As the legend goes, Charlie Munger was the one who convinced Warren Buffett to buy quality companies. Up until that point, Buffett has been managing his partnership by investing in cigar butts. By the early 1970s, Buffett had turned Berkshire around and had a high-class problem: too much money with too few opportunities.
In 1972, Buffett had the opportunity to buy See’s Candy for $30 million. See’s was an exceptional business. A candy business with untapped pricing power. Graham’s principles would never have allowed it. Buffett wrestled with it. Finally he was able to negotiate the price down to $25 million. Buffett paid a nosebleed ~12x after-tax earnings and 3x tangible book. The acquisition turned out to be a success.
Finally, Buffett saw the light and proclaimed, “IT’S FAR BETTER TO BUY A WONDERFUL COMPANY AT A FAIR PRICE THAN A FAIR COMPANY AT A WONDERFUL PRICE!” And the rest was history.
Since then, much has been said on returns on invested capital and returns on incremental invested capital. It turns out to be very important for future returns.
Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.Charlie Munger
This, of course, is mathematically true. But investors, armed with this information and Microsoft Excel, have been justifying paying crazy prices for businesses they are certain will maintain high ROEs over time. And it will work if you’re right on the ROEs. While some investors will have the conviction to hold forever and get it right, it’s not easy. And most people can’t hold a stock for 2 years, let alone 20.
It’s also instructive to look at Charlie’s actual investments the past 30 years. Here’s the list:
- Costco: High-quality business for which he paid 12-13x
- Tenneco: Over-leveraged business bought at cyclical lows
- Li Lu’s Hedge Fund (incl. BYD): Net-nets and cheap stocks in Asia
- Posco: Low-cost steel business trading below tangible book
- US Banks: Decent businesses bought below tangible book
Wonderful businesses at fair prices? Some of them are wonderful. But what constitutes a “fair” price? It’s certainly a lot lower than prices people currently pay for quality businesses.
My takeaway: Quality is great, but price matters too. A multiple of 12-13x might be their rule of thumb for a wonderful business.
But, in looking at Charlie, there doesn’t seem to be anything wrong with investing in a fair businesses at a wonderful price either.