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Timeless Investment Lessons from Warren Buffett's Business Partner, Charlie Munger

A look at the worldview and investment philosophy of one of the great investors of our time. Plus, five ETFs that we believe have many of the characteristics that Munger (and Buffett) look for.

Robert Goldsborough, 04/24/2013

With Berkshire Hathaway's BRK.A annual meeting--the Woodstock of Capitalism--set for Saturday, May 4, many investors are preparing to flock to Omaha once again to hear pearls of wisdom both from Berkshire's chairman Warren Buffett and vice chairman Charlie Munger.

It's virtually impossible to overstate the influence that Munger, who recently turned 89 years old, has had on Buffett and on Buffett's investing discipline. Buffett regularly labels Munger as his "partner" at Berkshire, and fills the firm's annual shareholder letters with phrases like, "Charlie and I believe..." In fact, in Berkshire's 2012 letter, Buffett makes reference to their long and fruitful working relationship, noting that "more than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price." That insight has guided Buffett over the years and helped him become more comfortable with paying up for outstanding businesses with economic moats, or sustainable competitive advantages.

Given Munger's age, no one can say how much longer investors can expect to see him sitting at Buffett's side each May, delighting audiences with his wisdom and also chiming in with his favorite line, "I have nothing to add," immediately after Buffett expounds on a topic.

As Berkshire's annual meeting nears, now is an appropriate time to pay tribute to Munger and to some of the core investment principles that he has espoused. Most of these can be found in the excellent 2005 book "Poor Charlie's Almanack," a collection of Munger's best talks, quotations, and thoughts. Modeled after "Poor Richard's Almanack" by Munger's hero, Ben Franklin, "Poor Charlie's Almanack" lays out Munger's worldview, including his "multidisciplinary" approach to clear, elegant thinking.

It's obviously not just investors in Berkshire Hathaway who can benefit from the collective investing wisdom of Buffett and Munger. Exchange-traded fund investors can employ certain funds as a way to tap investment themes the duo have espoused.

The World According to Charlie
One of Munger's principal frameworks is to more broadly understand, collect, and organize the factors affecting an investment candidate. This means drawing what he calls "multiple mental models" from a variety of disciplines, including engineering, mathematics, physics, chemistry, and psychology. Driving this need to understand the various dynamics surrounding an investment--both in its internal and external environment--is Munger's understanding that these various factors can work in concert. Munger termed that dynamic a "Lollapalooza Effect"--when anywhere from two to four forces all are driving the investment in the same direction. And yet, Munger noted in Outstanding Investor Digest in 1997 that the effect isn't "simple addition" but rather more akin to a "nuclear explosion."

One doesn't need to be an academic to tap these different models, including the modern Darwinian synthesis model from biology or cognitive misjudgment models from psychology. Indeed, Munger himself acknowledges that his understanding of these models is entirely self-taught.

Munger's invocation of multiple mental models has given him having a mindset characterized by four guiding principles that any ordinary investor should follow: preparation, patience, discipline, and objectivity. When practiced correctly, these attributes should result in buying great businesses at good prices and keeping one's portfolio turnover low. As Munger himself once said, "You're paying less to brokers, you're listening to less nonsense, and if it works, the tax system gives you an extra 1, 2, or 3 percentage points per annum."

Can anyone else follow Munger's mindset? "Poor Charlie's Almanack" describes his worldview, perhaps tongue-in-cheek, as "Quickly Eliminate the Big Universe of What Not to Do, Follow Up with a Fluent, Multidisciplinary Attack on What Remains, Then Act Decisively When, and Only When, the Right Circumstances Appear." But as Munger and Buffett have proven, it works. Munger once said, "It's kind of fun to sit there and outthink people who are way smarter than you are because you've trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience."

How Munger Picks Investments
In addition to favoring a narrow, concentrated portfolio, Munger holds the view that he should stick to his knitting when evaluating investment candidates. "Yes" candidates are easy-to-understand businesses with distinct and sustainable competitive advantages with a dominant franchise. He immediately dismisses other possibilities, especially in health care and technology, into what he calls the "too tough to understand" pile and others--deals pushed by brokers, including IPOs--into the "no" pile.

Munger considers every aspect of a business when considering a candidate for investment, evaluating management’s character and capital allocation decision-making. He also analyzes a business' competitive advantages, mindful that few businesses endure for multiple generations. Thus, understanding a business' sustainable competitive advantages is critical. Munger pays close attention to the company's operating and regulatory environment, the impact on it from changes in technology, hidden exposures, and the current and future impacts of stock options, pension plans, and retiree medical benefits. Finally, Munger carefully attempts to compute the business' underlying value. To avoid anchoring, he tries to calculate a business' value independently of the price at which a company trades.

ETFs for Munger (and Buffett) Followers
Below are a quintet of ETFs for investors looking for a diverse basket of the sort of companies Munger (and Buffett) would invest in.

IShares Dow Jones Transportation Average IYT.--In recent years, Munger and Buffett have done a 180-degree turn and begun investing heavily in railroad companies, which make up 30% of this ETF's assets. They've made investments in several of the rail firms that make up large positions in IYT. And in 2010, Berkshire Hathaway went a step further, making a massive investment in railroad companies by acquiring rail giant Burlington Northern Santa Fe outright. Munger and Buffett view railroads as a long-term bet on the United States economy. This ETF, which charges 0.46%, also holds overnight delivery firms and trucking companies, whose performance also is an indicator of macroeconomic conditions.

Vanguard Consumer Staples ETF VDC.--With their longtime investments in Coca-Cola KO, which makes up 9% of this ETF's assets, and Procter & Gamble PG, which comprises 12% of VDC, Buffett and Munger clearly have shown a preference for trusted and global consumer brands that are difficult to replicate and that have broad distribution. What's more, Berkshire Hathaway recently acquired 50% of a holding company that will own all of H.J. Heinz, which until that point had been held in this ETF. With a 0.14% price tag, this ETF is a relatively concentrated, low-cost way to access the consumer staples sector that the duo long have favored. It's also a fund with very high-quality companies; fully 94% of its assets are invested in firms with economic moats.

Financial Select Sector SPDR XLF.--Munger and Buffett long have invested in wide-moat financials firms, such as Wells Fargo WFC and American Express AXP, both of which are top-six positions in this ETF. In fact, fully 23% of XLF's portfolio is invested either in financials firms in which Berkshire Hathaway has a large position or in the stock of Berkshire Hathaway itself. That's meaningfully greater than the 15% of assets that a primary competitor, Vanguard Financials ETF VFH, invests in such firms. Also, in XLF, Berkshire Hathaway is the single largest position. (It's the fifth-largest position in VFH.) In fact, according to Morningstar data, XLF devotes a greater portion of its portfolio to Berkshire Hathaway than any other ETF.

Vanguard Dividend Appreciation ETF VIG.--With about 90% of its portfolio devoted to stocks with economic moats and an attractive 0.13% price tag, this ETF sticks to high-quality companies, focusing on firms that have raised their dividends for at least 10 years straight. That's a solid indicator of quality. The ETF's index provider keeps secret its exact methodology, but it seems to focus on firms with lower leverage and ample cash flow--traits favored by Munger and Buffett.

SPDR Dow Jones Industrial Average DIA.--This ETF tracks the iconic Dow Jones Industrial Average Index, which is seen as a bellwether of the U.S. stock market and consists of 30 mega-cap U.S. industrial leaders, excluding companies in the utilities and transportation sectors. The fund follows the index's odd price-weighting scheme, which gives greater weights to companies whose numeric stock prices are higher. That means that stock splits--which should have no impact on the underlying value of a security--actually reduce the weighting of a constituent in the index. We believe Munger would like this ETF's low turnover and low price tag, as well as the fact that fully 95% of the assets in this ETF's portfolio are invested in companies with economic moats. The ETF charges 0.17%.

 

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. 

Robert Goldsborough is an ETF Analyst at Morningstar.
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