A special Charlie Munger-inspired edition of The Long-Term Investor, as we remember one of the greatest investors of all time.
Remembering Charlie Munger (1924-2023)
Legendary investor and philanthropist Charlie Munger passed away on November 28th, 2023, at 99 years old, just over a month shy of his 100th birthday. While most people know who Warren Buffett is, not as many are aware of Charlie Munger - and without Charlie, not many would likely know of Buffett.
Mr. Munger is most well known as the vice-chairman of Berkshire Hathaway, which has a current market valuation of $772 billion. Charlie joined Warren Buffett at Berkshire in 1972, which is why Buffett changed his investing style from the Benjamin Graham value investing methods of buying fair companies at great prices to purchasing great businesses at fair prices with long-term competitive advantages.
Charlie Munger was a brilliant man who enjoyed studying various subjects that interested him, such as architecture, mathematics, law, philosophy, physics, and engineering. Interestingly enough, Charlie never took courses in finance and was largely critical of what is still taught today in most finance curriculum. One of Charlie's most significant assets was his strong desire to be a lifelong learner.
One of Charlie's many great quotes is, "I did not intend to get rich. I wanted to get independent; I just overshot!" I think this is an excellent summary of how most people truly feel about money; the goal isn't to have a massive number of dollars but to have true freedom and independence in their lives where they are not required to make their daily decisions based on a job or career, but what they are genuinely passionate about. Charlie Munger and Warren Buffett provide excellent examples; as both are multi-billionaires, they still decided to live relatively modest lives while following their passions, which happened to be investing.
I highly encourage you to spend some time studying Charlie Munger - Google some of his best quotes, watch some of his interviews on YouTube, or pick up some books such as Poor Charlie's Almanack, The Tao of Charlie Munger, or many of the other books and articles about the incredible Charlie Munger.
Learning From Charlie Munger's Investing Style
In place of our company spotlight this month, I will give an example of how Charlie Munger invested using two companies, Ford and Alphabet (formerly Google).
When Warren Buffett began his investing career after learning from the great Benjamin Graham, he focused on finding very cheap companies (selling at a discount to book value) and selling them once their price reflected book value. While this method worked well for some time, it is much more challenging to do in today's environment and is akin to buying "cigar-butt" companies that might still have a little smoke left in them. When Charlie came along, he taught Warren that "a great business at a fair price is superior to a fair business at a great price." This method of investing has proven to be a superior long-term investment strategy and is the reason Berkshire Hathaway has been so successful for such a long period of time.
Using that framework, let's look at an example of two companies to see what Mr. Munger meant. One "value" stock that may have interested Mr. Buffett before meeting Charlie Munger today may have been something like Ford. Although Ford is not quite as "cheap" as he would have liked, it is close enough for this example. Ford is a great American company, and I have personally driven a Ford vehicle for the past ten years. However, I am not a fan of owning Ford stock. Ford is a stock that appears cheap on the surface, as it trades below book value (0.96x book value currently), which the company should be worth according to the balance sheet if, in theory, you shut it down today and sold all its assets. Ford's price/earnings ratio is 6.96x, and next year's earnings estimates price the stock at a forward price/earnings ratio of 6.12x. Compare this price/earnings ratio to the S&P 500, which is over 20x and appears to be a bargain!
So why would someone buy Alphabet at over 25x price/earnings and 19.5x forward price/earnings estimates instead of Ford for over 3x the price/earnings basis and over 6x on a price/book basis? This is where Charlie Munger reminds us it's better to buy a great business at a fair price rather than a fair business at a great price. Ford is a very cyclical business, which means it is a very boom-and-bust business, and it is difficult to predict its earnings over a long period. Ford also requires a lot of capital to produce its vehicles, which means it takes on a lot of debt. Alphabet is a business that still has some cyclicality, as the vast majority of its revenues come from advertising, but it has not been nearly as cyclical as Ford.
Ford | 2018 | 2019 | 2020 | 2021 | 2022 |
Operating Income | $12,666 | $10,046 | $4,199 | $9,775 | $12,772 |
Interest Expense | $10,691 | $10,521 | $10,258 | $7,055 | $7,778 |
Income Before Taxes | $4,345 | -$640 | -$1,116 | $17,780 | -$3,016 |
Alphabet | 2018 | 2019 | 2020 | 2021 | 2022 |
Operating Income | $32,595 | $35,928 | $41,224 | $78,714 | $74,842 |
Interest Expense | $114 | $100 | $135 | $346 | $357 |
Income Before Taxes | $34,913 | $39,625 | $48,082 | $90,734 | $71,328 |
*All numbers in millions
If we take a small sample of items from each company's income statements, we can see that Alphabet is much more consistent and has a much smaller reliance on debt. In 2 of the past five years, Ford has paid more in interest expense than they have earned from their operations! This is not something we want in businesses that we own. On the other hand, Alphabet has been highly profitable all five years and has never paid more than 5% of its earnings from operations for interest expense.
Another critical area to focus on is growth; over the past ten years, Alphabet has grown its free cash flow (or Owner's earnings as Warren Buffett likes to call it) by over 20% compound annual growth rate from $11.3 billion in 2013 to over $77.6 billion over the past year. In addition to the astounding growth, Alphabet has had positive free cash flow for each of the ten years. Contrast this with Ford, who has seen free cash flow of $3.8 billion in 2013 grow to $5.6 billion over the past year, a 3.9% compound annual growth rate, while seeming to yo-yo from year to year, reaching a high of $18.5 billion in 2020 to a low of -$13 million in 2022.
So, how has each company performed as an investment since 2013? $1,000 invested in Ford on 1/3/2013 would have been worth $1,236.44 on 11/28/2023 representing an annualized return of 1.96%. $1,000 invested in Alphabet over the same period would have been worth $7,592.32, or a 20.43% annualized return. While this is an oversimplified example, we can see the power of the investing style Charlie Munger taught Warren Buffett.
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Thank you for joining us in this edition of "The Long-Term Investor."As you can see, just because a stock looks cheap doesn't mean it is necessarily a good long-term investment. If you'd like help investing with a similar philosophy to the great Charlie Munger, we'd love to help.
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Disclaimer: All information provided in this newsletter, including references to past performance of investment strategies, market segments, or individual securities, is purely for informational purposes and should not be construed as investment advice, nor does it constitute an offer or solicitation of an offer to buy or sell any securities or adopt any investment strategy. It is important to note that past performance does not indicate future results. Investments can go up and down in value, and you could lose money or not gain as much as expected. Every investment has its own set of risks which could adversely affect results. Before making any financial decisions or investments, readers should consult with a qualified financial advisor to assess the appropriateness based on individual objectives, financial situation, or needs.