American billionaire investor Charles Munger poses for a portrait with his arms crossed in Los Angeles … [+]
Charlie Munger, one of the greatest investors of all time, deceased this week. He was 99 years old.
Munger was a successful lawyer and Warren Buffett’s most trusted associate at Berkshire Hathaway. Munger was able to give his opinion on many subjects. This article is about the most important investing lesson I learned from Charlie Munger: only invest in high-quality companies.
High Quality Stocks Compound Best
When Warren Buffett first met Charlie Munger over dinner in 1959, Buffett was more of a classic value investor who focused on investing in companies at cheap prices. Munger helped Buffett transform Berkshire Hathaway into the Mona Lisa of business conglomerates by convincing Buffett to only invest in wonderful companies. at a fair price.
Munger has long advocated investing in high-quality companies with strong brands, competitive advantages and the ability to increase prices over time.
One of Berkshire’s best investments of all time, See’s Candies, meets these criteria. When Berkshire purchased the company in 1972, it was a well-established confectionery company based in California. Originally from California, Munger knew the brand and its solid reputation. He convinced Buffett to move away from his traditional approach of buying cheap, undervalued companies and instead pay a premium for a company that Munger considers a high-quality broker.
It turns out Munger was right. See’s Candies, originally purchased for $25 million, has since generated more than $2 billion in pre-tax profit. This investment not only generated substantial returns but also taught Buffett valuable lessons about the power of brands and quality, thereby determining future investment decisions. For example, Berkshire later purchased a significant stake in Coca-Cola, based on a similar principle.
Munger had a unique ability to simplify complex subjects down to their essential truths. He said: “Over the long term, it is difficult for a stock to perform much better than the company behind it. If the company earns 6% on its capital over 40 years and you hold it for those 40 years, you ‘It won’t make much different than a 6% return, even if you initially buy it with a huge discount. »
There is so much wisdom in this sentence. I encourage you to re-read it and really try to remember it.
What Munger meant was that the value of common stock follows the trajectory of a company’s earnings over the long term. Highly profitable companies with sustainable competitive advantages generate above-average returns on capital, reflecting the fundamental quality of a company. Sometimes the market assigns a higher or lower than average valuation to these fundamentals. However, if a company is fundamentally strong and growing consistently, the market Ultimately reward shareholders for this value creation. This is why Munger favored very long holding periods, once he found something worth investing in.
For example, if you test the highest 20% of the Russell 3000 Index based on 5-year average capital return (to normalize for cyclical fluctuations) and assume annual rebalancing every year on December 31, a hypothetical investor would have earned more than double the long-term compound return of the index (cumulative return of 770% versus 323%) from 2000 to 2022.
Top 20% of the Russell 3000 Index, rebalanced annually and ranked by 5-year average return of … [+]
How to Find Wonderful Companies
The type of companies Munger considered high-quality compounds rarely come up for sale. But when they do, it usually pays to buy.
To select high-quality companies, you can use stock screeners available from your online broker or through a website that tracks fundamental data. You can also use the backtest criteria above or focus on other profitability measures and balance sheet strength indicators.
Another option is to subscribe to a service like Morningstar. They have analysts specializing in different sectors and assign Economic Moat scores to individual companies. In general, ‘large moatThe businesses are the type of high-quality franchises Munger preferred. These are companies that consistently achieve above-average returns on capital due to their sustainable strategic attributes.
Sometimes a wide-moat company misses a quarterly earnings number or runs into other frictions that temporarily sour Wall Street sentiment toward the company. When a large company faces short-term uncertainty (and all do), Wall Street often misinterprets it as a signal of long-term risk. This can lead to large companies being downgraded to valuations that may still exceed the broader index, but which represent a lower premium than average. When I spot situations like this, I often think of Munger and jump.
Why fundamental investing will never go out of style
Early in Charlie Munger’s career, it could be argued that investing was simpler. There weren’t as many algorithms or smart analysts dissecting every tick by tick. Yet his mental model of favoring high-quality companies still holds true.
In my experience, one of the most common situations in which stock investors find themselves in trouble is when they forget or ignore Munger’s point about business fundamentals.
For example, remember the stock mania even from a few years ago? AMC Entertainment (AMC) has been aggressively bid on by retail investors, reaching a huge valuation well beyond its intrinsic value. This price action temporarily made many millionaires. The CEO of AMC, for example, did very well thanks to the Reddit audience. He earned $25.2 million in total compensation in 2021 and an additional $48.2 million in 2022. However, AMC stock has fallen 98% since its peak on June 2, 2021!
AMC cratered because it’s the antithesis of a company with a high return on capital. The company has been losing money every year since 2020, while cutting staff and closing theaters. In retrospect, the meme stock phase represented a gargantuan misallocation of capital to the benefit of a few low-quality companies, incapable of profitably recycling that capital for the benefit of shareholders.
In 2023, many investors have commented on how small-cap stocks lag behind large-cap stocks. While the large-cap Russell 1000 index is up 21.5% year to date, the small-cap Russell 2000 index is only up 7.2%. One of the main reasons for this dramatic disparity: 41% of Russell 2000 companies are unprofitable, compared to just 17% in the Russell 1000.
Charlie Munger taught many great lessons in his life. Even though life is limited, its lessons can still serve investors in the long term.