Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!

  • The four fundamental principles of value investing as created by Ben Graham are as follows:
    • Treat a share of stock as a proportional ownership of the business
    • Buy at a significant discount to intrinsic value to create a margin of safety
    • Make a bipolar Mr. Market your servant rather than your master
    • Be rational, objective, and dispassionate
  • The successful Graham value investor also works diligently to reduce the downside risk of any investment. For this reason, the Graham value investing system tends to shine most brightly during a flat or falling stock market. The Graham value investing system is intentionally designed to underperform an index in a bull market

PRINCIPLES

  • First Principle: Treat a Share of Stock as a Proportional Ownership of a Business

    • If you do not understand the actual business of the company, you cannot understand the value of assets related to that business, like a share of stock or a bond. Graham value investors approach any valuation as if they were actually buying a business in a private transaction. In buying a business, Munger believes the place to start is at the bottom, with business fundamentals, and work up. What does the company sell and who are its customers and competitors? What are the key numbers that represent the value the business generates? The list of important questions that an investor must answer is extensive. For a true Graham value investor, there is no substitute for a bottom-up valuation process. In undertaking this process, Graham value investors are focused on the present value of the cash that will flow from the business during its lifetime and whether the business generates high, sustained, and consistent returns on capital

    • What Munger looks for is a business that has a significant track record of generating high, sustained, and consistent financial returns. If valuing the business requires understanding how cash flows will change in the future based on factors like rapid technological change, Munger puts that business in the too hard pile and moves on to value other companies

    • A Graham value investor puts short-term predictions about mass psychology in the too hard pile and focuses on what he or she can do successfully with far greater ease. Graham value investors do not spend time with top-down factors like monetary policy, consumer confidence, durable goods orders, and market sentiment in doing a business valuation or investing

    • A share of stock cannot be divorced from the fundamentals of the specific business

    • Be motivated when you’re buying and selling securities by reference to intrinsic value instead of price momentum

    • If you focus on the value of the business, you have no need to predict short-term changes in the economy because that takes care of itself

    • If you do not follow the business to value the stock approach, in the view of Graham value investors, you are a speculator and not an investor. If you are an investor, you are trying to understand the value of the asset. By contrast, a speculator is trying to guess the price of the asset by predicting the behavior of others in the future. In other words, a speculator’s objective is to make predictions about the psychology of large masses of people

    • 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 does not own gold as an investment because it is impossible to do a bottom-up fundamental valuation, because gold is not an income-producing asset. Gold has speculative value and commercial value, but in Munger’s view it has no calculable intrinsic value

  • Second Principle: Buy at a Significant Discount to Intrinsic Value to Create a Margin of Safety

    • A margin of safety is “a favorable difference between price on the one hand and indicated or appraised [intrinsic] value on the other

    • Intrinsic value is the present value of future cash flows. Margin of safety reflects the difference between the intrinsic value and the current market price

    • A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world

    • Price is what you pay, and value is what you get

  • Third Principle: Make “Mr. Market” Your Servant Rather Than Your Master

    • Graham’s value investing system is based on the premise that risk (the possibility of losing) is determined by the price at which you buy an asset. The higher the price you pay for an asset, the greater the risk that you will experience a loss of capital. If the price of a stock drops, risk goes down, not up. For this reason, the Graham value investor will often find that price decrease for a given stock is an opportunity to buy more of that stock
  • Fourth Principle: Be Rational, Objective, and Dispassionate

    • Rationality is not just something you do so that you can make more money; it’s a binding principle. Rationality is a really good idea. You must avoid the nonsense that is conventional in one’s own time. It requires developing systems of thought that improve your batting average over time

    • At a fundamental level, investing is just one form of making a bet. It is essential, however, that the bet be made in a way that is investing (net present value positive) rather than gambling (net present value negative)

THE SEVEN VARIABLES IN THE GRAHAM VALUE INVESTING SYSTEM

  • First Variable: Determining the Appropriate Intrinsic Value of a Business 

    • There are two kinds of businesses: The first earns 12 percent, and you can take it out at the end of the year. The second earns 12 percent, but all the excess cash must be reinvested—there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business —CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2003

    • When Munger and Buffett value a business, they use what they call owner’s earnings as the starting point. Owner’s earnings can be defined as: Net income + Depreciation + Depletion + Amortization – Capital expenditure – Additional working capital. Berkshire uses the owner’s earnings figure in this process to take into account capital expenditures that will be necessary to maintain the business’s return on equity

  • Second Variable: Determining the Appropriate Margin of Safety

    • Graham had this concept of value to a private owner—what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety—as he put it—by having this big excess value going for you —CHARLIE MUNGER, UNIVERSITY OF SOUTHERN CALIFORNIA (USC) BUSINESS SCHOOL, 1994
  • Third Variable: Determining the Scope of an Investor’s Circle of Competence

    • We have to deal with things that we’re capable of understanding. —CHARLIE MUNGER, BBC INTERVIEW, 2009
  • Fourth Variable: Determining How Much of Each Security to Buy

    • Our investment style has been given a name—focus investing—which implies 10 holdings, not 100 or 400. Focus investing is growing somewhat, but what’s really growing is the unlimited use of consultants to advise on asset allocation, to analyze other consultants, etc —CHARLIE MUNGER, WESCO ANNUAL MEETING, 2010
  • Fifth Variable: Determining When to Sell a Security

    • There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: you’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded. —CHARLIE MUNGER, DAMN RIGHT, 2000
  • Sixth Variable: Determining How Much to Bet When You Find a Mispriced Asset

    • Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside. —SAM ZELL, NEW YORKER, 2007
  • Seventh Variable: Determining Whether the Quality of a Business Should Be Considered

    • How do Munger and Buffett assess quality?

    • Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite—that is, consistently employ ever-greater amounts of capital at very low rates of return —WARREN BUFFETT, 1992 BERKSHIRE SHAREHOLDER LETTER, 1993

    • Grahamites … realized that some company that was selling at two or three times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. —CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

  • Eighth Variable: Determining What Businesses to Own (in Whole or in Part)

  • Why do some businesses create easy decisions for entrepreneurs and investors? A significant part of the answer lies in microeconomics: if there’s no significant barrier to entry that creates a sustainable competitive advantage, inevitable competition will cause the return on investment for that business to drop to opportunity cost and there will be no economic profit for the producer. The analogy they use at Berkshire is that the business itself should be viewed as the equivalent of a castle and the value of that castle will be determined by the strength of the protective moat.
  • Whether a business has a durable moat is without question the most important attribute for an investor like Munger

  • Proper allocation of capital is an investor’s number one job. —CHARLIE MUNGER, POOR CHARLIE’S ALMANACK, 2005

    • The only duty of a corporate executive is to widen the moat. We must make it wider. Every day is to widen the moat. We gave you a competitive advantage, and you must leave us the moat. There are times when it’s too tough. But duty should be to widen the moat. I can see instance after instance where that isn’t what people do in business. One must keep their eye on the ball of widening the moat, to be a steward of the competitive advantage that came to you. A General in England said, “Get you the sons your fathers got, and God will save the Queen.” At Hewlett Packard, your responsibility is to train and deliver a subordinate who can succeed you. It’s not all that complicated—all that mumbo jumbo. We make bricks in Texas which use the same process as in Mesopotamia —CHARLIE MUNGER, WESCO ANNUAL MEETING, 2008
  • Munger thinks about the opportunity cost of capital by considering what the alternatives are for that capital

    • The mathematical process that Munger and Buffett use at Berkshire is simple

    • First, Berkshire calculates the past and current “owner’s earnings” of the business. Then they insert into the formula a reasonable and conservative growth rate of the owner’s earnings. They solve for the present value of the owner’s earnings by discounting using the 30-year U.S. Treasury rate. The focus of the investing process at Berkshire is on return on equity (ROE), not earnings per share (EPS)

    • Berkshire does not use price to earnings multiples in calculating value. Owner’s earnings is a very specific type of earnings, and they stick to that set of figures.

5 ELEMENTS WHICH CREATE MOATS

  • Supply-Side Economies of Scale and Scope

If a company’s average costs fall when more of a product or service is produced, there are supply-side economies of scale

Regarding the impact of supply-side economies of scale, Munger has pointed out:

In some businesses, the very nature of things cascades toward the overwhelming dominance of one firm. It tends to cascade to a winner-take-all result. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, “to hell with it. We’re either going to be number one or two in every field we’re in or we’re going to be out.” That was a very tough-minded thing to do, but I think it was a correct decision if you’re thinking about maximizing shareholder wealth. —CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

If it is cost efficient for a company to produce several different products or services, a company can also benefit from supply-side economies of scope. To benefit from economies of scope, a business must share resources across markets while keeping the amount of those resources largely fixed. Businesses that desire to benefit from economies of scope must avoid running as isolated units.

  • Demand-Side Economies of Scale (Network Effects) 

Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it. Craigslist, eBay, Twitter, Facebook, and other so-called multi-sided markets have demand-side economies of scale that operate on their behalf. American Express is an example of a company in the Berkshire portfolio with network effect benefits; the more merchants that accept their card, the more valuable the service gets, and the more people who use the card, the more valuable the services are for merchants

  • Brand

See’s Candies is also a great side-by-side test of brand power. To illustrate, if you grew up in a home that bought See’s Candies (mostly on the West Coast, especially in California,) and your experiences around that candy have very favorable associations, you will pay more for a box bearing the See’s Candies brand. By contrast, someone who grew up on the East Coast of the United States will not attribute much value to that brand because they do not have those same experiences. For this reason, See’s Candies has found it hard to expand regionally and has done so very slowly. What See’s Candies sells is not just food, but rather an experience

Take See’s Candies. You cannot destroy the brand of See’s Candies. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s Candies sponsoring the local funeral home. We are at the Thanksgiving Day parades though. —WARREN BUFFETT, NOTES FROM UNIVERSITY OF GEORGIA VISIT, 2007

A very important test for Buffett and Munger in determining the strength of a brand-based moat is whether a competitor can replicate or weaken the moat with a massive checkbook

  • Regulation

Certain businesses have created a competence with regard to regulation that is so strong that the regulation itself actually serves as a moat. Regulations can often end up protecting existing entrenched producers rather than helping consumers. For example, some people believe banks have created such a powerful layer of regulatory expertise that the regulators have become captured by the industry they regulate For Berkshire, the regulation-driven moat that Moody’s possessed in the bond rating business was a big attraction. To issue bonds, regulators actually require that the issuer get an opinion from a very small number of bond rating firms, which means that rating firms like Moody’s, S&P, and Fitch have a moat

  • Patents and Intellectual Property

Companies that have been granted a patent, trademark, or other type of intellectual property by the government have in effect been given a legal monopoly. This barrier to entry can create a substantial moat for the owner of the intellectual property

  • When it comes to moats, durability matters. Munger wants to avoid a business that has a moat today but loses it tomorrow. Some moats atrophy gradually over time and some fade much more quickly

  • How long your moat lasts is called your competitive advantage period (CAP)

  • Mathematical formulas will not tell you how to get a moat, but they can help prove that you have one—at least for now. To test whether you have a moat with a given company, determine if you are earning profits that are greater than your opportunity cost of capital (OCC). If that level of profitability has been maintained for some reasonable period (measured in years), then you have a strong moat. If the size of the positive difference between return on invested capital (ROIC) and OCC is large and if that spread is persistent over time, your moat is relatively strong

  • If you must hold a prayer meeting before you try to raise prices, then you do not have much of a moat, if any, argues Buffett

  • Berkshire’s insurance operations generate low-cost float (cash that comes in from insurance premiums collected well in advance of future insurance claims). This float is a major source of funding for investments. At Berkshire, float has grown from $39 million in 1970 to just over $77 billion in 2014, and significant amounts of that cash can be put to work within Berkshire

  • Identifying a startup that may acquire a moat before it becomes evident is something that some venture capitalists can do when there is a sufficiently high level of probability that they can generate an attractive return on capital overall. Venture capitalists harvest something called optionality, which is a different form of arbitrage than Graham’s value investing system. The skill needed to be successful as a venture capitalist is rare, as evidenced by the fact that the distribution of returns in venture capital is a power law. Moats that emerge from complex adaptive systems like an economy are hard to spot. This is because a moat is something that is greater than the sum of its parts, emerging from something else that is greater than the sum of its parts. In contrast, a moat being destroyed is easier to spot because this is a process of something transforming into nothing

  • Graham value investors spend a lot of time thinking about return on equity and return on capital

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