Sunday, 15 January 2017

Key Investment Principles of Charlie Munger

What Are The Eight Key Investment Principles of Charlie Munger?





As we all know, Charlie Munger uses mental models to look at issues and problems. He’s got hundred of them but the selected core models handle most of the freight.
What then are Charlie Munger’s Keys Investment Principles?
  • Take Into Account Your Personality and Own Psychology.

CM: 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 patterns of investment and saving all your life.
  1. If You Can Find Three Good and Super Investments, That Can Be Good Enough. (Caveat Emptor: Are you and me who are mere mortals as good as Charlie Munger? If not, we may need more than three.)
CM: My own inquiries on that subject were just to assume that I could find a few things, say three, each which had a substantial statistical expectancy of outperforming averages without creating catastrophe. If I could find three of those, what were the chances my pending record wouldn’t be pretty damn good. I just sort of worked that out by iteration. That was my academic study—high school algebra and common sense.
  • Odds Must Be In Your Favor And You Are Not Risking Everything On A Penalty Shoot-Out

CM: This great emphasis on volatility in corporate finance we regard as nonsense. 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.
  • Go For An Index Fund If You Are Average Investor

CM: Does that mean you should be in an index fund? Well, that depends on whether or not you can invest money way better than average or you can find someone who almost surely will invest money way better than average.
  • Achieve The Optimal Position Of A Few Great Investments and Sit Back

CM: There are huge advantages for an individual to get into position where you make a few great investments and just sit back. You’re paying less to brokers. You’re listening to less nonsense. If it works, the governmental tax system gives you an extra one, two, or three percentage points per annum with compound effects.
  • Read, Not Just A Little, But A Lot

CM: I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.
  • Invest In A Way That Does Not Require Continuing Intelligence

CM: Berkshire’s assets have been lovingly put together so as not to require continuing intelligence at headquarters.
CM: Invest in a business any fool can run, because someday a fool will. If it won’t stand a little mismanagement, it’s not much of a business. We’re not looking for mismanagement, even if we can withstand it.
  • For Companies ([Sic] And In Many Things In Life), There Is No One Size Fits All

CM: 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.


https://www.facebook.com/groups/charliemungersays/

Your investments using Mutual Funds or Money Managers

There are various avenues individual investors may exercise in managing their investments. 

Investing properly is a full-time job, and that it would be very difficult for individual investors to manage their own money if they have other employment. 

This leaves them two options:

1) Mutual Funds
2) Money Managers



Open-end mutual funds

Open-end mutual funds offer the investor access to both liquidity and the ability to sell for net asset value. 

On the other hand, many funds are driven by relative performance and often grow to sizes where market-beating returns are not possible. 

Since managers are compensated by assets under management, they are also prone to follow short-term trends in order to avoid falling behind their peers in the near-term which could trigger a mass exodus of investors.



Closed-end funds

Closed-end funds do not offer investors ready liquidity at net asset value.

However, they may be prudent investments when they trade at substantial discounts to their net asset values. 



Money Managers

In evaluating money managers, individual investors should raise the following questions which will help select a manager:
  • Do they manage their own money in parallel with their clients'?
  • Has the size of the portfolio grown exceedingly large?
  • What is the investment philosophy of the manager? Does it make long-term sense?

In evaluating investment results, investors must look deeper than a manager's historical investment returns. 
  • For example, any manager can generate phenomenal returns within a certain period of time. 
  • Are the returns described over at least one full business cycle
  • Also, were the returns generated using leverage?
  • Or were they generated despite the portfolio holding large amounts of cash (in which case risk is much lower)?


Take Home Message

Investors who adopt a value-oriented investment approach should be able to invest safely with promise of a satisfactory return. 

If they do not have the time to manage their money full-time, find a trustworthy manager who employs this value investing philosophy.


Read also:


Trading and portfolio management from a value investing point of view.


Portfolio Management

Portfolio management is described as an on-going process that is never complete. 

While certain businesses may be fairly stable, its prices will fluctuate over time, and so the investor must constantly monitor the situation. 

Value investors are not into buying certain industries or business ideas without regard to price, and so price changes are a fundamental factor that drive portfolio decisions.

The portfolios need to be somewhat liquid. 

Investors are advised not to purchase their entire positions at one go, but rather to leave room to buy in at cheaper prices should the stock go down. 

A good test for an investor is to consider whether he would indeed buy more of the stock were it to drop; if he is not, he is probably speculating and should not be buying in the first place!



The Decision of When to Sell 

Determining when to buy a stock is usually a much easier decision for a value investor, since the stock at that time is trading below what the investor considers an adequate margin of safety. 

But when the stock is trading within the range of values the investor believes it to be worth, what is the investor to do? 

We can argue against selling after percentage gain thresholds or price targets have been reached.   

Instead, the investor should compare the investment to available alternative investments:

  • It would be foolish to sell if there were no better investments and the stock was still undervalued, but 
  • it would be foolish not to sell if there are better bargains around!



Read also:

Value Investor's Opportunities in Distressed Securities

Some of the risks and opportunities associated with investing in distressed securities. 


While regular value investing involves dealing with a wide number of unknowns, distressed securities represent particularly complex situations. 

Because most investors are unwilling to put in the time and effort involved with analysing such securities; for some, the opportunities are plentiful in this realm.



Three Reasons for financial distress

There are three reasons a company might run into financial distress: 
  • operating issues, 
  • legal issues, and/or 
  • financial issues



Responses to financial distress and the implications to the investment

Issuers can respond to such situations in one of three ways: 
  • continue to pay obligations, 
  • attempt to convert obligations into less stringent obligations (e.g. get debt holders to accept preferred stock), or 
  • default and declare bankruptcy. 


Investors must understand the implications to their investments as the above scenarios play out. 

Investors must also: 
  • understand how other stakeholders will react to such situations, and 
  • understand the power that various stakeholders have (for example, one third of a stakeholder groups constitutes a blocking group, and can use this to further that stakeholder group's interests).


Investing Opportunities in Bankruptcies

While bankruptcies are often complex and difficult to analyse.

Investors who know what they are doing usually have tremendous opportunities for returns with very little risk. 

At the same time, someone who doesn't know what he's doing risks losing his entire investment.

The process of analysing financially distressed securities starts at the balance sheet. 
  • Assets should be valued so that the size of the pie can be estimated. 
  • Obligations should then be subtracted from this amount. 
  • This task is much more difficult than it appears, however. 
  • For a distressed company, asset values are usually a moving target, and getting a handle on their value can be difficult. 
  • Furthermore, off-balance sheet liabilities must also be considered.

In bankruptcies, mis-pricing can occur which allow the enterprising value investors the opportunity for excellent returns.





Read also:

Value Investing Opportunities in the Banking Sector

Opportunities available for value investors in the banking sector. 

In the mid-1980s to early 1990s, many banks were selling for less than book value. 

During the recession of the early 90s, many banks had to be bailed out by the government due to some of the high-risk loans they had offered and due to the general downturn in the US real-estate market...remind you of today?

Apart from the top 10 to 20 largest banks, Wall Street analysts did not follow thrifts.

As a result, small and mid-sized shops were trading at inefficient prices, allowing value investors to purchase some companies at a large discount.



Some elements of valuing banks. 

Many banks are "un-analysable", for example if they deal in junk-bonds or complex mortgage securities or other exotic lending instruments.

Conservatism is of the utmost importance when valuing companies in this industry, due to the fact that they are highly leveraged and thus already contain a certain amount of risk.

Book value is a good start for valuing a bank, but is usually a conservative estimate of what it is worth.

  • Book value should be adjusted upward for understated assets such as appreciated investment securities, below-market leases, real estate carried below cost and a stable customer/deposit base. 
  • Investors must also be on the lookout for items that should be used to adjust book value downward, such as intangible assets, bad loans and poor investments that are carried at cost.


There are no sure things in this banking industry. 

These factors play large roles in determining whether an investment will have a good outcome:

  • asset quality
  • management discretion, and 
  • interest rate volatility 

All investors can do is pick low-risk individual banks with the best prices to their fundamentals and hope for the best.





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Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions

Look at Fundamentals

Value investors who paid attention to fundamentals (e.g. strong businesses masked by unprofitable divisions, or companies trading at discounts to cash etc.) reaped enormous profits.




Look for potential catalysts

Investors should look for potential catalysts when making investment decisions.   Catalysts are events that cause a stock's value to be recognised, thus resulting in immediate returns to investors who purchased at a discount. 
  • A liquidation is an example of a catalyst, and there are some companies where such events have returned generous - and quick - positive results for investors (e.g. during bankruptcy events, where securities generally trade at a discount to their recoverable values).
  • Share buybacks and asset sales also represent partial catalysts, as they can cause a stock to inch closer to its underlying value.  More importantly, such events signal that management is interested in returning value to shareholders, which bodes well for the future.
Some areas where value investors can indeed find value include: 
  • liquidations, 
  • complex securities (i.e. securities institutions can't purchase because they don't fit set categories), 
  • rights offerings (often offering prices lower than current market value), 
  • spinoffs (as they are usually sold by holders of the parents, thus depressing prices immediately) and 
  • risk arbitrage (depending on the market's mood, as sometimes the market's exuberance can erode returns).




Read also:

Where to look for Investment Opportunities

Where to find Investment Opportunities

Sometimes, there are so many value investments available that the only constraint on the investor is a lack of funds. 

Most times, however, investors find it difficult to find value investment opportunities. Investors can spend a lot of time reading through financial reports, research reports, and other financial news and end up finding nothing but fairly valued opportunities. 

Therefore, it is important that the investor look in the right places.


A few of the places for finding investment opportunities include 
  • the new-low lists, 
  • the largest percentage-decliners lists which are published by major news sources, and also,
  • companies whose dividends have been cut or eliminated can also be unduly punished by the market, leaving investment opportunities. 

Of course, just because a stock shows up on one of these lists does not make it a buy; one still has to go through the valuation process in order to determine whether it trades at a discount to its fair value.



Is the management buying or selling the company's stock?

Investors should look at what management is doing with respect to the company's stock. 

Nobody knows the business as well as management does, and so if management is buying that is often a good sign for the stock.



Why? Why?  Why has a stock been performing poorly?

Investors are also encouraged to consider why a stock has been performing poorly (and therefore may make for a good investment). 

If an investor can pinpoint this reason, he can be more comfortable that he may have found value. 

If this reason cannot be found, it is possible that the investor is missing some information which the market knows (important lawsuit pending, competitor coming out with similar product etc.).





Read also:

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:
The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.




There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.


2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.


3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).





When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 
  • liquidation value would be more useful for a company with losses that trades below book valuewhile 
  • net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.




Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.





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