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Charlie Munger: Life Long Learning

This year marked my 10th trip to Omaha for the Berkshire Hathaway annual meeting. Dubbed the “Woodstock of Capitalism,” it is an event-filled weekend with many opportunities for learning. Although Warren Buffett’s name is synonymous with Berkshire, those outside the cult-like group often fail to recognize the immense contributions from Charlie Munger, Berkshire’s Vice Chairman.

Munger, like Buffett, is an Omaha native who is well past the age of “normal retirement.” And yet, at age 93, Munger shows few signs he has slowed mentally.

Munger is a learning machine. His family has described him as a “book with legs.” However, for someone who is intellectually curious, his lifelong desire for continuous learning may be his fountain of youth. Munger, a Harvard Law School graduate, is a voracious reader spanning from science to energy to architecture.

Unlike Buffett, who is often known for his folksy manner, Munger can be a crusty curmudgeon whose bluntness cuts like a hatchet. There is no room for political correctness or participation trophies in his vocabulary.

The two make an interesting and complementary pair. And although Buffett may be credited with building Berkshire into the fifth largest company by market capitalization, it may actually be Munger that deserves the credit. For the first 20 years of Buffett’s investing career, he successfully focused upon “cigar butt” investing. These businesses could be purchased at incredibly cheap prices and offered up a few last puffs of remaining value. However, there was no enduring value.

Although the cigar butt strategy worked well for Buffett, it was Munger who recognized this strategy had significant long-term limitations. Cigar butt investing lacked the ability to repeatedly compound wealth over decades and was always predicated upon constantly finding another deal.

A turning point happened in 1972. Buffett and Munger had the opportunity to purchase See’s Candies, a 50-year-old Los Angeles based company with a reputation for great products. The See’s family wanted $30 million for the iconic business at a time when it was producing $4 million in pre-tax profits.

Buffett offered $20 million and was prepared to walk away from the deal until Munger stepped in. Munger convinced Buffett that paying up for very good businesses not only made their lives easier, but it was a better investment also.

Eventually, at Munger’s prodding, Berkshire acquired See’s Candies for $25 million—a little more than 6 times pre-tax profits.

Since that transaction, See’s Candies has produced $2 billion in profits for Berkshire Hathaway shareholders. Obviously, it has proven to be a very wise decision.

What can be learned from this?

Great franchises and brand names can offer enduring long-term value. Much like McDonalds, Coca-Cola, Proctor & Gamble or Johnson & Johnson, a strong reputation can be as valuable as any hard asset a business may have. Furthermore, if reputation is properly cultivated it does not suffer from depreciation the way an automobile or airplane will.

Focus on Return on Invested Capital. Munger recognized that See’s Candies produced large amounts of net income relative to the amount of capital required to keep the business going. This allowed See’s to have tremendous amounts of operating leverage. Once the relatively minor physical plant was up and running, the cost to sell an incremental pound of chocolate was minor.

Businesses requiring lots of capital to produce an incremental dollar of sales are highly exposed to inflation and the use of debt. As such, they are far more economically cyclical. If you study the financial structure of steel mills, chemical plants or auto manufacturers, this capital structure flaw is quite apparent.

Focus on decades. By taking control of See’s, Berkshire got to keep all the net profits. As they sold more candy, the value of the franchise continued to grow. However, because they held the asset and allowed it to grow, they paid no capital gains tax. This allowed the value to compound geometrically over the next five decades. Remember, the capital gains tax is not a tax on gains. Rather, it is a tax on the transaction of selling. If you buy great businesses and hold them for very long periods of time, you reduce taxes and increase efficiency.

As I reflect upon the wisdom of Munger, it is readily apparent that wise business allows intelligent investing and wise investing owns the intelligent business.

Dave Sather is a Certified Financial Plannerand owner of Sather Financial Group. His column, Money Matters, publishes every other week.