B000U5KFIC EBOK (47 page)

BERKSHIRE HATHAWAY AND WESCO INVESTORS listen carefully to maxims
about life, but they literally crowd the doorways to hear Munger and
Buffett talk about investment issues. A frequently asked question is, how
do you learn to be a great investor?

First of all, you have to understand your own nature, said Munger.
"Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses
are going to make you miserable-and some losses are inevitable-you
might be wise to utilize a very conservative pattern of investment and
saving all your life. So you have to adapt your strategy to your own nature
and your own talents. I don't think there's a one-size-fits-all investment
strategy that I can give you."'

Then, says Munger, you have to gather information. "I think both
Warren and I learn more from the great business magazines than we do
anywhere else," said Charlie. "It's such an easy, shorthand way of getting
a vast variety of business experience just to riffle through issue after issue
covering a great variety of businesses. And if you get into the mental habit
of relating what you're reading to the basic structure of the underlying
ideas being demonstrated, you gradually accumulate some wisdom about
investing. I don't think you can get to be a really good investor over a
broad range without doing a massive amount of reading. I don't think any
one book will do it for you."

Each year at the Berkshire annual meeting Munger recommends a
wide range of reading material. These include Value Line charts, Robert B.
Cialdini's book Influence on how people are persuaded to buy products and take other actions, and recently, Robert Hagstrom's book, The
Warren Buffett Portfolio: Mastering the Power of the Focus Investment
Strategy.

Munger explained that a person's reading should not be random: ".. .
you have to have some idea of why you're looking for the information.
Don't read annual reports the way Francis Bacon said you do sciencewhich, by the way, is not the way you do science-where you just collect
endless data and then only later do you try to make sense of it. You have to
start with some ideas about reality. And then you have to look to see
whether what you're seeing fits in with proven basic concepts.

"Frequently, you'll look at a business having fabulous results. And the
question is, `How long can this continue?' Well, there's only one way I
know to answer that. And that's to think about why the results are occurring now-and then to figure out the forces that could cause those results
to stop occurring."

This is the method of thinking that helps Munger and Buffett spot a
company that has a franchise on a certain product, a so-called "moat"
around its business. There are several examples of companies that have
such a strong name brand that they seem invincible. Coca Cola has been
such a company, though the challenges are relentless. Munger also uses
the example of Wrigley's Chewing Gum.

"It's such a huge advantage to be by far the best-known gum company
in the world. Just think of how hard it would be to replace that image. If
you know you like Wrigley's Gum and you see it there for two bits, are you
really going to reach for Glotz's Gum because it's 20 cents and put something you don't know in your mouth? It's not worth it for you to think about
buying an alternative gum. So it's easy to understand why Wrigley's Gum
has such a huge advantage."

Once you grasp the value of a company, then you have to decide how
much the company is worth if you were buying it outright, or as in the
case of the typical investor, simply buying a portion of the company on
the stock market.

"The trouble with the Wrigley Gum-type investments is that everybody can see that they're wonderful businesses. So you look at it and you
think, 'My God! The thing's at eight times book value or something. And
everything else is at three times book value.' So you think, `I know it's wonderful, but is it wonderful enough to justify that big a premium?'"

The ability to answer such questions explains why some people are
successful investors and others are not.

"On the other hand, if it weren't a little difficult, everybody would
be rich," Munger insisted.

Observing business over time gives an investor greater perspective on
this type of thinking. Munger said he remembers when the downtown department stores in many cities seemed invincible. They offered enormous
selections, had large purchasing power, and owned the highest priced real
estate in town, the corners where the streetcar lines crossed. However, as
time passed, private cars became the prevalent mode of transportation. The
streetcar lines were taken out, customers moved to the suburbs and shopping centers became the dominant shopping venues. Some simple changes
in the way we live can completely alter the long-term value of a business.

Munger is passionately opposed to certain economic theories and
business practices and enjoys the freedom his status and wealth give him
to express those opinions. For example, he is perpetually miffed at investors and academics who promote the harsh form of the efficient
market theory of investing:

"If you think psychology is badly taught in America, you should look at
corporate finance. Modern portfolio theory? It's demented!" Munger proclaimed.

The concept is taught in mainstream business schools and takes the position that all information on publicly traded companies is spread rapidly
throughout the investing universe, dispelling any advantage one investor
has over another. Nobody can really beat the market because adjustments to
news are worked into the price of a security so quickly.'

Munger recalled one efficient market theorist who over the years
made a career of explaining how Buffett's success was merely the result
of good luck. As Buffett's performance held steady and even improved, it
became more difficult to explain Buffett as a mere anomaly. "... this theorist finally got all the way up to six sigmas-six standard deviations-of
luck. But then, people started laughing at him because six sigmas of
luck is a lot. So what did he do? He changed his theory. Now, he explains,
Warren has six or seven sigmas of skill."

Refuting the claims of financial writer Michael Lewis, who also
seemed to portray Buffett as a greedy manipulator whose success is
mainly the result of happenstance, Munger says. "He's got the idea that
Warren's success for 40 years is because he flipped coins for 40 years and
it has come up heads 40 times. All I can say is, if he believes that, I've got
a bridge I'd like to sell him."

There is no doubt whatsoever that Berkshire attained its high level of
performance, in a large part, because of the commonsense notions shared
between Munger and Buffett. For example, they ignore the popular financial indicator called Beta, which measures a stock's volatility in relation
to the overall market. A company with a Beta that is higher than the market average is considered by many professional investors to be a high-risk
proposition.

"This great emphasis on volatility in corporate finance we regard as
nonsense ... ," said Munger. "Let me put it this way: as long as the odds
are in our favor and we're not risking the whole company on one throw of
the dice or anything close to it, we don't mind volatility in results. What
we want are the favorable odds. We figure the volatility over time will
take care of itself at Berkshire."

Both Munger and Buffett are indignant over the way the regulators
allow stock options to be counted on the books so that they don't show
up as an expense to the company. They mention the problem at nearly
every annual meeting.

"It's fundamentally wrong not to have rational, honest accounting in
big American corporations," said Munger. "And it's very important not to
let little corruptions start because they become big corruptions-and
then you have vested interests that fight to perpetuate them. Accounting
for stock options in America is corrupt, and it's not a good idea to have
corrupt accounting."

Buffett and Munger agree on most things, but they have a different
opinion about who should be the decision maker when an unsolicited
tender offer is made to a corporation. Buffett says his heart is with the
shareholders, but Munger says there is a social interest in some cases,
making it okay to make laws to govern such transactions.

"I totally agree that for the ordinary little family business that owns a
theater, the shareholders ought to decide whether the theater is sold. But
once you get into great big social institutions, that given certain circumstances, will go together in waves of acquisitions into huge agglomerations, that bothers me. So, I think that it's appropriate to have laws that
prevent it," said Munger.'

If he were teaching finance, Munger said he would use the histories of
100 or so companies that did something right or something wrong.

"Finance properly taught should be taught from cases where the investment decisions are easy," said Munger. "And the one that I always cite is the
early history of the National Cash Register Company. It was created by a very
intelligent man who bought all the patents, had the best sales force, and the
best production plants. He was a very intelligent man and a fanatic, all of
whose passions were dedicated to the cash register business. And of course,
the invention of the cash register was a godsend to retailing. You might even
say that cash registers were the pharmaceuticals industry of a former age. If
you read an early annual report when Patterson was the CEO of National
Cash Register, an idiot could tell that here was a talented fanatic-very favorably located. Therefore, the investment decision was easy."

John Henry Patterson was an Ohio retailer who did not invent the
cash register, but immediately saw its benefits and purchased the moneylosing company. In his zealousness, Patterson became the prototype for
the contemporary business innovator. He virtually invented the concept
of employee benefits (the low-cost company cafeteria, for one), sales
force training and motivation, and was responsible for the first house
organ, "The Factory News." During the great Dayton flood of 1913,
Patterson halted production and devoted the company to saving the city.
He gave food, shelter, supplied electrical power, and fresh water, and
his company doctors and nurses tended the injured and ill. Factory workers built boats for flooded out residents. Nevertheless, Patterson was a
bulldog competitor and once lost an antitrust suit, which later was overturned by a higher court. One of Patterson's most noteworthy achievements was hiring T.J. Watson, a piano salesman, who worked at NCR
for years. After Patterson fired Watson, he went to work at ComputerTabulating-Recording Company, which Watson transformed into IBM,
using many of the business skills he'd learned at NCR.

Patterson left a great business when he died, but he'd spent so much
on social causes that his estate had very little money. Not that it mattered
to him. Patterson was fond of saying "Shrouds don't have pockets." 9

Though few companies last forever, all of them should be built to last
a long time, says Munger. The approach to corporate control should be thought of as "financial engineering." Just as bridges and airplanes are
constructed with a series of back-up systems and redundancies to meet
extreme stresses, so too should corporations be built to withstand the
pressures from competition, recessions, oil shocks, or other calamities.
Excess leverage, or debt, makes the corporation especially vulnerable to
such storms.

"It is a crime in America," stated Munger, "to build a weak bridge.
How much nobler is it to build a weak company?"")

AMERICANS ARE OVERSOLD ON THE benefit they receive from money managers, and particularly, from mutual fund managers, and that bothers
Munger enormously.

"It is, to me, just amazing what's happened in the mutual fund business," he said. "It just grows and grows and grows. And they get these fees
just for maintaining shares in place-12-B-1 fees or whatever they call
them. I am not charmed with the mechanics of that business."

Addressing a group of charitable foundation executives in Santa Monica, California, in 1998, Munger especially criticized Yale University for
investing its endowment in the equivalent of a fund of mutual funds:
"This is an amazing development. Few would have predicted that, long
after Cornfeld's fall into disgrace, major universities would be leading
foundations into Cornfeld's system."" Bernie Cornfeld in the 1970s created the ill-fated, fund-of-funds concept.

An eminence gris of no less stature than John Bogle, founder of the
Vanguard Funds, has taken up Munger's cudgel. When Munger made his
comment he was speaking to directors of nonprofit organizations and was
attacking the practice of hiring consultants to hire money managers who
in turn select mutual funds operated by other money managers. At each
step, there is a commission to be paid, which skims off the money that
can be used in the work of the charity.

"Mr. Munger goes on to point out," said Bogle, "the devastating impact of the cost of all this complexity on the return of foundations and
endowments in a stock market with lower returns. Market returns-5
percent; total cost, 3 percent; net return, 2 percent."

And, said Bogle, "Please don't scoff at the use of the 5 percent return
on stocks. The long-term real returns on stocks has been 7 percent, so
Mr. Munger's hypothetical future figure is far from apocalyptic."12

Munger's recommendation to managers of the funds of not-for-profit
foundations was simple: Save yourself a lot of time, money, and worry.
Just put your endowments into index funds. Alternately, the foundations could follow Berkshire's lead and simply buy high quality stocks (if they
are not highly overvalued in price) and hold on for the long term.13

It isn't even necessary to worry about diversification. "In the United
States, a person or institution with almost all wealth invested, long term,
in just three fine domestic corporations, is securely rich," said Munger.
"And why should such an owner care if at any time most other investors
are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior
by reason of his lower costs, required emphasis on long-term effects, and
concentration in his most preferred choices."'-'