairly-priced great company and buy it and sit, that tends to work out very,
very well indeed ‑ especially for an individual,
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.
That existed in Disney. It's such a
unique experience to take your grandchild to
So a lot of the great record of Eisner and Wells was utter brilliance but the
rest came from just raising prices at Disneyland and
At Berkshire Hathaway, Warren and I raised the prices of See's
Candy a little faster than others might have.
And, of course, we invested in Coca-Cola ‑ which had some untapped
pricing power. And it also had brilliant
management. So a Goizueta
and Keough could do much more than raise prices. It was perfect.
You will get a few opportunities to profit from finding underpricing. There are actually people out there who don't
price everything as high as the market will easily stand. And once you figure that out, it's like
finding in the street ‑ if you have the courage of your convictions.
If you look at
In one of those ‑ The Washington Post ‑ we bought it at about 20%
of the value to a private owner. So we
bought it on a Ben Graham‑style basis ‑ at one‑fifth of
obvious value ‑ and, in addition, we faced a situation where you had both
the top hand in a game that was clearly going to end up with one winner and a
management with a lot of integrity and intelligence. That one was a real dream. They're very high class people ‑ the
Katharine Graham family. That's why it
was a dream ‑ an absolute, damn dream.
Of course, that came about back in '73‑74. And that was almost like 1932. That was probably a once-in-40-years‑type
denouement in the markets. That
investment's up about 50 times over our cost.
If I were you, I wouldn't count on getting any investment in your lifetime
quite as good as The Washington Post was in '73 and '74.
But it doesn't have to be that good
to take care of you.
Let me mention another model. Of course,
Gillette and Coke make fairly low‑priced items and have a tremendous
marketing advantage all over the world.
And in Gillette's case, they keep surfing along new technology which is
fairly simple by the standards of microchips.
But it's hard for competitors to do.
So they've been able to stay constantly near the edge of improvements in
shaving. There are whole countries where
Gillette has more than 90% of the shaving market.
GEICO is a very interesting model. It's
another one of the 100 or so models you ought to have in your head. I've had many friends in the sick‑business‑fix‑up
game over a long lifetime. And they
practically all use the following formula ‑ I call it the cancer surgery
formula:
They look at this mess. And they figure
out if there ' s anything sound left that can live on its own if they cut away
everything else. And if they find
anything sound, they just cut away everything else. Of course, if that doesn't work, they
liquidate the business. But it
frequently does work.
And GEICO had a perfectly magnificent business
‑submerged in a mess, but still working.
Misled by success, GEICO had done some foolish things. They got to thinking that, because they were
making a lot of money, they knew everything.
And they suffered huge losses.
All they had to do was to cut out all the folly and go back to the perfectly
wonderful business that was lying there.
And when you think about it, that's a very simple model. And it's repeated over and over again.
And, in GEICO's case, think about all the money we passively made.... It was a wonderful business combined with a
bunch of foolishness that could easily be cut out. And people were coming in who were
temperamentally and intellectually designed so they were going to cut it
out. That is a model you want to look
for.
And you may find one or two or three in a long lifetime that are very
good. And you may find 20 or 30 that are
good enough to be quite useful.
Finally, I'd like to once again talk about investment management. That is a funny business because on a net
basis, the whole investment management business together gives no value added
to all buyers combined. That's the way
it has to work.
Of course, that isn't true of plumbing and it isn't true of medicine. If you're going to make your careers in the
investment management business, you face a very peculiar situation. And most investment managers handle it with
psychological denial ‑just like a chiropractor. That is the standard method of handling the
limitations of the investment management process. But if you want to live the best sort of
life, I would urge each of you not to use the psychological denial
mode.
I think a select few ‑ a small percentage of the investment managers ‑
can deliver value added. But I don't
think brilliance alone is enough to do it.
I think that you have to have a little of this discipline of calling
your shots and loading up ‑ if you want to maximize your chances of
becoming one who provides above average real returns for clients over the long
pull.
But I'm just talking about investment managers engaged in common stock
picking. I am agnostic elsewhere. I think there may well be people who are so
shrewd about currencies and this, that and the other thing that they can
achieve good long‑term records operating on a pretty big scale in that
way. But that doesn't happen to be my
milieu. I'm talking about stock picking
in American stocks.
I think it's hard to provide a lot of value added to the investment management
client, but it's not impossible.