A few months have passed since I received my copy of Poor Charlie's Almanack in the mail so this post has been marinating in my mind for some time. But I didn't really have the chance to crack open the book and dive into it until recently. Poor Charlie's Almanack is a compilation of Charlie Munger's (Buffett's right hand man) speeches, lectures and other commentary all rolled up into one absurdly heavy and awkwardly large coffee table book. The book reads like a stream of consciousness of Munger, which is wonderful if you're like me and eat that stuff up. The book is such an easy and simple read that the brilliance of Munger is easy to miss if you aren't paying attention. If the book piques your interest, the best place to get it is here, as it doesn't seem to be readily available through most normal channels.
Charlie Munger is the Pippen to Warren Buffett's Jordan or the Thompson to his Curry (as I try to contemporize myself a bit). I'm sure Warren Buffett would have been very successful without Munger, but I don't know if he would have been as successful. Buffett often credits Munger with moving him away from the cigarette butt style investing (buying very cheap stocks that have one last puff left in them) he was taught by Benjamin Graham.
Munger espouses an approach to investing (and life) that is rooted in multiple mental models. These mental models consist of theories, tools and general principles from many different disciplines (economics, biology, law, mathematics, physics, philosophy, etc.) that seek to explain more or less how the world works. The idea is that all of these mental models are interconnected in a meaningful way and to become wise in investing (and life), it is important to make and understand these connections. Further, wisdom is the ability to understand a principle from one domain and apply or extend its learnings to another domain. Munger refers to the entire group of models as a "latticework of mental models" to highlight their interconnectedness.
Munger in his own words from a commencement speech at USC in 1994:
"You've got to have mental models in your head. And you've got to array your experience-both vicarious and direct- on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and they fail in life. You've got to hang experience on a latticework of models in your head.
What are the models? Well, the first rule is that you've got to have multiple models- because if you have just one or two that you're using, the nature of human psychology is that you'll torture reality so it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor, who, of course is the great boob in medicine. It's like the old saying, 'To the man with only a hammer, every problem looks like a nail.'"
In the book, Munger describes many of the mental models that guide his life and investing. Many of these are also discussed eloquently on the Farnam Street blog. I can't profess to know all of Munger's mental models, but there are several models that I have leveraged many a time in my investing pursuits. Most of these tend to reside in the realm of economics and business. At first blush, this seems contradictory to Munger's entire theory that a multi disciplinary approach is required, but it's not. I am just covering some models that have benefitted my investing over the years. Inevitably I have unconsciously mixed these models with others from alternate disciplines. These models have enabled me to infer what's not being said, ignore the talking heads and maintain my conviction in the face of uncertainty.
The Power of Secular Shifts
I don't know if this is a mental model that Munger would officially endorse, but secular shifts are an important phenomenon that are sometimes under-appreciated and other times over-appreciated by market participants. Secular shifts are a change in volume, demand or relevance driven by secular or permanent forces. This is as compared to a cyclical shift or change that is driven by temporary forces like supply and demand. Secular shifts have the power to put entire companies out of business if they are no longer relevant (think Kodak with the advent of digital photography). Secular shifts pose two interesting challenges for long term investing. First, it is difficult to determine if a shift is driven by secular or cyclical forces in the early days. Second, it is difficult to determine when a secular shift is slowing down and reaching some point of equilibrium. The reality is that secular shifts can go on for long periods of time without slowing down all the while market prognosticators predict their imminent doom. Often times, companies benefitting from a secular shift can defy gravity and logic because they are able to thrive despite a declining or volatile operating environment.
The examples of secular shifts impacting companies and industries are numerous, but let's discuss two- Google (GOOG) and coal - not in any way related.
Google has managed to grow its revenue by double digits nearly every year for the last decade. Mind you, this is amidst one of largest recessions that the US has ever seen. Even while total advertising revenues were declining by double digits in 2009, Google's revenues increased by some 9%. How could this be? Well, online advertising and specifically search advertising was gaining share from traditional advertising mediums (newspapers, yellow pages, radio, etc.). In other words, Google's slice of the pie was growing even while the total advertising pie was shrinking or staying flat. This shift is still in play today as digital advertising continues to take share from traditional advertising, hence the success of Facebook in growing its revenue and earnings stream over the last several years. I expect this phenomenon to continue to play out over several more years as marketers seek the superior targeting and higher ROIs that these digital mediums can provide, especially as consumers shift their media consumption habits.
Coal is a very different story. The demand for coal as an energy source is also experiencing a secular shift, although this shift has been in a direction opposite that of Google. Coal fired power generation is declining in the US primarily because it is environmentally unfriendly and recent regulatory policies make the economics less compelling. Net net this is probably good for society in the long term although it’s not so good for coal mining jobs in the short term. Demand for coal is in a secular decline and will continue to decline for many years. This is a secular shift to the downside and will continue to impact the coal industry and other industries that benefit from coal - like the railroads. Although developing countries will continue to drive some demand for coal in the short term, these countries too will eventually learn that the long term detriment to society and the environment isn't worth a few jobs and cheaper energy.
Secular shifts are a powerful phenomenon but they sometimes make it difficult to differentiate skill from luck (even though management will still often take the credit). Sometimes a company may grow because it is lucky enough to be part of a category or segment that is experiencing a secular shift. After all, a rising tide lifts all boats.
The Inevitability of Reversion to the Mean
The basic premise of reversion to the mean is that nothing can go on endlessly - whether in a positive or negative direction. Eventually there are factors that act to stop or decelerate growth or decline to some normal or equilibrium level. To put it concisely: Extreme outcomes tend to be followed by more moderate ones. For example, a company that is growing at 20% per year cannot grow at that rate forever. If it did, it would eventually become bigger than the entire economy. Eventually, the growth of a given company slows down and begins to resemble the industry average. The more interesting question though is how or why this happens and how companies can work to delay (stopping it is more challenging) the inevitable reversion.
On the former statement, growth or margin expansion slows down or speeds up due to a few key reasons:
1. High growth or high margins (success in general) invite competition and imitation until those higher margins are competed away to equilibrium. Other companies realize that high margins and juicy profits are being had and decide to compete because they want a piece of the action. Similarly, declines are often stemmed because competitors exit a given product line or industry given low profits or margins. As competition and supply is rationalized, pricing power becomes more normalized and declines slow down or turn into growth.
2. Law of large numbers. As companies get bigger, it becomes harder for them to grow at the same rate because each percentage point of growth becomes worth more on an absolute basis and thus more difficult to attain. On the decline, the inverse is true - each percentage point of decline is worth less on an absolute basis. But, at the same time, each absolute dollar becomes more difficult for competitors to steal away as a company acts to defend itself
An example of reversion to the mean might help articulate the point even better:
I am a big NBA basketball fan. If you haven't been living under a rock for the past year, you know that Steph Curry and the Golden State Warriors have redefined the sport of basketball in the most recent regular season. They have pretty much destroyed every NBA record that matters by playing a different style of basketball and could go down as the greatest team in the history of the NBA. Some of the records they set this season:
- Best regular season record of all time with 73 wins and 9 losses surpassing the 1995-1996 Chicago Bulls at 72 and 10
- Best start to a season in the NBA at 24-0 surpassing 15-0 set by the Houston Rockets and Washington Capitals and the best start in professional sports surpassing the 1884 St. Louis Maroons in baseball
- Best regular season home game win streak of 54 games surpassing the 1995-1996 Chicago Bulls
- Most three pointers in a season at 402 by Steph Curry, surpassing his own previous record at 286 (side note: that is an absurdly huge margin by which to beat a record)
- Most three pointers by a team in a season at 1,077 surpassing the 2014-2015 Houston Rockets at 933
As much as I admire the Warriors and the three point master that is Steph Curry, I do not expect next season to be as good as this season. The Warriors are an extremely skilled team and they actually improved from their incredible 2014-2015 championship run to the 2015-2016 season that just ended. I am sure they will be very good next season, but they are unlikely to be as good.
In his book Fooled by Randomness, Nassim Taleb says, "A result is that in real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills."
In the case of the Warriors, their record setting regular season record was a large deviation from the norm and next season is more than likely to revert to the norm (note that for the Warriors, the norm is still likely to be a great season). First, no matter how skilled the Warriors are, part of the stupendous result this season was inevitably driven by luck and luck doesn't come with consistency. Second, there will be several countervailing forces that will act to normalize their success next season. The latest example is that of Luke Walton recruited to become head coach for the Lakers next season. We could debate how much of the team's success can be attributed to Walton, but inevitably he added something that contributed to that record (especially during the first 43 games where he was on the sidelines as coach in place of Steve Kerr). Other talented players (bench or otherwise) that also contributed to that record in some way will undoubtedly be recruited by other teams. And finally, other basketball teams will learn to imitate the successful playing style of the Warriors - a faster pace and more three-point shooting. All of these factors will work in concert to normalize the Warriors success next season. Don't get me wrong; I think they will be very successful, but just not as successful as this season.
The interesting thing is that most observers are accustomed to relying on historical results as a way to predict future results. But when historical results are outliers, it is more likely that future results will revert to the mean. This applies to basketball team performance as much as returns on capital for companies.
Taleb goes on to say, "Consider that two average-sized parents (dogs) produce a large litter. The largest dogs, if they diverge too much from the average, will tend to produce offspring of smaller size than themselves, and vice versa. This "reversion" for the large outliers is what has been observed in history and explained as regression to the mean."
Reversion to the mean in performance applies to pretty much any sport and in many different ways. With the Warriors I chose to highlight the track record of the entire team over an entire season, where the sample size is quite large – 82 games. It could be argued that the impact of luck is lessened as the sample size is increased and this is true. The impact of luck and the lesson of reversion to the mean is much more obvious when analyzing one players’ performance in a specific game. For example, in February of 2016, Steph Curry made twelve three-pointers in one game to tie the NBA record for the most three pointers in a game. He also played a few other games during the season where he put up ten or eleven three pointers in a single game. Extrapolating Curry’s performance from these few games would be dangerous as the data is not likely to be representative of Curry’s performance over the entire season. In fact, Curry’s average number of 3 pointers per game over the entire 2015-2016 season was much lower than 12 at 5.1 (mind you – still incredibly high). Over time, extreme outcomes are dampened by more moderate outcomes. While Curry’s high three point performance in one game was an extreme outcome driven partly by incredible skill and partly by luck, his three-point average over an entire season is much more representative of his expected performance in any given game.
Many industry forecasts and projections often don't factor in reversion to the mean but it is very real. Many analysts are guilty of projecting out the good times or bad times into perpetuity. But this is almost never the case. Extreme performance tends to moderate over time as external and internal forces act to normalize it. Having said that, there are ways to extend the good times (high growth, high returns on capital and/or margin expansion) or delay reversion to the mean. The first way is if said company is benefitting from the first mental model - a secular shift. When a secular shift is at play, the good times can often go on for a long time and even seem to defy gravity when not viewed in context of the losing party in the industry. Most of the time, that growth is not coming out of thin air, but is a result of share gains from another category competitor (direct or indirect). The second way to delay reversion to the mean is by leveraging a durable competitive advantage, which leads me to the next mental model.
Building Durable Competitive Advantage
Buffett talks about competitive advantage often in his writing and also refers to it as a moat similar to the body of water around a castle that affords it protection from raiders.
In the 2007 Berkshire Hathaway annual report, Buffett wrote:
"A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns."
Competitive advantages are characteristics of a business or business model that help keep competitors at bay or drive pricing power. These characteristics can exist in the form of:
- High barriers to entry for new competitors: Think of the US freight railroads like Union Pacific (UNP) or Norfolk Southern (NSC). It would be nearly impossible to build a new railroad competitor in the US given the massive amount of land and permits required.
- Patents that grant a legal monopoly: Think of pharmaceutical drugs like Pfizer's (PFE) Viagara (now off patent) where a patent prevents competitors from selling the same drug for a set period of time.
- High switching costs for customers: Think of a new software competitor to Microsoft Excel (MSFT) where new training would be required. Businesses and customers would be reluctant to switch lest they have to retrain themselves and suffer a loss in productivity
- Strong network effects (winner take all being the holy grail): Think of switching to a new social network from Facebook (FB). The new social network probably wouldn't provide much value unless all your friends and family also switched.
- Strong brand name: Think of a competitor to Mondelez's (MDLZ) Oreo cookies, the iconic creme filled chocolate cookie. Sure, a generic cookie can probably grab some market share but likely only at a discounted price.
- Strong technological advantage: Think of a new electric car competing with Tesla (TSLA). Tesla has a big head start on state of the art battery technology and electric car design that even the large auto companies with significantly more resources have struggled to produce a worthy competitor
All of these competitive advantages help prevent competitors from entering a given business or help an existing business defend itself when competitors do enter. Merely possessing a competitive advantage, however, is not enough. The goal is to find businesses that demonstrate a durable or sustainable competitive advantage. Can the competitive advantages driving excess returns today continue to drive excess returns well into the future? Ultimately, most competitive advantages deteriorate or wear down over time so the key is finding companies that are investing to continuously widen that moat whether it is investing in R&D to develop better technology, investing in marketing and brand building to drive consumer willingness to pay for a brand or adding features to a product to further embed it into peoples' lives. The Ensemble Capital team explores moats and competitive advantage a bit deeper on their wonderful Intrinsic Investing blog.
The canon of work on mental models is broad and deep and I have barely even splintered the surface of it, which is why I would still direct you to some of the other wonderful blogs I have peppered throughout this post. I should add that the three mental models covered here are merely those that have impacted my investing most meaningfully but the models certainly don’t end there. Some of the other mental models that I would give a nod to are Confirmation Bias, Circle of Competence, Operating Leverage, Diminishing Marginal Returns, Second Level Thinking, Tragedy of the Commons and Margin of Safety.
Thinking through the models discussed here, there is an interesting takeaway – these models are inherently conflicting. I’ve said that reversion to the mean is inevitable for every business...that is unless a business builds durable competitive advantages or benefits from a secular shift. So there are forces that push a business in one direction and conflicting forces that push it in the opposite direction. To truly understand the fates and fortunes of a business, one must understand how these models interact and compete. Here I go back to the expert:
"More commonly, the forces coming out of these one hundred models are conflicting to some extent. And you get huge, miserable trade-offs. But if you can’t think in terms of tradeoffs and recognize tradeoffs in what you’re dealing with, you’re a horse’s patoot. You clearly are a danger to the rest of the people when serious thinking is being done. You have to recognize how these things combine."
Charlie Munger, Outstanding Investor Digest, December 29, 1997