Tuesday, 28 February 2012

Stock Picking Philosophy from Charles Munger - Part 9

The following came from a 1994 article by Charles Munger, best known as one of the lead Berkshire Hathaway investors with Warren Buffett.

As a warning, its very long and talks about a lot of topics from role of math and psychology, business management, stock picking, etc but its very informative.

I've picked out a few more juicy paragraphs from it but if you have time, make sure to read it.  I've broken it up into several smaller chunks that I found interesting and will post them out over a few days.

Source: (Courtesy: The Big Picture)
Charles Munger, USC Business School, 1994
A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

See Part 1 - Value Investing
See Part 2 - Fewer But Bigger Bets
See Part 3 - Efficient Market Hypothesis & Race Tracking Betting Model
See Part 4 - Advantages & Disadvantages of Scale
See Part 5 - Bureaucracy & Yes Men
See Part 6 - Efficiencies & Profitability Differences from Competition
See Part 7 - Negative Effects of Technology on Business Profits
See Part 8 - Focusing on Your Competitive Edge & Follies of Investment Management
See Part 9 - Sector Rotation & Yearly tax avoidance

  • Sector Rotation
In the stock market, some railroad that’s beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So it’s just like the pari-mutuel system. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn’t so clear anymore what was going to work best for a buyer choosing between the stocks. So it’s a lot like a pari-mutuel system. And, therefore, it gets very hard to beat.

What style should the investor use as a picker of common stocks in order to try to beat the market—in other words, to get an above average long-term result? A standard technique that appeals to a lot of people is called “sector rotation”. You simply figure out when oils are going to outperform retailers, etc., etc., etc. You just kind of flit around being in the hot sector of the market making better choices than other people. And presumably, over a long period of time, you get ahead.

However, I know of no really rich sector rotator. Maybe some people can do it. I’m not saying they can’t. All I know is that all the people I know who got rich—and I know a lot of them—did not do it that way.

  • Not worrying about yearly tax avoidance
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.

In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end,  your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

But in terms of business mistakes that I’ve seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.

Warren and I personally don’t drill oil wells. We pay our taxes. And we’ve done pretty well, so far. Anytime somebody offers you a tax shelter from here on in life, my advice would be don’t buy it.
In fact, any time anybody offers you anything with a big commission and a 200-page prospectus, don’t buy it. Occasionally, you’ll be wrong if you adopt “Munger’s Rule”. However, over a lifetime, you’ll be a long way ahead—and you will miss a lot of unhappy experiences that might otherwise reduce your love for your fellow man.

There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf’? Lots of luck.

No comments:

Post a Comment