Thursday, April 8, 2010

Munger: Keeping it Simple

Charlie on Berkshire Hathaway's straightforward approach to the insurance biz. What he says about insurance applies to investing.

"More insurers don't copy BRK's model (underwriting for profit and stepping out of the market for extended periods of time when pricing is bad) because our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

Sidekick has sage advice of his own

This comment by Charlie on insurance is true of investing more generally. As an example, market participants seem too rarely to choose buying at a fair price then holding, for long periods, the durable high return on capital franchises as a core part of their investing strategy.

Some do. Many do not.

Why? Possibly, at least in part, because it's just too damn simple.

Instead, it is common to treat these companies as places to park money until some "high beta" opportunity comes along.
(I use the term "high beta" here since it is commonly used, though it is one I'd never use otherwise. Beta is often thought of as a proxy for risk. It is not. To me, things like CAPM are very flawed and EMH is, well, an abomination.)

In this BBC interview last year, Charlie Munger states why his investing ideas are not widely used. He says it is because the ideas are "too simple".

It's not difficult to understand why some businesses are likely to produce returns in excess of the market (likely but obviously not guaranteed...moats do get wrecked) decade after decade even if bought at slightly higher than what seems reasonable P/FCFs*.

Still, many choose** the path toward more the complex and risky strategies.

"The hedge fund known as Long Term Capital Management collapsed...despite I.Q.'s of its principals that must have averaged 160. Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger

Buying simple things that you understand also reduces the chance of making big mistakes. Fewer mistakes combined with low frictional costs allow the long-term effects of compounding to be the dominant factor.

Adam

* One of the nice thing about this style is that minimal trading skill is required since the emphasis is on the long-term effects of the company's economics. So you buy, sit back, and monitor threats to the moat. Is the moat getting wider or narrower? Is management actively attempting to reinforce/widen that moat?
** I am not suggesting that this approach will outperform the best money managers. It won't. It's just that many investors take on risk and complexity that is not necessary.
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