Charlie Munger's Secret 4-Step Investing Checklist

I think that the methods that I've used, including the checklists, are the correct methods, and I'm grateful that I found them as early as I did. The methods have worked as well as they have, and I recommend that other people follow my example. Charlie Munger has quickly become one of my favorite investors to study. In this video, we are going to look at Munger's four-step investing checklist that he uses to decide if he wants to invest in a company or buy a particular stock.

Make sure to stick around to the end of this video because this checklist is something you can apply to your own investment process today to make you a better investor. Now, let's get into the video. We have to deal with things that we're capable of understanding.

Number one: Do we understand the business? Even though this concept sounds so simple, this is probably one of the biggest mistakes investors make. In my job as an investment analyst, I even see professional investors who have been investing for decades make this mistake. They invest in stocks that they don't fully understand simply because they have FOMO or fear of missing out. In this case, it's fear of missing out on strong investing returns.

However, one of the key takeaways from studying Warren Buffett and Charlie Munger is the concept of circle of competence. Listen to Buffett talk about circle of competence using a baseball analogy: "I don't have to understand all kinds of businesses. There are all kinds of businesses I don't understand, but there are thousands of opportunities there I did understand, the Bank of America, you know. I'm able to understand some given percentage," but Ted Williams wrote a book called "The Science of Hitting."

In "The Science of Hitting," he's got a diagram that shows him at the plate, and he's got the strike zone divided into 77 squares, each the size of a baseball. He says, "If I only swing at pitches in my sweet zone," which he shows there, "he has what his batting average would be, which is 400." If he had to swing at low outside pitches, but still in the strike zone, his average would be 230. He said, "The most important thing in hitting is waiting for the right pitch."

Now, he was at a disadvantage because if the count was on two or one and two and so on, even if that ball was down where he was only going about 230, he had to swing at it. In investing, there's no called strikes. People can throw Microsoft at me, and you know, you name it, any stock, General Motors, and I don't have to swing, and nobody's going to call me out on called strikes. I only get a strike called if I swing at a pitch and miss. So I can wait there and look at thousands of companies day after day, and only when I see something I understand and when I like the price of which it is selling, then if I swing, if I hit it, fine. If I miss it, it's a strike, but it's an enormously advantageous game.

Then once we're over that filter, we have to have a business with some intrinsic characteristics that give it a durable competitive advantage.

Number two: Does the business have a durable competitive advantage? This is what Charlie Munger refers to as a moat. Simply put, a moat refers to a business's ability to maintain competitive advantages in order to protect its long-term profits and market share from competing firms. The term "competitive advantage" and "moat" gets thrown around a lot in investing, so I want to make the term more tangible for you guys. Over my investing career, I have identified four different types of moats.

As I go over each of these kinds of moats, I'm going to provide examples to help you better understand each type. The first type of moat is what is referred to as network effects. Network effects are a phenomenon whereby a product or service gains additional value as more people use it. This concept is especially pronounced with technology companies.

A perfect example of network effects is right here on YouTube. As more viewers join the YouTube platform, the creators of videos benefit from more views on their videos and therefore more advertising revenue, incentivizing them to continue making videos. As more viewers on YouTube leads to more money being made by creators, people are incentivized to start making videos of their own. As more videos are made on a wide range of topics, it makes the platform even more valuable to viewers, attracting even more new viewers and leading to existing viewers spending more time on the platform.

So, in summary, more viewers lead to more creators, and more creators lead to more viewers, and those additional viewers lead to even more creators. This is a perfect example of a network effect at work. The next type of moat is low cost advantage. This is where a company has an advantage over its competitors by being able to produce its products or offer its services at lower cost than its competitors, and therefore is able to sell those products to customers at a lower cost.

A perfect example of this is Walmart. I would guess that when most people think of low-cost advantages, they think of Walmart. Put simply, Walmart's large size means it has the power to negotiate lower prices with its suppliers. Walmart, with its 10,500 stores spread across the world, is able to charge lower prices for items than the local corner grocery store with only one location. Because Walmart is able to purchase its products for lower prices than its smaller competitors, it is able to charge lower prices to customers and still make profits. If the smaller competitors tried to match Walmart's low prices, those smaller competitors, without the valuable low cost advantage, would likely start losing money.

The next type of moat is what I refer to as a brand moat. This is where a company has such a strong brand that customers are willing to pay a premium price for the product or service. A perfect example of a brand moat at work is Starbucks. Starbucks has built a strong brand over the years that allows a company to charge five dollars for a cup of coffee that a customer can make at home for 20 cents or purchase from a convenience store for a couple of dollars at the most.

By Starbucks' brilliant advertising and brand building, the company has turned its Starbucks brand a cup of coffee into a type of status symbol that millions of people are willing to pay a premium price for. The fourth type of moat is what I refer to as a resource moat. When I say resource, I am referring to things such as patents, technology, or other intellectual property that a company has that gives an advantage over competitors.

An example of this that comes to mind right away is pharmaceutical companies. When a pharmaceutical company develops a medicine that is proven to be effective, they receive a patent on that medicine, meaning that they are the only company legally allowed to produce that medicine. You can very quickly see why having a patent and the exclusive right to produce a medicine would be an example of a resource moat that protects a company from its competitors.

Then, of course, we would vastly prefer a management in place with a lot of integrity and talent.

Number three is the management of the company: talented and of the highest integrity. The quality of a company's management, meaning the company CEO, the rest of the company's executives, and the company's board of directors, is critical to the long-term success of the business and, as a result, helps you determine your investment returns.

While Charlie Munger and his partner Warren Buffett have a saying, "We try to invest in businesses that are so wonderful that an idiot can run them because sooner or later one will," they still consider it a big positive when a company they are looking to invest in has a great management team in place. 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.

On the first point, how well they have run the business, you can learn a lot about this by seeing what they have accomplished compared to what their competitors in the same industry have accomplished. It is important to see how a manager performed relative to the company status and competitive position in its industry after he or she first took a leadership role.

On the second point, capital allocation this frequently gets overlooked by both new and experienced investors, but it matters a ton if you plan to hold the stock for the long term. Capital allocation is simply what a company does with all the cash it generates and profits. When a company generates cash, the management team has a few choices with what they can do with that cash. They can reinvest that cash back in the business to grow, they can use it to purchase another company, or they can return it to shareholders via dividends and/or share repurchases.

This is one of the biggest areas management teams can mess up and hurt the stock's value. One particular area you need to watch out for is acquisitions. A lot of times, companies can spend billions on acquisitions that don't work out because the company they bought isn't good or the management team simply paid too much for the company. Let's say a CEO of a company spends one billion dollars acquiring a smaller company, and that smaller company fails and has to be closed down over the course of the next few years.

That billion dollars was wasted for you as a shareholder and would have been much better used being paid to you in the form of a dividend as opposed to being spent on this acquisition.

And finally, no matter how wonderful it is, it's not worth an infinite price. So we have to have a price that makes sense and gives a margin of safety considering the natural vicissitudes of life.

Number four: Is the price fair? No matter how great or amazing a company is, it isn't worth an infinite amount. Charlie Munger has made a career and a name for himself by buying stocks for below the stock's true value, or in other words, its intrinsic value. Think of it this way: You want to buy a stock for seventy dollars a share that's true value is worth one hundred dollars a share.

This thirty dollar difference between the true value of the stock and what you paid for it is referred to as the margin of safety. This helps protect you from losing money in case your estimate of the company's intrinsic value turns out to be incorrect.

Now the concept of how that intrinsic value is calculated deserves its own video entirely, so if you are interested in that, check out the video I made on how to calculate intrinsic value here. 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.

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Talk to you soon.