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My recommendation: 10/10

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Summary of notes and ideas

Learning from the success and failure of others is the fastest way to get smarter and wiser without a lot of pain.

Charlie often says that most investors, no matter how smart, won’t succeed because they have “the wrong temperament.”

The four fundamental principles of value investing as created by Ben Graham are as follows: 1.  Treat a share of stock as a proportional ownership of the business. 2.  Buy at a significant discount to intrinsic value to create a margin of safety. 3.  Make a bipolar Mr. Market your servant rather than your master. 4.  Be rational, objective, and dispassionate.

Because investing is a probabilistic activity, decisions made in ways that are fundamentally sound may sometimes produce bad results. Sometimes a person will produce an unfavorable result even when his or her process is well constructed and executed.

By focusing on finding decisions and bets that are easy, avoiding what is hard, and stripping away anything that is extraneous, Munger believes that an investor can make better decisions.

The Graham value investing system is designed to remove from the process any decisions that may lead an investor to make mistakes. The “yes” basket is tiny compared to the other two baskets because an investing decision that results in a “yes” will happen rarely.

Confucius said that real knowledge is knowing the extent of one’s ignorance. Aristotle and Socrates said the same thing.

[…] of the Graham value investing system during a bull market is an essential part of this style of investing. By giving up some of the upside in a bull market, the Graham value investor is able to outperform.

“Munger strives to find investments for which a significantly positive outcome is obvious. Because this type of investment is identified only rarely, Munger suggests that one be very patient but also very ready to aggressively invest when the time is right.

All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers’ costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers’ take, which median result may well be somewhere between unexciting and lousy.

You must learn to overcome certain behavior that drives poor decisions. If you can do that successfully, Munger believes you can create an investing edge over other investors. Part of that trained response is to avoid distracting noise made by people who do not understand investing or who have a financial interest in keeping you from understanding investing.

Munger is a firm believer in the Ben Graham view that “an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

John Maynard Keynes defined speculation as “the activity of forecasting the psychology of the market.”5 Keynes went on to say that the speculator must think about what others are thinking about, what others are thinking about the market (and repeat).

By sticking to investing activities that are easy, avoiding questions that are hard, and making decisions based on data that actually exists now, the Graham value investor greatly increases his or her probability of success. Understanding the present is unsurprisingly easier if you know what you are doing and the underlying business is understandable.

What is cheap to buy relative to the past may in fact not be a bargain in the present. To deliver a margin of safety to the Graham value investor, the stock must be worth significantly more than what he or she paid.

For a Graham value investor, reacting quickly and aggressively to favorable prices when they unpredictably appear is essential

Munger has repeatedly said that the most important quality that makes anyone a successful investor is the ability to make rational thoughts and decisions. It is difficult to overestimate how important being rational is to the Graham value investing system.

Munger once recalled that a person sitting next to him at a dinner party asked him, “Tell me, what one quality accounts for your enormous success?” Munger replied, “I’m rational. That’s the answer. I’m rational.” This rationality is something he works hard to cultivate, as will be explained shortly. Being rational is neither simple nor easy.

What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang

Capitalistic inherently means that others will always be trying to replicate any business that is profitable. You are always in a battle to keep what you have.

If you cannot understand the business, then you cannot determine what you did wrong. If you cannot determine what you did wrong, then you cannot learn. If you cannot learn, you will not know what you’re doing, which is the real cause of risk.

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.

Either the buyer or the seller is making a mistake, unless the price of the asset does not change and the result is a draw. In other words, one truism about investing is this: for you to find a significant mistake, someone else must be making a mistake too.

The iron rule of nature is that you get what you reward for. If you want ants to come, put sugar on the floor.

Relatives and friends in receipt of your money as a loan too often acquire a short-term and fuzzy/selective memory. Another example of this tendency arises when people fall in love with a company and make investing mistakes about that company as a result of that love.

Munger believes that structuring compensation incentives is critical. If the right structure exists, then a seamless web of deserved trust can be created which lessens problems related to this tendency.

Unfortunately, as is the case with every heuristic, what is mostly helpful can sometimes be harmful.

All you need in this life is ignorance and confidence; then success is sure.

“Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.

The urge to reciprocate in some way so as to cancel the debt is so strong that it can even make people give up substantially more than they would if the process was fully rational. In other words, the desire to reciprocate often results in an unequal exchange of value.

Failure to handle psychological denial is a common way for people to go broke.

If someone who has spent his life studying dysfunctional decision-making falls prey to the same problems he studies (e.g., overoptimism), these tendencies are indeed strong.

In other words, people tend to be too conservative in seeking gains and too aggressive in seeking to avoid losses. The most important point to remember about this tendency is that it causes investors to do things like sell stocks too early and hold on to them for too lon

“A good example of how loss aversion creates dysfunctional behavior happens at the racetrack. People betting on horses bet more and more on longshots as the day goes on. This happens because the majority of people have lost money because, with the odds stacked in favor of the house, the racetrack has the betting edge. Because people are averse to losses, as the day progresses they bet more on long shots in the hope that they can recoup their losses and perhaps generate a gain before they go home

Profit can be made by sometimes zigging when the crowd zags if you see a wager in which the odds are substantially in your favor. It is not enough to be contrarian; you must also be sufficiently right in terms of the magnitude of the positive outcome that you outperform the markets.

Investors have a tendency to make decisions based on what they can easily recall. The more vivid and memorable the event, fact, or phenomenon may be, the more likely it will be used by the investor in making a decision—even if what is being recalled is not the best data on which to make a decision.

When people are uncertain … they don’t look inside themselves for answers—all they see is ambiguity and their own lack of confidence. Instead, they look outside for sources of information that can reduce their uncertainty. The first thing they look to is authority.

His talent sprang from his unrivaled independence of mind and ability to focus on his work and shut out the world.” The same things can be said about Charlie Munger.

Patience combined with opportunity is a great thing to have. My grandfather taught me that opportunity is infrequent and one has to be ready when it strikes. That’s what Berkshire is.

Buffett has said that the stock market is designed to transfer money “from the active to the patient.”

Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day. Of course, for your efforts in these regards to be profitable, your estimate of value has to be on target.

Courage is an essential part of success in the Graham value investing system. If you are trying to outperform the market, mathematics dictates that you must deviate from the view of the crowd.

Finance writer Morgan Housel absolutely nailed it when he wrote, “There’s a strong correlation between knowledge and humility.” Humility is at the core of concepts like the circle of competence and always searching for evidence that disproves what you or others may assert.

The principal problem with ideology is that you stop thinking when it comes to hard issues. Munger believes in regularly taking your best ideas, tearing them down, and looking for flaws as a means of improving yourself, which is hard to do if you are an ideologue.

Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.

Life is a lot more pleasant when you let other people make most of the big mistakes. After all, you will make enough mistakes all by yourself. Carefully learning from the mistakes of others is a way to accelerate the learning process. Nothing vicariously exposes you to more mistakes committed by others than reading.

Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior are vital to long-term investment success.”

The way to wealth is as plain as the way to market. It depends chiefly on two words, industry and frugality: that is, waste neither time nor money, but make the best use of both. Without industry and frugality nothing will do, and with them, everything.

There are two kinds of businesses: The first earns 12 percent, and you can take it out at the end of the year. The second earns 12 percent, but all the excess cash must be reinvested—there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business.

For example, in The Little Book that Beats the Market, Greenblatt says that he views the depreciation part of EBIT as a proxy for capital expenditures and seems to imply that replacing depreciation with capital expenditure would be a better approach.

The idea behind the circle of competence is so simple that it is arguably embarrassing to say it out loud: when you do not know what you’re doing, it is riskier than when you do know what you’re doing. What could be simpler?

Averaged out, betting on the quality of business is better than betting on the quality of management.

Intelligent people make decisions based on opportunity costs—in other words, it’s your alternatives that matter. That’s how we make all of our decisions.

He will only invest if he strongly believes the current earnings are nearly certain to continue. While most other investors will adjust the discount rate for what they may believe to be greater risk, Berkshire wants essentially no risk as a starting point. In other words, rather than adjust the discount rate to account for risk, Munger and Buffett use a risk-free rate to compare alternative investments.

Berkshire is on return on equity (ROE), not earnings per share (EPS). As an aside, Munger believes that every manager of a business should be thinking about intrinsic value when making all capital allocation decisions. Note that Berkshire does not use price to earnings multiples in calculating value. Owner’s earnings is a very specific type of earnings, and they stick to that set of figures.

The mathematical process that Munger and Buffett use at Berkshire is simple. (Please do not stop reading because I used the word mathematics.) First, Berkshire calculates the past and current “owner’s earnings” of the business. Then they insert into the formula a reasonable and conservative growth rate of the owner’s earnings. They solve for the present value of the owner’s earnings by discounting using the 30-year U.S. Treasury rate. The focus of the investing process at

Demand-Side Economies of Scale (Network Effects): Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it. Craigslist, eBay, Twitter, Facebook, and other so-called multi-sided markets have demand-side economies of scale that operate on their behalf.

Howard Marks pointed out the following rules for a value investor: “Rule No. 1: Most things will prove to be cyclical. Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.”8 Buffett has his own version of this which states: “Rule No. 1 is never lose money. Rule No. 2 is never forget rule number one.”9 Berkshire’s results must be compared with alternatives on a risk-adjusted basis.

To test whether you have a moat with a given company, determine if you are earning profits that are greater than your opportunity cost of capital (OCC). If that level of profitability has been maintained for some reasonable period (measured in years), then you have a strong moat. If the size of the positive difference between return on invested capital (ROIC) and OCC is large and if that spread is persistent over time, your moat is relatively strong.

The bridge between book value and earnings/cash flow can be found in a company’s return on equity. That is: Earnings yield = Return on equity × Book to market.

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