Charlie Munger’s Investment Principles And Checklists [IN-DEPTH]

Charlie Munger’s Investment Principles And Checklists

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“You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.” – Charlie Munger

  • Good checklists are precise, efficient, easy to use even under difficult conditions, do not try to spell out everything, and provide reminders of only the most critical and important steps; the power of checklists is limited
    • Bad checklists are vague, imprecise, too long, hard to use, impractical, and try to spell out every single step
  • Do-confirm checklist: perform jobs/tasks from memory and experience, but then stop, run the checklist and confirm that everything was done correctly
  • Read-do checklist: carry out tasks as they are checked off – more like a recipe

Process

Focus on original source documents, working from in to out

  • SEC fillings
    • Read 10-Qs, 10-Ks, proxies and other filings in reverse chronological order
  • Press releases and earnings calls/transcripts
  • Other public information
    • Court documents, real estate records, etc.
  • Industry publications
  • Third-party analysts
    • Sell-side research only as a consensus-checking exercise
  • Research the company’s competitors with the same process
  • Research and speak to competitors, (former) employees, and people in the supply chain
  • Estimate valuation before looking at market valuation
    • Valuation – What would a rational, long-term, private buyer would pay in cash today for the entire business?
      • Asset value
      • Earning power
        • if EP >NAV, then franchise value
      • Growth value
  • Requirements
    • Large, well understood margin of safety
    • Reinvestment opportunities for capital in the business
    • Quality, ownership stake, and shareholder-orientation of management
    • Ability to bear pain, both the company’s and my own
  • Munger’s “Four Filters”
    • Understand the business
    • Sustainable competitive advantages (aka, favorable long-term economics)
    • Able and trustworthy management
    • Price that affords a margin of safety (aka, a sensible purchase price)

Pause Points in the Process

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Always think in terms of Process + Patience

How big is the margin of safety? How reliable is it? Why?

Pause #1

  • Are the business and its securities able to be understood and valued?
    • Avoid loss by

Pause #2

  • Go back through all financial disclosure looking for information and context missed the first time
    • Patterns/trends
      • Level and quality of disclosure
    • Specifics (see next section)

Pause #3 – final checks

  • What can go wrong? Do a “pre-mortem”
  • How can capital be permanently impaired by this investment?
  • What are the probabilities? Are the odds heavily in my favor?
  • What is the time horizon?
  • How attractive is the opportunity? Namely, how attractive is compared to my best current investment?

Munger’s “two-track analysis”

  • First, lay out and deeply understand the rational factors that govern the situation under consideration
  • Second, focus attention on psychological missteps – either your own or those of other investors

“The Most Important Things”

  • Margin of safety
  • Balance sheet
    • Capital structure and liquidity
    • Asset value
  • Cash flow
    • Realistic and reliable owner’s earnings (especially a few years from now)
    • Can cash be reinvested at attractive compound rates?
    • How has management allocated capital?

Initial ideas to consider in the process

  • Separate the business from the balance sheet
    • How is the business capitalized? Is it sustainable? Is it relatively efficient/optimal?
    • What are the assets worth? Liquidation value and reproduction value
    • Are there any “hidden” assets or liabilities?
      • Excess cash, real estate, LIFO, etc.
      • Pension, legal liability, litigation, operational malfeasance, funding/liquidity puts, etc.
  • Separate the business from the cash flows
    • What are the cash flows saying, regardless of the broader business stereotypes/assumptions?
    • How much cash can be taken out of the business every year? Owner’s earning (net income plus DA minus capex) normalized and over time
    • Earnings yield (EBIT/TEV) and ROIC (EBIT/(WC+fixed assets))
    • What are the capex requirements? With regard to inflation? Depreciation?
  • What is the business’s competitive situation? How good is management?
    • What could kill the business? What disrupts the underlying fundamentals?
    • Competition/moat
    • Cost structure
    • What are incremental margins? How attractive is the compounding opportunity?
    • Is capital being allocated properly? Investing in the business vs. returning capital to shareholders
    • Are the company’s end markets stable/shrinking/growing? Susceptible to rapid (technological) change?
  • Other considerations
    • Market perceptions
    • Quality of management and alignment of interests
    • Is this opportunity worth a punch on our punch card?
  • Psychological factors
    • Think in terms of the “psychology of misjudgment” and common biases (see below)
  • Where are we in the cycle?
    • Where are we in the economic cycle?
    • Where are we in the cycle for risk assets?
    • Where are we in the industry cycle applicable to this company?
  • Portfolio composition
    • Target 15-25 individual (i.e., diversified or uncorrelated) investments
    • Size constraints
    • Portfolio liquidity
    • Ability to withstand pain

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