Munger's Comprehensive Description: Criteria and Examples for Selecting Good Stocks

### **Increase Winning Probability: Ten Insights to Solve Most Problems**

The first question is: "What is the essence of the stock market?" This may immediately remind you of the "Efficient Market" theory, which has been a popular theory since I stepped out of business school.

Interestingly, one of the greatest economists in the world is a shareholder of Berkshire Hathaway, who wrote in textbooks that the stock market is very efficient and no one can beat it. Yet, his own funds continuously flow into Berkshire and then begin to grow. So, just like the famous "Pascal’s Wager" (the principle proposed by Pascal, which essentially states that if you believe God truly exists, you will go to heaven after you die; even if God does not exist, you will not lose anything—translator's note), Buffett hedged his bets.

Is the stock market really that efficient that no one can beat it? The Efficient Market Theory is generally correct, meaning that **for a smart and rule-abiding stock picker, the market is very efficient, and it is quite difficult to beat the market.**

In reality, average results are merely average results; theoretically, no one can beat the market. As I often say, **a "iron law" in life is that only 20% of people can make it into the top 15%. That is the law of how things operate.**

For those who take the Efficient Market Theory to extremes, I have nicknamed them "mental madness." This theory intersects with human intelligence; some people can exploit it to play with mathematical skills, which is why it is so appealing to those with strong mathematical abilities. The problem is that the basic assumptions do not necessarily align with the facts.

**Similarly, for someone with a hammer, every problem looks like a nail.** If you are accustomed to using advanced mathematics, why not use your mathematical tools to make predictions?

The model I like is a simplification of the concept of "common stock market," which is akin to the parimutuel betting system in horse racing (a system where, after deducting the bookmaker's management fees, the prize money is distributed based on the amount wagered—translator's note); a parimutuel betting system is equivalent to a market where everyone comes in to place bets, and the odds change based on the betting amounts. This is clearly the operational model of the stock market.

Even a fool can see that a lighter horse with a good winning rate and advantageous position has a higher chance of winning compared to those with poor racing records and overweight. But looking at the odds, the former is 3:2, while the latter is 100:1. Using Pascal and Fermat's mathematical theories to calculate, what is the wisest betting strategy remains unclear. Stock prices change in a similar manner, making it very difficult to beat the system.

Moreover, the bookmaker takes a 17% commission from the total bets collected, so you need to outsmart other bettors, meaning you have to take 17% from all your bets to give to the bookmaker and then let the remaining money work for you
Can a person use their intelligence based on mathematics to become a winner in horse racing? Intelligence can provide some advantages, as many people know nothing about betting on horses and simply bet on lucky numbers. Therefore, if a person references the performance of various competing horses while being proficient in mathematics and quick-witted, without the bookmaker charging frictional costs, they have a considerable advantage.

Unfortunately, in many cases, a smart, advantaged bettor is merely trying to reduce the average loss for a season from 17% to 10%. In any case, very few people can win after paying a 17% fee.

When I was younger, I was a poker player, and I had a companion who did nothing but participate in harness racing, living a fulfilling life. What my companion did was treat harness racing as his main profession, but he only placed bets occasionally when he saw some practical, mispriced wagers. Thus, after paying all the bookmaker's commissions—I estimate around 17%—he lived quite well.

You might say that such examples are rare. However, the market is not completely efficient; if it weren't for the high 17% commission, many people would have a chance to win. It is efficient, but not completely efficient; with enough savvy and passion, some people will achieve better results than others.

The stock market is the same—only the broker's commission is much lower. If you take away transaction costs—such as the bid-ask spread and commissions—if you are not trading excessively, the transaction costs are quite low. Therefore, as long as there is enough passion and sufficient training, some savvy individuals will be able to achieve better-than-average results. This is not easy; most people's investment results are mediocre. But some people are quite talented, and in operations with lower transaction costs, they may achieve better-than-average results in stock selection.

So how do you become one of those successful individuals—in a relative sense, rather than a loser? Let's take a look at the pari-mutuel betting system. Last night, I happened to have dinner with the chairman of Santa Anita Park, who said that two or three bettors deposit some money with the racetrack for off-track betting. The racetrack starts distributing payouts after deducting all management fees—many of which go to Las Vegas—to those who achieve net profits after paying commissions. Even in such unpredictable betting on horses, these individuals perform quite well.

**Humans are not born with the talent to understand everything, but the heavens bestow a talent upon those who are diligent—they observe and seek out mispriced bets in the world and occasionally discover one. Since the heavens have given them this opportunity, the smart ones place substantial bets, but at other times, they hold back.** This is a very simple concept, and I agree with it—there are many such examples based on the experience of the pari-mutuel betting system
But very few people operate this way in investment management, and we are the exception—I mean Buffett and Munger. Although we are not a unique type of person, many people have some crazy ideas in their minds; they want to double their efforts, hire more business school students, and gradually learn every aspect of everything, rather than waiting for a single opportunity to strike hard. I think this is an extremely foolish approach.

What kind of foresight do you need? I believe not much is required; if you think about Berkshire Hathaway and the hundreds of billions of dollars of wealth it has amassed, the top ten insights can solve most problems. This is also an impressive achievement that Warren—who is far more talented than I am and very disciplined—has achieved after a lifetime of hard work. I don't mean to say he only has these ten insights, but most of the profits come from these ten insights.

If your thinking aligns with the winners of the betting system, your investment performance will be very significant. Treat the market as a meaningless game with high odds, where there are occasionally some mispriced items. Perhaps your intelligence is limited, and you won't find many such opportunities in your lifetime, but if you do find a few, you should go all out.

Warren said during a speech at a business school: **“Here’s a card with 20 holes; you have 20 chances to punch it. I can increase your lifetime financial wealth—these 20 holes represent all your investments in life. Once you’ve punched all the holes in this card, it indicates that your investment career is over.”**

He said, “According to this rule, you must consider your actions carefully and think twice before acting. This is how you can get ahead of others.”

For Warren and me, this is a very clear concept. But in American business courses, this perspective is rarely mentioned because it transcends traditional wisdom.

**For me, winners must bet selectively; this principle is obvious.** I realized this principle early on, and I don't understand why it is so difficult for many people to grasp.

The reason we make this foolish mistake in investment management can be explained by a story: I once met a person selling fishing hooks, and I asked him, “Goodness, there are purple ones and green ones; do fish really bite?” He said, “Sir, I’m not selling to the fish.” Investment managers are in a situation similar to that of this fishing hook seller; they are like those who sell salt to others, ignoring the fact that others do not lack salt. As long as the other party buys salt, they will sell it. But this does not apply to clients purchasing investment advice.

As an investment manager, if you invest in companies like Berkshire Hathaway, it is hard to achieve such a high salary—because you hold stocks like Walmart and Coca-Cola, which will make clients richer without much thought. Before long, clients will become somewhat disgruntled: “Why should I pay that guy 50% a year for doing nothing with this beautiful stock?” Therefore, what is meaningful to investors is not necessarily meaningful to managers, and in interpersonal matters, the behavior is determined by the incentive mechanisms of those decision-makers
Among many companies, one of my favorite motivational cases is FedEx. Its core operating system — which is also the key to integrating its products — is to gather all the planes at midnight and transfer all the packages from one plane to another. If there is any delay, the entire system cannot smoothly deliver products to FedEx's customers.

However, FedEx employees always mess up and have never completed tasks on time. Managers tried everything — moral persuasion, threats, etc., but it didn't work. In the end, someone came up with a good idea: reduce the hourly wage but increase the pay for each shift — once all the work is done, they can go home. Ha, an old problem was solved in one night. Therefore, the correct incentive measures are a very important lesson that FedEx struggled to understand; perhaps from now on, this principle will be clear to you. Well, we have realized that market efficiency is like a betting system — betting based on personal preferences during horse racing yields better returns than risk-based betting, but it does not necessarily have a betting advantage.

In the stock market, the railway sector is performing poorly, but when its price reaches one-third of its book value, it is a good buying opportunity. In contrast, IBM should have been sold at six times its book value during its peak. Just like the betting system, any fool can see that IBM's business prospects are better than the railway sector, but if you calculate the prices of both using probabilities to determine which is more cost-effective, the answer seems to become somewhat elusive. **The stock market is very similar to the betting system; it is difficult to beat it.**

As an investor selecting common stocks, what approach should be taken in the attempt to beat the market? That is, how can one achieve better-than-average results in the long term? One standard technique that fascinates many people is the so-called "sector rotation." You speculate in your mind about the timeline for oil stocks to outperform retail stocks, and then you roam around, diving into the hottest sectors of the market, making more astute decisions than others. Over time, you might find yourself ahead. But I do not know anyone who has truly become wealthy through sector rotation; that possibility cannot be ruled out. It's just that the wealthy people I know — they did not get rich this way.

### **II. Seek Margin of Safety and Optimize Valuation Methods**

The second fundamental method is the one used by Ben Graham — which both Buffett and I really like. As a key point, Graham recommended this value concept to private investors — how to price a business if you want to buy it. This formula can be applied in many cases. **You can multiply the stock price by the number of shares, and if the resulting number is not greater than one-third of the liquidation value, you have many advantages.** Even if an old drunkard runs a boring industry, the actual excess value per share is entirely in your hands, which is a great thing. With such a large amount of excess value, you have a significant margin of safety.

But to some extent, he was operating this theory during the "shellshock" of the 1930s when the world was experiencing the worst economic contraction in 600 years in English-speaking countries
In Liverpool, England, wheat prices have fallen to their lowest point in 600 years, at a time when countries were shrouded in a "shell shock" sentiment. Ben Graham used his Geiger counter (the first successful detector created by German physicist Geiger in 1927 to detect individual alpha particles and other ionizing radiation - translator's note) to probe the ruins and found that some things were selling for less than their working capital per share.

At that time, working capital essentially belonged to the shareholders, and if employees were not useful, they could be laid off, allowing the owners to pocket the working capital. This is how capitalism operates.

But this calculation method no longer works—because once a company starts to tighten, these important assets will no longer exist. Regulations and legal provisions in some civilized societies indicate that many assets belong to employees, and once the company enters a recession, some assets on the balance sheet will disappear.

If you are a car dealership, the above situation does not apply; your operations may lack careful planning or have various flaws, and according to your business model, the company may become increasingly desolate, ultimately allowing you to pack up your working capital and take it away. However, IBM cannot do this. IBM once announced that due to the development of global technology and its declining market position, they decided to change their scale. I wonder if anyone has observed what has disappeared from IBM's balance sheet. IBM is a typical example. Its operators are smart and disciplined people, but technological changes have brought them chaos, leading IBM to leave the wave after successfully "surfing" for six years. This is a kind of decline—a vivid lesson in technology falling into a predicament. (This is also one of the reasons Buffett and Munger do not like technology, as it is not their strong suit and they cannot cope with the various bizarre things that may happen in it.)

In any case, I believe the main problem facing Ben Graham's philosophy is that gradually people around the world have come to know this rule, and those cheap stocks that were easy to spot have disappeared. You pick up the Geiger counter to detect rubber, but unfortunately, it does not emit a "tick" sound. This is the nature of those who hold hammers—just as I said before, every problem in their eyes looks like a nail—Ben Graham's followers respond by changing the scale on the Geiger counter. In fact, they have begun to define cheap stocks from another perspective, continuously updating the definition to keep Graham's philosophy alive, and the results are not bad. The effectiveness of Ben Graham's thinking system is thus evident.

Of course, **the best part of the Graham system is the theory of "Mr. Market." Graham did not agree with the efficiency of the market; on the contrary, he felt it was a manic-depressive patient who visited every day.** Mr. Market sometimes says, "I will sell to you at a price below its value." Other times it says, "I will buy at a price above its value." So you can choose whether to decide to follow up, sell some stocks, or wait and see
For Graham, doing business with this frantic Mr. Market is truly a blessing, as he always provides you with so many options. Graham's way of thinking is very important and has deeply influenced Buffett—who occasionally applies it to his own investments. In any case, if we blindly follow Ben Graham's classic techniques, our investment performance might be far worse than it is now, because Graham did not rigidly adhere to dogma.

Graham was even reluctant to talk about management. His reasoning was that just as the best professors teach to the general public, he tried to invent a system that everyone could utilize. He believed that not just anyone on the street could run around talking extensively about management and learning. He also had a theory: information in management is often distorted and can easily mislead the public.

If we act like Graham's followers, we will gradually gain what is called "better foresight." We realize that some companies sell for 2 to 3 times their book value but are still far below their intrinsic value, because their inherent momentum is limitless, and some managers or systems exhibit extraordinary management skills.

Once we calculate its cheapness on a quantitative basis, which might surprise Graham, we begin to consider entering that business. By the way, most of Berkshire Hathaway's funds come from these good companies. Our first $200 million or $300 million was obtained through continuous exploration using Geiger counters, but most of the other funds still come from good companies. For example, Buffett's partnership heavily bought shares of American Express and Disney when their stock prices plummeted.

Most investment managers are immersed in the games of various investment paths they are familiar with. At Berkshire Hathaway, no client can trade us, so we have a high degree of freedom. If we find cheap bets and are confident in our judgment, we act immediately.

But to be honest, I think (many fund managers) using existing systems probably cannot satisfy clients. But since you have decided to invest in a pension fund for 40 years, what does it matter if there are some bumps along the way or if your investment path is somewhat different from others? As long as it ends well, that's all that matters. So some small fluctuations do not signify much.

However, in today's investment management, everyone not only wants to be a winner but also wants to win through conventional methods. This is a very unrealistic and crazy idea, akin to the Chinese custom of foot binding, which Nietzsche criticized as those who take pride in being crippled. This approach will indeed make you a cripple, and fund managers might respond, "We have to do this because everyone measures us by this standard." If a business is already established, then their actions are understandable. But from the perspective of a rational consumer, the whole system is "insanity," and it also causes many talented individuals to get involved in pointless social activities. Berkshire's system is perfectly normal; in this fiercely competitive world, smart people will generate some very valuable insights when they confront other diligent wise individuals
After brewing a good vision, it makes sense to set off fully prepared. The idea that one is an all-round talent anywhere and anytime is harmful and unhelpful. If we start from a feasible plan, the chances of success are very high. How many of you have generated 56 insights and are confident about them? Please raise your hands. And how many have 2 to 3 good ideas? Good, that's the end of my speech. (Munger mimics a lawyer's speech, showcasing his sense of humor—Translator's note.)

### **3. Undervalued Good Companies, At Least One, Preferably Both**

We need to make money from those efficiently run companies. Sometimes we buy the entire company, but sometimes we only buy a majority of the company's stock. Looking back, we have made a lot of money from excellent companies. In the long run, the return on a stock is closely tied to the company's development. If a company's profits have consistently been 6% of its capital over 40 years, then after holding it for 40 years, your returns will be no different from 6%—even if you initially bought it at a bargain. If the company has profits of 18% of its capital over 20 to 30 years, even if you paid a higher price initially, the returns will be more satisfying. **So the trick is to enter companies with better performance, which involves scale advantages, such as the momentum effect.**

**How to implement this? One method is what I call "spotting the gems while they grow," targeting and entering afterward.** For example, following up after Sam Walton first took Walmart public. Many people use this method, and it is quite enjoyable. If I were younger, I might do the same. But for Berkshire Hathaway, which has massive funds, this method does not work because we cannot find investment targets that meet our scale parameters, so we gradually formed our unique approach. However, I believe that "spotting the gems while they grow" is a wise method for those trying to operate through training; it's just that I haven't adopted it.

Due to competitive factors, "finding them while they grow" is very difficult to implement. Berkshire follows this route. But can we continue? For us, who is the next Coca-Cola? I don't know; the answers to these questions are becoming increasingly difficult. Fortunately, we have gained a lot in this regard—after entering an excellent company, we find that it also has outstanding management, which is crucial. For example, General Electric had Jack Welch, not the management of Westinghouse Electric Company, which made a big difference—and a world of difference. Therefore, the role of management should not be underestimated.

Some things are foreseeable. I believe everyone can easily realize that Jack Welch has more insights than his peers in other companies, and his management is more effective. Similarly, we can easily understand that Disney has more development momentum; Eisner and Weus are not ordinary managers
Therefore, if you enter an excellent company and happen to encounter a capable manager, it is a rare stroke of luck (hog heaven day, a metaphor for a very fortunate event—translator's note). If you are not well-prepared when opportunity knocks, you have made a serious mistake. You may occasionally find that some talented individuals can indeed do things that ordinary technicians cannot. I recommend Simon Marks—the second-generation leader of the century-old British brand Marks & Spencer—as well as the National Cash Register Company and Sam Walton; they all belong to this category. The emergence of such individuals is often not difficult to identify. They possess reasonable characteristics—passion, wisdom, just like the qualities they often display in social situations.

But **generally speaking, betting on the quality of the enterprise will yield better results than betting on the quality of management. In other words, if you can only choose one, bet on the potential of the enterprise rather than the intelligence of the manager.** At certain exceptional moments, you may find a manager who stands out and shines, and you may even be willing to follow him into a seemingly ordinary and unremarkable company.

There is also a simple effect that some investment managers rarely consider: the tax effect. If you buy a stock with a 15% annual compound return, after paying 35% in taxes 30 years later, your annual return will be 13.3%. Conversely, if the same investment requires you to pay 35% in taxes each year based on the 15% annual compound return, your annual compound return will be 9.75%. The difference in returns between the two is greater than 3.5%. For investors holding stocks for 30 years, a 3.5% figure is astonishing. If you invest long-term in some outstanding companies, simply benefiting from the different ways income tax operates will earn you a lot more money. Even if the annual investment return drops to 10%, after paying 35% in taxes at the end of the investment, you will achieve an 8.3% annual compound rate after 30 years. In contrast, if you pay 35% in taxes each year, on average, your annual compound return will drop to 6.5%. Therefore, even when investing in common stocks of companies with lower dividend ratios, the after-tax return at historical average return levels increases by about 2% per year. **Based on my experience with corporate mistakes, it can be concluded that extreme tax avoidance is a common cause of foolish errors; due to excessive consideration of taxes, some people make serious mistakes.**

Neither Warren nor I drill oil wells; we pay taxes. So far, we have been doing quite well. From now on, whenever someone tries to sell you tax avoidance measures, my advice is to never listen. In fact, if anyone recommends something with a 200-page manual that requires a large commission, do not be fooled. If you adopt this "Munger rule," you may occasionally make mistakes, but in the long run, you will be far ahead of others in your lifetime—while also avoiding some unpleasant experiences that could wear down your love for those around you.

If a person can make a few wise investment decisions and then sit back and wait for the returns, he does not need to pay a large sum of money to brokers or hear so much nonsense
Similarly, if this investment is effective, the government's tax system will also add an extra 1 to 2 percentage points or more to your annual compound returns.

Many people believe that by hiring investment advisors and paying them a 1% fee to look for tax avoidance methods, they can gain an investment advantage. Does this really work? Is this philosophy dangerous? Of course.

**Since everyone knows that investing in excellent companies is a viable method, sometimes it can lead to extremes.** During the era of the "Nifty Fifty," everyone was well aware of outstanding companies, and as a result, their price-to-earnings ratios began to rise to 50, 60, or even 70 times. With the decline of IBM, other companies also fell one after another. Excessive prices led to severe investment disasters, so you must always be vigilant about these dangers. Risks are always present; nothing is taken for granted or easy. But if you can find fairly valued and outstanding companies, buy in at the right time and wait, this approach can be effective—especially for some individual investors.

### **Four Standards and Cases for Good Stocks**

There is another branch in the stock market investment growth model: **You may have discovered a few such companies in your life, where simply raising prices by the management can significantly increase returns—but they haven't done so, thus they have the ability to reprice.** Disney has done this. Taking your grandchildren to Disney is a very unique experience; although you do it only occasionally, many Americans love going to Disney. When Disney discovered the opportunity to raise prices significantly, they immediately took action.

The remarkable records written by Eisner and Weus for Disney reflect their extraordinary wisdom, and the rest is thanks to the price increase measures at Disney World and Disneyland, as well as the booming sales of classic animated video tapes.

At Berkshire Hathaway, I also raised the prices of See’s Candies (a well-known chocolate manufacturer in the U.S. acquired by Berkshire—translator's note) with Warren, and of course, we also invested in Coca-Cola—it also has pricing power and excellent management. So, what its presidents Coizueta and Keough could do went far beyond just raising prices. It was fantastic.

If you find some companies whose prices are undervalued, you have encountered several good opportunities for profit. Some companies are priced below what the public can bear, and if you can see through these, it's like picking up money on the street—provided you have the courage to trust your own ideas. If you want to learn from Berkshire's fruitful investment model, you can see that we bought two newspapers twice, and these two newspapers eventually merged into one. So in a sense, we were taking a gamble.

One of the newspapers we bought—The Washington Post—was purchased at 20% of its value. This was in accordance with Ben Graham's classic method, buying when the price reached one-fifth of its value—at that time, the background was that this newspaper had top-notch players in a competition (who would obviously become the final winners), and it also had honest and intelligent management. This was a real dream; they were the elite crowd—the Katharine Graham family
It is a dream—unbelievably like a dream. This goes back to 1973-1974, seemingly a reappearance of the investment boom of 1932, possibly a once-in-40-years market opportunity. The return on investment was 50 times our initial cost; if it were someone else, I would never have dreamed of achieving such generous investment returns like those from The Washington Post in 1973 and 1974 in my lifetime.

I also want to talk about another model. Some projects of Gillette and Coca-Cola are priced low, while their global marketing advantages are significant. Take Gillette, for example; they have been "surfing" in the field of new technology, of course, their technology is relatively simple compared to the complex microchip standards. But in the eyes of their competitors, their position is lofty and unmatched. Gillette has always been far ahead in the improvement of razors, holding over 90% market share in many countries.

GEICO (Government Employees Insurance Company, a subsidiary of Berkshire Hathaway—translator's note) is a very interesting model and one of the 100 models you must keep in mind. I have many friends who have spent their lives constantly gambling in these near-bankrupt companies, applying almost all the rules below—I call it the "cancer therapy rule."

They look at the chaos and calculate whether they can cut everything else and leave only the healthy parts, allowing them to "come back to life." If they can indeed find them, they throw away all the useless things. If this method doesn't work, they liquidate the company's assets. GEICO once had some outstanding businesses, but due to being intoxicated by success, GEICO did some foolish things. Because of their excellent performance, they once thought they were invincible, only to experience severe setbacks. What they needed to do was cut off those paralyzed businesses and return to their areas of expertise. This is a very simple model that has proven effective time and again.

GEICO has made us a lot of money; although its content is somewhat mixed, overall, it is a good company. GEICO has brought in some extraordinary and talented individuals who began to make significant cuts. This is the model you should be looking for.

### **5. The Mission of Investment Managers: Enhancing Value for Clients**

Finally, I will talk about investment management. This is an interesting industry—because in terms of net worth, the entire investment management industry has not brought value enhancement to clients. Of course, the plumbing manufacturing industry is not like this, nor is the healthcare industry. If you want to enter the investment management industry, you will face this unique situation where most investment managers operate using "psychological denial"—like chiropractors, this is a standard method to cope with the limitations of investment managers. But if you want to be among the best, I suggest avoiding this "psychological denial" model.

**I believe that a small elite among investment managers is needed to enhance value, but merely having intelligence is not enough; they must also undergo some training in action—seizing every opportunity to provide your clients with above-average returns.**

What I refer to above are those investment managers dedicated to selecting common stocks, not other fields; there are certainly many who excel in areas like currency, and they can achieve good operational records in scale operations
But the environment I am in is different, so the discussion is only focused on the selection of U.S. stocks.

I believe that enhancing value for clients in investment management is very difficult, but it is not impossible.

Over the years, at various cocktail parties, we often encounter questions like this: they ask me, "How can we establish a solid system for financial stability and retirement savings?" I have managed to evade these questions.

The answer is: "Spend a little less than you earn, always have a surplus, and then put it into a tax-deferred account. Over time, it will yield some results. It's that simple and clear, everyone can understand it.

<span class="security-tag" type="security-tag" counter_id="ST/US/BRK.A" name="Berkshire Hathaway" trend="">$ Berkshire Hathaway.US</span><span class="security-tag" type="security-tag" counter_id="ST/US/BRK.B" name="Berkshire Hathaway B" trend="">$ Berkshire Hathaway B.US</span> Mark public account red and green