Warren Buffett said it perfectly. “Seek whatever information will further your understanding of the business.”
Charlie is a huge proponent of developing checklists to help him make better decisions, for each company, he develops a checklist to keep him on track The Four Filters For Develop An Understanding of The Business. The reason for a different checklist is that every company is different and have different guidelines to follow.
Charlie developed a system of “latticework of mental models” to help him sort through his thoughts and ideas. He used these models to help him think better.
Munger has come to the conclusion that to make better decisions in business and life you need to find and understand the core principles from all disciplines.
In short, learn all the big ideas and how the interrelate and better, more rational thinking will naturally follow.
So how does this help us understand a company?
Step one is to read, read, read all that you can about the company. Shareholder letters, letters from the CEO, 10k filings, 10Q filings. The Four Filters For Develop An Understanding of The Business Go to the website and read about all of their products. Look at any references to competitors and read about them. Just about every industry has a newsletter or magazine that follows that particular industry, read those publications for knowledge about the different trends, products, and services that other companies offer.
We do this to get a better understanding of how the company operates, what they produce and who they sell it too. Think about anything you buy for your personal use. Do you buy a cell phone you don’t understand how to use? No way. Think about how these types of decisions affect our buying habits.
These are the types of information we need to digest as we learn more about a particular company. The Four Filters For Develop An Understanding of The Business I will give you an example; recently I was looking at a company that produces railroad cars. A pretty simple straightforward business but I noticed something in a 10k that I was reading that mentioned that they were solely dependent on steel as their main resource they used in all of their products. That got me to thinking about the price of steel and how it could affect their business, so I researched more about that particular field because I knew nothing about steel. I came to learn that steel is an extremely volatile commodity that has huge price swings, which would obviously affect this company I was researching. And sure enough, as I learned more about steel pricing and tracked the downturns in steel I noticed that coincided with a downturn in the price of the company.
Filter number two :Does the company have a durable competitive advantage?
A durable competitive advantage refers to a moat, according to Harvard Business School professor Michael Porter.
The need for the business is so strong that Munger made it one of his Four Filters that he uses the help decide whether to invest in business.
Very interesting response. Moats are all the rage today, especially among value investors, especially among the Buffett and Munger disciples. For good reason, because we would all like to own companies with a competitive advantage or a moat. The problem is that it is easy to identify a company that is doing well. It is much harder to look into the future and determine if the company will continue to do well.
The durability of a moat is much harder to determine than to identify the moat itself. And the durability is what we are looking for because the price of the company will have the most current info figured into it. Most of the time.
Let’s talk a little bit about creators of moats. Examples would be Bill Gates, Ray Kroc, Sam Walton, Estee Lauder, and Jeff Bezos. These are all creators of great moats, some of which have stood the test of time so far. Moat creation requires superior management skill and a little luck.
We buy barriers, building them is tough…Our great brands aren’t anything that we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it’s hard to replace, then you have a big advantage.
One competitor is enough to ruin a business running on small margins.”
Merely spotting a moat is one particular skill, but creating them is another whole set of different skills. The trick is to understand which set of skills it is that you own.
1. Supply Side Economies of Scale
2. Demand-Side Economies of Scale(Network Effects)
5. Patents and Intellectual Property
Filter number three: Is there management in place with integrity and talent?
For Munger and Buffett, management is part of the moat that they create with their businesses. Because they only have 20 people on staff at the home office they must rely on their managers to maintain their investments.
They have two criteria for their managers.
1. Capital Allocation – This is the primary management activity at Berkshire, the Capital allocation is job number one. One of the managers of Berkshire’s reinsurance company, Ajit Jain, who according to Buffett “has created tens of billions of dollars in value for this company with nothing but his brains and hard work.”
2. Compensation Systems – At Berkshire, because most of the managers that work for them are already rich, they have devised other compensation systems to entice talent to their businesses. They select management that loves what they do so much that it outweighs the financial aspects of the job.
They also understand that when the buy a business that they are buying a wonderful business, regardless of the state of management. They are looking for businesses that are so good that any “idiot” can run them because at some point they probably will.
Filter number four: A business with an attractive price with a margin of safety.
Anyone who wants to understand Munger needs to understand that when you invest, you are buying a piece of that business, not just a stock or a piece of paper but an actual piece of the business. You need to treat it like you are an owner of the business, which you are. Looking at it as a business owner gives you a different perspective on your purchase.
Charlie is a firm believer in what Benjamin Graham teaches which is this.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Munger is a firm believer that he is an investor and has a lot of disdain for those that are speculators. He feels that theirs is a losing game. People that “day trade” stocks use charts and other voodoo-like techniques are just guessing at the direction of the market, and anyone who is guessing on the behavior of the market is doing just that. Guessing.
The last factor of pricing a company is figuring out a valuation for that company.
As Munger stated.
Neither Munger or Buffett look for an of the fancy valuations out there. EBITDA and non-GAAP earnings mean little to them, they like genuine free cash flow. Munger stated.
An insatiable curiosity as to everything that is going on in the world.
The difference between a good business and a bad business is that good business throw up one easy decision after another. The bad businesses throw up painful decisions time after time.”