Value Investing

Charlie Munger – How To Dramatically Improve Your Financial Results

Here’s a great passage from the book – Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger, in which Munger illustrates how your financial results can be dramatically improved by being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical things.

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Here’s an excerpt from the book:

Munger and Buffett began to divert both Wesco and Mutual Savings away from the thrift business, preparing Wesco for what was to come. Wesco purchased 100,000 newly issued shares of Series A Cumulative convertible Preferred Stocks of Salomon Inc. on October 1, 1987, at a cost of $100 million. The investment was part of a $700 million transaction, in which Berkshire purchased $600 million and Wesco bought the remainder. In addition to the 9 percent dividend, each preferred share could be converted into 26.3 shares of Salomon common on or after October 31, 1990.

The way the contract worked, Wesco and Berkshire would make a profit on the conversion if the shares traded at or above $38.

As fate would have it, on October 19, 1987, the stock market experienced its worst day in recent history, Black Monday. Salomon was badly hurt by the crash, and its shares fell to as low as $16.62. Fortunately, by the end of 1989 Salomon common had recovered to $23.38.

In 1988, Munger and Buffett moved Mutual Savings another step away from its traditional role as a thrift. After a three-hour discussion, the pair decided to beef up Mutual’s small stake in the Federal Home Loan Mortgage Corporation, commonly called Freddie Mac.

Freddie Mac provides liquidity in the mortgage market by pooling and packaging home loans into securities that are sold to investors. The company thus earns fees and “spreads,” while side-stepping most interestrate-change risk. Additionally, the company insures mortgages. Freddie Mac was created by the government in 1938 to make home ownership more affordable by creating a secondary market for home loans. Over the years, the character of Freddie Mac changed. Under a charter drafted by Congress in the midst of a 1970 credit crisis, ownership was limited to
participating lenders, the S&Ls. Later Freddie Mac converted to private ownership largely held by institutional investors. It began trading on the New York Stock Exchange in 1988.

Freddie Mac is one of only two federally chartered companies that package and sell mortgage-backed securities. The other is the Federal National Mortgage Association, commonly called Fannie Mae. The implicit federal backing for Freddie Mac gave Munger and Buffett the competitive edge that they like.

Wesco-through Mutual Savings-bought 28.8 million shares of Freddie Mac for $72 million at a time when Freddie Mac shares could be lawfully owned only by an S&L.

It was the maximum investment in Freddie Mac then allowed by law. It was an investment that built a castle wall around Wesco during the later collapse of the thrift industry. By the end of 1999, the Freddie Mac holding had a market value of $1.38 billion.

“Our experience in shifting from savings and loan operation to ownership of Freddie Mac shares tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical things, will often dramatically improve the financial results of that lifetime,” said Munger. “A few major opportunities clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.”

When a similar opportunity arose to buy Fannie Mae shares, Buffett and Munger faltered. Buffett said they should have taken a large stake in Fannie Mae as well.

“My biggest lost opportunity was probably Fannie Mae. We owned a savings and loan, and that entitled us to buy 4 percent of Freddie Mac stock when it first came out. We did this and should have followed the same reasoning and bought more Fannie Mae stock. What was I doing? I was sucking my thumb.”

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