Charlie Munger: The Investment Opportunity of a Lifetime

And I think more inflation over the next 100 years is inevitable. It's not every day a year, given how rare it is for Munger to sit down and share his thoughts. What we are in for is a rare treat. Munger recently did a two and a half hour long interview where he shared his thoughts on everything from the economy, inflation, the stock market, and even the investing opportunity you can take advantage of to get very wealthy.

I have condensed this interview down to the absolute must-watch pieces that you need to know in order to help prevent you from losing money in the quote unquote challenging times that lie ahead. In the words of Munger, let's get into it. Given the increasing rate environment, what are the ramifications of moving away from a close to zero interest rate policy? Warren and yourself have frequently spoken about Aesop and a bird in the hand is worth two in the bush to describe the essence of investment decision making.

So what do you do now that the interest rate environment is changing? Well, there's no question about the fact that as the interest rates have gone up, it's hostile to stock prices, and they should go up. But we couldn't have kept them forever at zero. I just think this is one more damn thing to adapt to in investment life, is that there are headwinds and there are tailwinds.

One of the headwinds is inflation, and I think more inflation over the next 100 years is inevitable, given the nature of democratic politics in a democracy. So I think we'll have more inflation. That's one of the reasons The Daily Journal owns common stocks instead of government bonds. All politicians in a democracy tend to be in favor of printing the money and spending it, and that will cause some inflation over time. It may avoid a few recessions too; it may not be all bad, but it will do more harm than good, I think, from this point forward.

If you think we might have on and off waves of inflation like we did prior to when Volcker stepped in at the Fed in the '70s era, of course it will happen some in the future. Yes, I think we'll have some of that in the future. Do you think we'll have it immediately right now with what Jay Powell is dealing with? I don’t, I don’t, I don’t. I don’t regard myself—

I think I'm pretty good at long-run expectations, but I don't think I'm good at short-term wobbles. I don't know; the famous idea is what's going to happen short term. Okay, inflation is at its highest rate in 40. According to—remember it to use a term for Munger's business partner, Warren Buffett—inflation swindles the equity investor.

Equity investor is just a fancy way of saying people who own stocks. Here's what he means: Let's say your stock portfolio returned 10% in a year. Well, that's great, right? Well, not so fast. There is one part of the equation that's missing; that is inflation. Whether that 10% annual return is good or bad depends on how high inflation is. If your portfolio returned 10% and inflation was zero percent, well, that's great; your so-called real return was 10%.

That's an amazing real return! You can approximate your real return by subtracting your so-called nominal return by the inflation rate. Just as a quick aside, the actual formula to calculate your real return is a little more complicated, but this shorthand method will get you close enough. If inflation was two percent, which, by the way, is the long-term inflation rate the U.S. Federal Reserve is targeting, your real return would be eight percent. If inflation was seven percent, your real return would go all the way down to three percent—a very far ride from the 10% return you had before inflation quote unquote swindled your return.

In the words of Warren Buffett, there is a thought among many economists that inflation is subsiding. And while the data is showing that to be true, the big question is where the so-called normalized inflation rate will settle at. Before this period of elevated inflation, it was assumed that the long-term inflation rate would be around two percent.

Charlie Munger believes investors are in for a period of higher than normal inflation for a long time, not just one or two years. Munger believes that the next 100 years will carry with it higher inflation—definitely not a good thing for us as investors since inflation eats away at the real returns of our investments.

The reason Munger thinks inflation will be higher over the next 100 years has to do with the nature of politics. If you're a politician, at the end of the day you have one job: to win your next election, otherwise you're out of a job. And heck, I can't really blame them. That's just human nature. In order to win an election, a politician has to be popular with the people he or she represents, or, well, at least more popular than whoever the candidate they are running against is.

One way you can keep voters happy is by avoiding a recession. There's an old saying that voters tend to vote with their pocketbooks. If there is a recession, whether or not it is actually their fault, politicians are going to get the blame. So with this background, you can see why politicians are motivated to do everything in their power to avoid having the economy decline on their watch.

This is where money printing enters the equation. Conventional economic theory states that recessions are a normal part of an economy. There will be good years when the economy is booming and humming along, and there will also be bad years when unemployment is high and economic production is falling. However, those bad years are not ideal for politicians that are looking to keep their job.

As a result, they create government spending packages to spur the economy. Over the past few years in the United States, that took the form of checks mailed to citizens, forgivable loans for small businesses to keep employees on payroll, and various other programs to keep the economy ticking along. These programs are referred to as economic stimulus, and the goal is to keep the economy from entering a recession.

This is what Charlie meant when he said governments printing money can avoid recessions. However, there is at least one pretty big drawback of these stimulus programs: they increase what is referred to as the money supply. And here's why that matters for inflation. This is a basic supply and demand graph. This line here represents the supply of any given good or service. Think of this as how much of that good is available to be bought, and the line here is demand.

Think of this as how many people are trying to buy that good or service. The intersection of these two lines represents the price at which the good will sell for. So, for the sake of our example, let's say the good that we are discussing is cars. Typically, during a recession, people have less money to spend and are feeling uncertain about the economy. As a result, consumers' ability to make large purchases, such as a vehicle, decreases. This dynamic puts downward pressure on our demand line here.

What does our demand line do? It moves to the left as demand decreases. As we can see here, the point at which these lines now cross is at a lower price point. And this is why car prices tend to decrease during a recession.

Let's see what happens when the opposite occurs. Instead of a recession, let's say the government implements a stimulus program to keep the economy growing. This increases the money supply, which is just a fancy way of saying that there are more dollars in the economy chasing the same number of goods.

Additionally, the U.S. Federal Reserve may decrease interest rates, which would make it less expensive to purchase a vehicle using a loan. These actions cause the demand for vehicles to increase, pushing our demand line out to the right. Notice how the supply and demand lines now cross at a higher price point.

This example is, of course, simplistic but demonstrates how inflation works. Too many dollars, AKA too much demand chasing a fixed supply of goods results in higher prices. Charlie is convinced that the next 100 years will be a period of relatively high inflation.

However, that is not the only headwind investors will be facing. There is also something else investors will have to contend with, and here's what Charlie said when asked why he believed Berkshire Hathaway stock would outperform the market: "I don't think it will be as good in the future as it was in the past, but it will be okay considering how poorly everything else is going to do."

Why do you think everything else is going to do so poorly? Because the valuations start higher now and because government is so hostile to business. And that's a view over the next 5, 10, 20 years. How far out are you thinking? I would say it'll fluctuate naturally between administrations and so on, but I think basically the culture of the world will become more and more anti-business in the big democracies.

And I think taxes will go up, not down. So I think the investment world is going to get harder for everybody. But it's been almost too easy in the past for the investment class. It's natural it would have a period of getting harder.

Munger mentioned in this clip that one of the biggest reasons he thinks investors in the stock market are in for a rough time is due to rising taxes on corporations. Let me demonstrate what he means by using a hypothetical company named XYZ Corporation. Our hypothetical company is publicly traded, meaning investors can purchase stock in the company on an exchange like the New York Stock Exchange.

In this very simplified example, let's say XYZ Corporation does 100 million dollars in sales. The company also has 70 million dollars in expenses. This means that the company's profit before taxes is calculated by taking its sales of 100 million and subtracting up the expenses of 70 million, which gets us a profit before taxes of 30 million dollars.

However, this isn't the amount of profits that shareholders in XYZ Corporation get to split. Before shareholders see any money, the government has to take its cut in the form of taxes. Let's say in this example the tax rate is 20%. That means that the government gets 20% of that 30 million dollar profit before taxes, and that comes out to six million dollars that gets paid out to the government.

That brings the final profit number, also referred to as net income, down to 24 million dollars. This is the amount that gets spread out amongst all the owners of the stock. For simplicity purposes, let's say there's 24 million shares outstanding of the company. That means the company's EPS, or earnings per share, is one dollar, calculated by taking the company's net income and dividing it by the number of shares outstanding.

Now let's get exactly into why Charlie thinks rising taxes will be a headwind to investors in the stock market. Let's say instead of a 20% tax rate, the government doubles the tax rate to 40%. Using our same numbers as before, this increases the taxes the company has to pay from six million dollars all the way to 12 million dollars. This higher tax bill reduces the amount of profit, or net income, that is left over for shareholders.

The net income falls from 24 million down to 18 million dollars. Assuming the same number of shares outstanding, earnings per share, or EPS, falls from one dollar down to 75 cents. This is a reduction of 25% in EPS due to the higher tax rate, and this is less money the company can use to grow the business or pay out to shareholders in things such as dividends.

It doesn't just stop there. Stocks are valued in what is called a P/E ratio. Let's say XYZ Corporation stock trades at a P/E ratio of 25 times. That means that when the company is earning one dollar in EPS, each share of XYZ is worth 25.

However, when the EPS falls due to the increased tax rate, so does the stock price. Taking the 75 cents in EPS and multiplying it by the P/E ratio of 25 times gets you a stock price of 18.75. This is a reduction in the stock price of 25% purely just from the higher tax rate.

This hypothetical and albeit simple example demonstrates Munger's point on why raising taxes are a headwind for stock prices. Raising taxes decreases the amount of money companies make and therefore makes their stocks less valuable.

Everything isn’t all doom and gloom, however. Charlie did have advice on what investors can do to fight these headwinds in the investing opportunity that made him and his business partner Warren Buffett incredibly wealthy. Well, it helps to have somebody that lucked into a good position, so a great business would be what you'd like. And of course you'd like a great management too.

And occasionally we've had both to ride together for a long, long period, but of course everybody's looking for the same thing. The trouble with it is you will find when you get into those good businesses in a place picked over and analyzed, as American stocks are, you can imagine the amount of time spent thinking about American stocks. You will find by and large in America it's really a great business, it's at least 25 times earnings and maybe 30 or 35 or something.

So that makes it much harder, of course, because if something goes wrong, you can lose a lot of your investment. And of course, that's what makes investments so difficult is the fact that it's a good business. The good businesses don't stay cheap; you've got to somehow recognize a good business before it's recognizable as a good business.

That's very hard to do. Now, some people get good at it, but not many. Despite all the headwinds investors face, there is still plenty of opportunity out there. As Munger pointed out throughout the video, the best way to fight these headwinds is to buy great businesses.

And there are three things that Munger and his business partner Warren Buffett look for to determine if a business is great and whether it makes sense to invest. The first characteristic of a great business is a moat. Buffett says a truly great business must have an enduring moat that protects excellent returns on invested capital.

The moat he talks about refers to a competitive advantage that makes the business unique and better than others. In a literal sense, a moat protects a castle from oncoming attacks. In the markets, a moat protects a business from challengers. An example of a company with a great moat would be Apple.

Apple just happens to be Berkshire Hathaway's largest position in its portfolio, of which Munger is the vice president. Now, there are multiple different types of moats, but one that really stands out for Apple is its brand. In many countries, Apple products have become a status symbol in the eyes of consumers. As a result, Apple has developed immense brand loyalty.

Warren Buffett likes to use the example of how if someone goes into the store to buy an iPhone and it's out of stock, they won't just buy competitors' products. Instead, they will wait until the iPhone is back in stock or go to a different store. This brand moat allows Apple to charge premium prices for its products and be significantly more profitable than its peers.

Second on the list of what Munger looks for is a great manager of that business. This means the CEO and his or her management team. One of the most important aspects of a CEO's job is what is referred to as capital allocation. The goal of any business, especially large publicly traded companies, is to make a profit.

So, in simple terms, capital allocation is what the CEO of the company does with the profits that the business generates. Management teams have a few different options for what they can do with the profits: one, they can reinvest in the business if there are any attractive growth opportunities; second, they can buy smaller companies to grow through acquisition; or three, they can pay that profit out to shareholders in the form of dividends or repurchases.

What this CEO decides to do with the money has a huge impact on the share price. Take acquisitions as an example. If the CEO of a company decides to buy another company and that deal does not work out, it can cost shareholders literally billions of dollars. Capital allocation is a CEO's most important job. A great management team knows how to allocate capital in ways that benefit shareholders the most.

And number three on the list is the stock needs to be selling for less than its intrinsic value. This is the key to the value approach to investing that made Munger a billionaire. The difference between the true value of the stock, its intrinsic value, and the price it is currently selling for is referred to as your margin of safety.

This is where the investing opportunity of a lifetime comes into play. In the clip, Munger mentioned the key to investing successfully is to recognize a great business before everyone else does. This is because, by the time everyone knows that it's a great business, it is so incredibly expensive that it would be difficult to generate a high return by buying the stock.

An example that demonstrates this perfectly is Munger and Berkshire's investment in Apple. Berkshire Hathaway first started buying shares of Apple back in 2016. At this time, it was trading at a P/E ratio of around 10 times. For those who may not be familiar, the higher the P/E ratio, the more quote unquote expensive the stock is.

Now Apple stock is trading at a P/E ratio of 25 times. This is two and a half times higher than when Berkshire first bought it. The reason why Berkshire was able to buy Apple stock at such a discount to its current price was because the investment team at Berkshire was able to recognize Apple as a truly wonderful business.

Even arguably more importantly, they were able to come to that realization before the stock market was. Once everyone else started to come around to the fact that Apple was indeed a great business, its stock price skyrocketed. Apple has made Berkshire Hathaway 100 billion dollars because Buffett and Munger were able to recognize a great business before everyone else.

This is the investing opportunity that can make you rich despite all the other headwinds you may be facing. So there we have it. Make sure to hit the like button and 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.