Poor Charlie’s Almanack, The Wit and Wisdom of Charles T. Munger, is the definitive Charlie Munger guide and essential reading for all value investors. The book is a Charlie Munger bible and contains reams of advice from Warren Buffett’s right-hand man given out over the years.
The whole book is interesting but one particularly interesting resource on business valuation is an adaptation from Munger’s July 20, 1996 informal talk, Practical Thought about Practical Thought?
Charlie Munger: How Do You Create A Product Like Coca-Cola
“In a long career, I have assimilated various ultra-simple general notions that I find helpful in solving problems. Five of these helpful notions I will now describe. After that, I will present to you a problem of extreme scale. Indeed, the problem will involve turning start-up capital of $2 million into $2 trillion, a sum large enough to represent a practical achievement.”
Munger begins his lecture with the above statement. Rather than concentrating on the problem-solving aspect, I’m going to move straight to the problem of building a trillion dollar business as it’s here where Munger has some interesting insights on how to look for the best potential investments.
Munger and Buffett often talk about how important it is for a company to have a strong trademark, or business moat and this forms the basis of Munger’s discussion on how to create a trillion dollar brand.
“Let us start by exploring the consequences of our simplifying “no-brainer” decision that we must rely on a strong trademark. This conclusion automatically leads to an understanding of the essence of our business in proper elementary academic terms. We can see from the introductory course in psychology that, in essence, we are going into the business of creating and maintaining conditioned reflexes. The “Coca-Cola” trade name and trade dress will act as the stimuli, and the purchase and ingestation of our beverage will be the desired responses.”
How do you create and maintain “conditioned reflexes”? There are two answers (1) by operant conditioning and (2) by classical conditioning often called Pavlovian conditioning. Munger states that to achieve a “lollapalooza result” both conditioning techniques must be used.
“The operant conditioning part of our problem is easy to solve. We need only:
1. Maximize rewards of our beverage’s ingestion and
2. Minimize possibilities that desire reflexes, once created by us, will be extinguished through operant conditioning by proprietors of competing products.
For operant conditioning rewards, there are only a few categories we will find practical:
1. Food value in calories or other inputs;
2. Flavor, texture, and aroma acting as stimuli to consumption under neural preprogramming of man through Darwinian natural selection;
3. Stimulus, as by sugar or caffeine;
4. Cooling effect when man is too hot or warming effect when man is too cool;
5. Wanting a lollapalooza result, we will naturally include rewards in all the categories.”
For the Pavlovian element:
“In Pavlovian conditioning, powerful effects come from mere association. The neural system of Pavlov’s dog causes it to salivate at the bell it can’t eat. And the brain of man yearns for the type of beverage held by the pretty woman he can’t have. And so..we must use every sort of decent, honorable Pavlovian conditioning we can think of. For as long as we are in business, our beverage and its promotion must be associated in consumer minds with all other things consumers like or admire.”
As well as combining Pavlovian conditioning and classical conditioning, “social proof” will also be helpful in convincing customers to acquire the product:
“Social proof, imitative consumption triggered by the mere sight of consumption, will not only help induce trial of our beverage. It will also bolster perceived rewards from consumption. We still always take this powerful social-proof factor into account. We design advertising and sales promotion and as we forego present profit to enhance the present and future consumption. More than with most other products, increased selling power will come from each increase in sales.”
And when these effects are combined, what must be avoided? As long as the standard business practices of quality control and losing control of the trademark name, after a business (in this case Coca-Cola if you haven’t guessed) has a well-established flavor ingrained in its customers' minds, it must not suddenly change. The flavor must also be highly desirable:
“We must avoid the protective, cloying, stop-consumption effects of aftertaste that are a standard part of physiology, developed through Darwinian evolution to enhance the replication of man’s genes by forcing a generally helpful moderation on the gene carrier. To serve our ends, on hot days, a consumer must be able to drink container after container of our product with almost no impediment from aftertaste. We will find a wonderful no-aftertaste flavor by trial and error and will thereby solve this problem.”
“After our trademarked flavor dominates our new market, we must avoid making any huge and sudden change in our flavor. Even if a new flavor performs better in blind taste tests, changing to that new flavor would be a foolish thing to do. This follows because, under such conditions, our old flavor will be so entrenched in consumer preference by psychological effects that a big flavor change would do us little good. And it would do immense harm by triggering in consumers the standard deprival super-reaction syndrome that makes “take-away” so hard to get in any type of negotiation and helps make most gamblers so irrational. Moreover, such a large flavor change would allow a competitor, by copying our old flavor, to take advantage of both.”