Charlie Munger: How to Invest in 2024
That's a very simple set of ideas. The reason that our ideas have not spread faster is they're too simple. If you're not confused by what's going on, you're not paying attention. This Charlie Munger quote perfectly sums up what's happening in the stock market currently. 2024 is shaping up to be quite a challenging year for investors. The stock market is at all-time highs, causing many people to think it's in a bubble. As if this wasn't enough to worry about, our interest rates are at 20-year highs and inflation remains elevated.
Thankfully for us, legendary investor Charlie Munger has a simple four-step checklist that you need to follow in order to invest successfully in 2024 and beyond. Now let's get into it. We have to deal in things that we're capable of understanding. Once we're over that filter, we have to have a business with some intrinsic characteristics that give it a durable competitive advantage. Of course, we would vastly prefer a management in place with a lot of integrity and talent. Finally, no matter how wonderful it is, it's not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the natural vicissitudes of life.
That's a very simple set of ideas, and the reason that our ideas have not spread faster is they're too simple. The professional classes can't justify their existence if that's all I have to say. I mean, it's also obvious and so simple. What would they have to do with the rest of the semester?
First up on our checklist is: do you understand the business? While this may sound almost insultingly simple, one of the easiest ways investors can lose money is to invest in something they don't understand. This is why asking yourself if you truly understand the investment is number one on our checklist. Listen to him explain. Part of our secret is that we don't attempt to know a lot of things. I have a pile on my desk that solves most of my problems; it's called the "too hard pile." I just keep shifting things to the "too hard pile." Every once in a while, an easy decision comes along, and I make it. That's my system.
Everything was the "too hard pile" except for a few easy decisions which I make. It isn't that we were so good at doing things that were difficult; we were good at avoiding things that were difficult. Finding things that are easy. Munger and his business partner, Warren Buffett, popularized a concept known as "circle of competence." The circle of competence in investing refers to staying within your area of expertise and understanding. It's about investing in industries and companies that you have a deep understanding of, allowing you to make more informed decisions.
By staying within your circle of competence, you can better assess risks and opportunities, leading to potentially more successful investment outcomes. As Charlie Munger explained in the earlier clip, the majority of potential investments should end up in the so-called "too hard pile" because they fall outside of your circle of competence. This is an incredibly relevant reminder here in the year 2024 with the stock market at all-time highs. When stock prices are high, it is incredibly tempting to invest in things you don't understand. It seems like everyone is making easy money investing in whatever is trendy at the time.
However, it is important to remember that things can change quickly, and it's usually the uninformed investors that are left holding the bag. Second on Charlie Munger's checklist is: does the business have what is referred to as a "moat"? A moat in investing is a competitive advantage that protects a company from rival firms and sustains its profitability over the long term. Here's a simple analogy to demonstrate what that means: imagine a medieval castle full of treasure. In our story, it is widely known throughout the area that this castle is full of gold, jewels, and other valuables. Because of this, rival villages want to attack the castle and take what's inside.
To protect itself, the people in the castle built a moat around the outside of the structure; in other words, a deep, wide ditch filled with water. This serves as a line of defense against any potential intruders. As strange as it may sound, companies in a capitalist economy function much in the same way as a medieval castle. Businesses that are incredibly profitable have a target on them from competitors. These rival companies want a piece of the action and are quick to form an attack strategy.
It's only the company's competitive advantage, or its moat, that can truly keep competitors from encroaching on its territory. Here's Charlie Munger talking about the retailer Costco's moat: "Well, Costco, of course, is a business that became the best in the world in its category, and it did it with an extreme meritocracy and an extreme ethical duty. Self-imposed to take all its cost advantages as fast as it accumulates them and pass them on to the customers. And of course, that created ferocious customer loyalty, and it's been a wonderful business to watch. And of course, strange things happen when you do that and do that long enough. Costco has one store in Korea that will do over 400 million in sales this year. These are figures that can't exist in retailing, but of course, they do."
So, that's an example of somebody having the right managerial system, the right personnel selection system, the right ethics, the right diligence, etc. etc. That is quite rare. If you're once or twice in a lifetime you're associated with such a business, you're a very lucky person. For those of you that may not be familiar, Costco is a membership-based retail giant known for bulk discounts. Costco stores sell a wide range of products from groceries to electronics to everything in between, even engagement rings.
As Charlie described, Costco's moat comes from its ability to charge cheaper prices than its competition. The entire strategy of the business is focused on how they can reduce costs and pass those savings on to the customer in the form of lower prices. To get a sense of just how wide Costco's moat is, imagine if someone wanted to open up a store to compete with them. For starters, Costco owns the vast majority of its real estate, much of which the business has had for decades. This alone is a huge advantage. The newcomer would have to pay today's sky-high prices to rent or buy a high-quality location.
Costco also does billions of dollars of business each year with its key product suppliers, which gives Costco leverage to negotiate more favorable pricing for the products it carries. The newcomer, starting out with no sales, would likely have to pay full price to get products from suppliers and would get no preferential treatment. Additionally, each Costco location has tens of thousands of existing customers that pay an annual fee for the privilege to shop there. It took Costco years and years to build out its membership base, and this huge number of customers per location means Costco can spread out its costs over a large, established customer base.
The newcomer wouldn't be as fortunate. Since the new entrant is just opening his store, he has no existing customers. Instead, our newcomer here would have to spend aggressively on marketing to try to build up the customer base. Ultimately, these high marketing costs would have to be passed on to the consumer in the form of higher prices. These are just a few things, but I think you now get a sense of why having a wide moat is so important.
Number three on our checklist is: is management of the business talented? The quality of a company's management is incredibly important to the long-term success of the business and ultimately your investment returns. Charlie has jokingly said that he looks for a business so wonderful that an idiot can run it because sooner or later one will. However, Munger still considers it a big positive when management is talented.
In previous interviews, Munger has said you should evaluate management on two criteria: one, how well they run the business, and two, how they have allocated capital over time. Regarding the first part, which is how successfully they have managed the company, you can find out a lot about this by comparing management's accomplishments to those of their rivals in the same industry. Things such as the company gaining market share over competitors or has profitability in the business improved relative to the rest of the industry.
On the second point, capital allocation, this is an area that frequently gets overlooked by both new and experienced investors. However, it is incredibly important if you plan to hold the stock for the long term. Capital allocation is simply what a company does with the cash it generates from the operations of the business. When a company produces cash, the management team has a few choices with what they can do with all of that money. They can reinvest it back in the business, they can use it to purchase a company to grow through acquisitions, or they can return it to shareholders by paying out dividends or repurchasing shares.
Capital allocation is one of the biggest areas management teams can go wrong. One particular area you need to watch out for is growth through acquisitions. Often companies can spend billions on acquisitions that don't work out because the company they bought turns out to not be a good business or the management team simply paid too much for it. Frequently, this money would have been better off if it was paid out in a dividend to shareholders.
Number four on the Munger checklist is: does the investment have a margin of safety? The concept of margin of safety when it comes to investing was coined by Warren Buffett's mentor, Benjamin Graham, way back in the 1930s. However, given what's happening in 2024, with the stock market hitting all-time highs, it's even more relevant today. Listen to Charlie explain how he thinks about margin of safety: "Yeah, you're that margin of safety concept boils down to getting more value than you're paying. That value can exist in a lot of different forms. If you're paid four to one on something, that's an even money proposition. Well, that's a value proposition too; it's high school algebra. People who don't know how to use high school algebra should take up some other activity."
As Charlie said, a good way to sum up the concept of margin of safety is that you're getting more value than what you're paying. No matter how great a stock is, it isn't worth an infinite price. Charlie Munger made his fortune by buying stocks for below what is referred to as their intrinsic value. Intrinsic value is an estimate of a stock's true worth based on the cash that business will generate in the future.
Think of it this way: imagine there is a stock that has an intrinsic value of $100 per share. At the same time, let's say investors are worried about some short-term problem the business is facing. As a result, the stock is only trading for $60 a share. The margin of safety here would be the difference between the intrinsic value of the stock and the price it is currently trading at. A margin of safety is important because it helps protect investors from losing money in the event their estimate of the company's intrinsic value turns out to be incorrect.
As Warren Buffett likes to say, there are only two rules when it comes to investing: rule number one: never lose money. Rule number two: never forget rule number one. So, there we have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.