Charlie Munger's "Investment Checklist"
“How can smart people so often be wrong? They don’t do what I’m telling you to do: use a checklist to be sure you get all the main models and use them together in a multimodular way.” – Charlie Munger
Charlie Munger is a gem of a human being. I’ve yet to come across anyone that matches Munger’s broad knowledge across subjects – from physics and engineering to psychology to accounting – woven into a “latticework” of decision making. If you read Munger’s speeches or listen to him at Berkshire annual meetings (which you can do later today!), it’s not surprising he has become a billionaire and remains as sharp as ever at age 97. To top it off, he generally delivers his point without holding back on the wit and sarcasm, making learning from him all the more enjoyable.
Needless to say, investors and business people can learn a thing or two from what Charlie has to say.
Over the decades various authors have covered Warren Buffett ad nauseam, and for good reason. Buffett’s partner in crime, maintaining a lower profile and rarely speaking or writing publicly, flies under the radar a bit more to the general public. Fortunately, Peter Kaufman, a longtime friend and business associate of Munger, compiled “Poor Charlie’s Almanac” in 2005 and has expanded it several times over the years. In the book Kaufman presents eleven of Charlie’s speeches along with quips from Berkshire annual meetings, interviews with friends and family, and other accounts of Munger’s wisdom.
Munger often references using a checklist methodology when making decisions in investments or life, though he never prescribes exactly what that checklist should entail. Kaufman does readers the favor of compiling his own “Munger Investment Checklist” based on common themes woven into Munger’s talks.
Charlie undoubtedly does not run down each item in orderly fashion when making an investment as the checklist name might imply. Rather, as Kaufman explains, “each (point) must be considered as part of the complex whole or gestalt of the investment analysis process, in much the same way that an individual tile is integral to the larger mosaic in which it appears”. Nevertheless, any investor is sure to be better off with a quick-reference guide to how Charlie may evaluate different aspects of an investment opportunity. Many of these ideas are related and I’ll do my best to briefly distill the main themes from each point.
With that, let’s run through the following ten-point list that Kaufman has compiled and see how we incorporate some of these ideas into our process.
Risk
According to Charlie any investment should start with the evaluation of risk. Importantly, Munger does not measure risk the way finance professors do. In academia, risk is defined as volatility, or how much a stock price moves relative to the broader market. This makes no sense to Munger (or me).
Risk should be evaluated both qualitatively and quantitatively and cannot be reduced to a single number. From a financial standpoint, risk is best characterized as the chance of permanent loss of capital. Shun opportunities that present a reasonable chance of a big loss. Qualitatively, investors should avoid dealing with people of questionable character and abstain from undertaking investments that expose them to reputational risk. Additionally, without trying to predict their direction, always be cognizant of how inflation and interest rate exposure might impact your investment.
Above all, Munger says, always incorporate a margin of safety in your purchase price to compensate for the unknown and insist upon proper compensation for risk assumed.
Independence
Finding exceptional investments requires independence of thought. In any investment trend, macro or micro, following the herd is likely to result in average performance. Of course, being different than the crowd is not enough. Similar to Howard Marks, Munger reminds us that to deliver exceptional returns you have to be different, and you have to be right. Remember that whether others agree with you doesn’t make you right or wrong, “the only thing that matters is the correctness of your analysis and judgement”.
Be especially mindful when reading analyst reports and projections, as these sources are often far from independent and have motivations that may differ dramatically from your own. Going directly to primary sources, typically SEC filings and call transcripts, is the best way we’ve found to remain impartial.
Preparation
It’s impossible to know when opportunity, in investing or otherwise, will strike. All one can do is remain prepared. At Eagle Point, maintaining our blog is one way that keeps us prepared, as our writings tend to represent a “shopping list” of potential investments. It also keeps us learning and evolving as investors as we work to expand our circle of competence.
Munger advises us that the way to remain prepared is to read voraciously and never stop learning. Learning vicariously through others (through reading) is a great way to learn how to avoid costly mistakes that otherwise would be learned by making them yourself. Buffett is famous for reading 500 pages per day, and it has worked pretty well for him. While this is likely unrealistic for many, reading just 30 pages per day translates into about 35 books per year. Surely most of us can find time for 30 pages per day. Imagine how knowledge compounds over time with even this level of reading.
Intellectual Humility
Staying within your circle of competence and accepting the limits of your knowledge is incredibly important in investing. Avoid false precision that often comes with detailed models and be on the hunt for disconfirming evidence. Matt and I call this avoiding stupidity rather than seeking brilliance. Physicist Richard Feynman said "The first rule is you must not fool yourself. And you are the easiest one to fool." We try to consciously seek out the bear arguments for our investments as it’s easy to only look for information confirming your prior beliefs.
Analytic Rigor
While Munger mostly preaches about qualitative aspects of investing, at the end of the day making a smart investment entails buying something for less than the discounted future steam of its cash flows, and investors need the analytical skills to do so. Doing this requires thinking of stocks as pieces of businesses and not pieces of paper. Investors should seek to be a business analysis first, and a securities analyst second. When studying businesses always determine the drivers of value instead of price, and don’t confuse wealth with size or activity with progress.
Munger is incessant on “inverting” investment decisions as part of his analysis. This means asking questions like “how will this investment fail?” or “how could this lose money?”. Answering these questions first, instead of only focusing on tantalizing upside, is likely to prevent investors from making dumb mistakes. Munger has frequently said that all he wants to know is where he is going to die, and he will avoid going there. Maybe this is why he’s lived to 97.
Allocation
Proper capital allocation is an investor’s most important job. Perhaps the most unique insight Munger gives us here is that the best use of capital should always be measured by the next best use, which is your opportunity cost. It seems obvious but it’s very easy to constantly look for new ideas when the best use of cash might be simply adding to an investment that you already own. Using your current best idea as a “yardstick” against which new ideas are measured should help investors from continually falling in love with shiny new objects.
Also on allocation, Munger reminds us that good ideas are rare and when the odds are in your favor, allocate heavily. Buffett has suggested that if investors only had twenty investments to make throughout their lives they’d think more closely, and bet more heavily, on their best ideas. This makes a ton of sense to us. Holding 10 positions or less forces us to concentrate on only our best ideas and discard the mediocre ones.
Patience
As good ideas are rare, it can be difficult to resist the urge to act every week or every month, especially for professional investors. Enjoying the process, because that’s what your days entail, is important in combating the natural human bias towards activity.
Focusing on patience minimizes transaction expenses, frictional costs, and taxes while waiting for the arrival of new opportunities. It also helps investors avoid interrupting the eighth wonder of the world (at least according to Einstein) – compound interest.
Decisiveness
When patience is rewarded and opportunity meets the prepared mind, it is time to act decisively. This may mean exercising aggression when others are fearful in the stock market, or opportunistically taking a career leap. Either way, all of Munger’s principles above come together into swift action when the conditions are right.
Change
The world, not to mention the financial markets, change at a dizzying pace. This can be particularly true in certain sectors like technology. Investors should be comfortable living with this change and accept the financial world as a complex system. Just as Munger tells us to accept the limits of our knowledge investors should also accept the world as it is, not as we wish it was, even if we don’t like it. Never fall in love with an investment and continually challenge your favorite ideas as the world and economies change.
Acknowledging that businesses face a seemingly ever-increasing rate of change, we try to learn about areas of the market that are less likely to be disrupted. Jeff Bezos has long focused on things that won’t change – like consumers wanting lower prices and faster shipping – instead of trying to predict what will change (and there will be a lot). For example, HEICO has an enduring cost advantage likely to persist for decades. Though I know little about what air travel will look like ten years from now, I can say with certainty airlines will always desire lower prices for replacement parts.
Focus
Munger says that “a majority of life’s errors are caused by forgetting what one is really trying to do”. As an investor, never forget what you’ve set out to do. To us, that means focusing on finding investments that will compound wealth at acceptable rates over very long periods of time with minimal risk of permanent loss. Any idea that doesn’t contribute to that goal can be quickly discarded. Other investors may have different goals or time frames, and the important thing is to play the game you’ve set out to play.
This seems especially important in today’s markets. As you read articles about speculators becoming overnight millionaires by investing their retirement savings in Dogecoin, remember that they’re likely playing a different game than you, which is fine. It reminds me of what Joel Greenblatt has said; if you run through a dynamite factory with a lit match you might not die, but you’re still an idiot. When long-term investors are lured into quick profit gambles they’ve forgotten what they’re trying to accomplish, and it rarely ends well.
This ”checklist” will not by itself help you uncover great investments. Hopefully, it can help you build a better investment process, enjoy learning, and give you the confidence to recognize when you’ve uncovered a great idea. I’ve also found many of Munger’s ideas can be applied to making any big decision in life, not just in the markets. For anyone interested I’d highly recommend a copy of Kaufman’s book, as this list just scratches the surface of how Buffett’s longtime right-hand man approaches investing and life.
Before we make an investment Matt and I think about how we might explain the opportunity to Munger. If an investment idea fails many of the points in the above list, it’s probably not for us and we wait for the next one.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.