Stock picking has been viewed as a faux pas for some time…wrongly. There is nothing wrong with picking stocks if it’s done intelligently.
Intelligently can’t be emphasized enough because it’s often done stupidly. Which is why the act gets condemned outright. Except, some investors pick stocks and do it well by using a framework as a guide.
In a speech, Charlie Munger offered up his framework that he’s improved upon over his career. For Munger, stock picking revolves around disciplined decision making.
Instead of trying to know everything about everything, he tries to make the least stupid mistakes. And in an activity were mistakes have big consequences, keeping them to a minimum has an immense impact on returns.
An approach to avoiding mistakes is something every investor should learn (even if it results in them realizing that stock picking isn’t for them) because it works beyond investing as well. Munger’s framework is based on a collection of mental models he relies on to help make decisions. The models are pulled from an array of disciples – math, physics, engineering, psychology, and more – because no model is perfect. They all have limitations.
His speech doesn’t cover every mental model (over 90) but it offers a starting point – as it relates to investing – to expand on. I’ve outlined the models he covers but recommend reading the whole speech. The first up is math.
Obviously, you’ve got to be able to handle numbers and quantities — basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it’s probably down to the eighth grade or so. It’s very simple algebra.
Math examples: Decision Tree Theory, Accounting, Statistics, Bell Curve
Engineering examples: Quality Control, Backup Systems, Breakpoints, Margin of Safety
Physics examples: Critical Mass
The elementary part of psychology — the psychology of misjudgment, as I call it — is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I’ve done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.
There’s another saying that comes from Pascal which I’ve always considered one of the really accurate observations in the history of thought. Pascal said in essence, “The mind of man at one and the same time is both the glory and the shame of the universe.”
And that’s exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others.
Now we come to another somewhat less reliable form of human wisdom — microeconomics. And here, I find it quite useful to think of a free market economy — or partly free market economy — as sort of the equivalent of an ecosystem….
But the truth is that it is a lot like an ecosystem. And you get many of the same results.
Advantages of Scale
Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.
The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That’s an enormous advantage. And it has a lot to do with which businesses succeed and fail….
I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is 40 cents and the other is 30 cents, am I going to take something I don’t
know and put it in my mouth—which is a pretty personal place, after all — for a lousy dime?
So, in effect, Wrigley, simply by being so well known, has advantages of scale — what you might call an informational advantage.
Example: Coca-Cola, Wrigley’s, Gillette
We are all influenced — subconsciously and to some extent consciously — by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step.
The most obvious one is daily newspapers. There’s practically no city left in the U.S., aside from a few very big ones, where there’s more than one daily newspaper.
And again, that’s a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-take-all situation.
Examples: Local Newspaper, Google, Microsoft’s Windows, Washington Post
I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power — which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments.
Example: Wal-Mart, Amazon
Disadvantages of Scale
We’d have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you’re getting a narrower and narrower specialization.
Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn’t have to waste the ink and paper mailing out stuff that corporate travel departments weren’t interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine.
The great defect of scale, of course, which makes the game interesting — so that the big people don’t always win — is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality — which is again grounded in human nature.
And the incentives are perverse… So you get big, fat, dumb, unmotivated bureaucracies.
They also tend to become somewhat corrupt… So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They’re too slow to make decisions and nimbler people run circles around them.
Cancer Surgery Model
They look at this mess. And they figure out if there’s anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn’t work, they liquidate the business. But it frequently does work.
And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.
All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that’s a very simple model. And it’s repeated over and over again.
Here’s a model that we’ve had trouble with. Maybe you’ll be able to figure it out better. Many markets get down to two or three big competitors — or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.
Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, and in other markets, there’s destructive competition that destroys shareholder wealth.
If it’s a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it.
Yet, the net amount of money that’s been made by the shareholders of airlines since Kitty Hawk, is now a negative figure — a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business. Yet, in other fields—like cereals, for example—almost all the big boys make out. If you’re some kind of a medium grade cereal maker, you might make 15% on your capital. And if you’re really good, you might make 40%. But why are cereals so profitable — despite the fact that it looks to me like they’re competing like crazy with promotions, coupons and everything else? I don’t fully understand it.
Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out—based on arguments about what was really invented and what relied on prior art. That isn’t altogether clear.
But they changed that. They didn’t change the laws. They just changed the administration — so that it all goes to one patent court. And that court is now very much more pro-patent. So Ithink people are now starting to make a lot of money out of owning patents.
Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it’s well known.
If there were only three television channels awarded in a big city and you owned one of them, there were only so many hours a day that you could be on. So you had a natural position in an oligopoly in the pre-cable days.
And if you get the franchise for the only food stand in an airport, you have a captive clientele and you have a small monopoly of a sort.
There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices — and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer.
Example: Disney, See’s Candy, Coca-Cola
The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.
That’s such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.
Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line.
You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead — you’re destroyed. It happens again and again and again.
Example: Automobiles, Smart Phone
And when these new businesses come in, there are huge advantages for the early birds. And when you’re an early bird, there’s a model that I call “surfing” — when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows…
But people get long runs when they’re right on the edge of the wave.
Examples: Microsoft, Intel, National Cash Register, Gilette
Circle of Competence
And Warren and I don’t feel like we have any great advantage in the high-tech sector. In fact, we feel like we’re at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it’s going to be very hard to advance that circle. If I had to make my living as a musician…. I can’t even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.
So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.
The model I like — to sort of simplify the notion of what goes on in a market for common stocks — is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.
The stock market is the same way — except that the house handle is so much lower. If you take transaction costs — the spread between the bid and the ask plus the commissions — and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.
Of course, the best part of it all was his concept of “Mr. Market”. Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think it’s worth.” And other days, “Mr. Market” comes by and says, “I’ll buy your interest at a price that’s way higher than you think it’s worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all.
To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it’s been very useful to Buffett, for instance, over his whole adult lifetime.