Charlie Munger Explains Berkshire Hathaway’s Long-Term Success

Out of all the possible topics in the world that Munger could have chosen to begin his letter to investors of Berkshire Hathaway, Munger began talking about the management system and policies that allowed Berkshire Hathaway to be so successful after giving a brief outline of what was to come. Although Munger didn’t explicitly say this, there is a reason why processes and systems are so important: they provide a template that systematically converts your labor into passive (or generally passive) sources of income.

There is a reason why high-profile football players and basketball players find themselves in long-term financial difficulty. It is because they fail to embark on this journey—either they spend the money they make and never truly convert the profits from labor (playing a sport) into something passive or they try their hands at business ownership and fail to select something that lends itself to holding over extraordinarily long time periods.

It is something almost never regularly discussed on finance sites, but it is nevertheless something that I would highly recommend: Create a scheme of investing that builds wealth for you even if you do nothing except sit back passively after making the initial investment.

For instance, let’s say that the following facts are true about yourself—you had $100,000 to invest, wanted to own real estate but had little operational knowledge of managing properties, and wanted to use the income to fund something with higher growth that is also likely to be around a few decades from now. If that were your objective, your execution of the strategy might look something like this:

One. Set up a private bank account that is used to facilitate investing, and has nothing to do with your day-to-day living expenses.

Two. Buy something like Realty Income at 15x P/FFO or lower. That’s sort of the realistic valuation at which you tend to do well with Real Estate (your results wouldn’t be as good if you started today with 20x P/FFO because this is the kind of valuation you get when you are six years into a low-interest rate bull market), and the reason why you would want to select something like Realty Income is because: (1) the dividend arrives every month without going down, (2) the real estate is spread across 49 states with no tenant accounting for more than 10% of the rent money although the Family Dollar merger will result in explaining 9% of Realty Income’s revenue stream, (3) the dividend has never been cut, and (4) the management team has yet to do something extremely stupid.

If you did it in 2004, an opportunity to buy the company at 15x funds from operations (the reason you use funds from operations rather than earnings with real estate companies is because earnings include depreciation that has already occurred and funds from operations tell you how much cash is actually coming your way so I find it to be a better metric to evaluate the power of the enterprise), you would be sitting on 4,000 shares of Realty Income assuming you spent every single dividend that came your way.

Those 4,000 shares would pay paying out $0.189 in dividends per month, and over the course of the year, would represent between 86% and 90% of Realty Income’s cash flow that comes from rents after expenses are paid. That would give you $756 per month to invest.

Three. Set up a scheme of automatic investment of those profits. You might open an account at Computershare and have $250 per month put into Exxon Mobil, $250 per month into Dr. Pepper, and $250 per month into Becton Dickinson. Those businesses grow between 8-12% per year, and the dividend matches it. Realty Income, meanwhile, grows around 4-5% per year, and the dividend growth matches this.

Four. Reap the benefits. Here is what you would be doing. You’d have a real estate basis that would grow through acquisitions and rent-raising so that the monthly income generated will increase by 4% every year. You will also start building an oil, soft drink, and health care enterprises that are constantly growing by: new contributions to the ownership position each month, dividend reinvestment, and the growth of those companies. It seems something wise to bet your financial future upon, given that Exxon and Dr. Pepper have been profitable for over a century and Becton Dickinson has raised its dividend every year since 1965. Also, you build a little cash position each year. The $6 spread isn’t much in the first year, but if you hold the contributions steady, you’ll develop a small amount of cash buffer getting built each month when Realty Income raises its dividend.

This is what I have in mind when I hear Munger talk about a system and process for building wealth. It turns an initial sum of capital into something ever-growing that requires little effort from your part once it is put into place. Of course, that is an investment system, and Munger had in mind a management system when he talked about why Berkshire performed so well over the past five decades.

He pointed to six things to explain Berkshire’s success: being a diffuse conglomerate that could engage in many different activities, the business itself was managed through subsidiaries with an extremely autonomous central authority in Buffett, there would be no distractions or surplusage at the company headquarters, the company has relied  on float from casualty insurers to produce low-cost capital to invest and generate a spread before payouts, there was no no stock option system at the companywide level, and the chairman would only focus on a few activities for himself.

Those are all accurate descriptions of reasons why Berkshire has been an overwhelming success for long-term BRK.A investors and has turned Buffett into a celebrity professionally. But presumably you have in interest in how the spirit of those observations can help you personally.

My thoughts: It is important to develop a circle of competence that comes with a tailwind. When Buffett speaks on this issue, he usually mentions that you should refrain from engaging in activities beyond your scope of knowledge—don’t pretend to know what you don’t know, because then your results are left to chance. What Buffett doesn’t mention, and I would add, is this: Try to focus your circles of competence where the knowledge can be really lucrative.

As an investor, try to learn how to value healthcare, energy, and consumer staple stocks. Those are the sustainable moneymaker darlings of the S&P 500. An expert on valuing Abbott Labs is going to do much better, with less work, over the long haul than an expert on aluminum companies like Alcoa. That’s because healthcare stocks give you growth and changing valuations to work with. In the aluminum sphere, you have less to work with: The growth is lower, so you make your money by forecasting changes in valuations like P/E’s and stuff of the like.

You want to put yourself in a position where even mediocre earnings power can get good results, and if you are better than mediocre, your results will be even better. If your chosen profession is a janitor, you are not going to be a millionaire unless you have a successful investing record, a very long time to invest, and a high savings rate caused by an extremely low consumption lifestyle. If I were in that position, I’d move to Silicon Valley and try to get a job as a janitor at some kind of startup, and keep my eyes pried upon for the ability to get in on some stock before a public stock offering. If you are a janitor at a family grocery store, there is no lottery ticket attached to the position. If you are unsatisfied with the money you make in your industry, ask yourself: Where do the people who do what I do reap the best results? And then either abruptly or gradually get yourself into that position. If you don’t do that, you will likely need to lower your material expectations or live the rest of your life with an extremely unsatisfied heart.

The other bit of Munger’s advice on Berkshire’s systems that are applicable here—avoid the trappings that show up on the road to accomplishment. Berkshire’s corporate headquarters are very lean, and Buffett has successfully avoided lifestyle inflation. Sometimes, the press overdoes it—they talk about him living in the same house for 50+ years without moving, without mentioning the $14 million Laguna Beach home he purchased decades ago. Buffett is often portrayed as a billionaire that lives on a common man’s salary with a penchant for air travel. The reality is that he is a man with $50 billion that lives as if his net worth is $50 million. The thing is—he has always been this way. There has been a significant gap between what he could spend and what he does spend, and this gap provides the capital that has allowed him to be such an extraordinary financial success.

Munger and Buffett both talk about how insurance float provided much of their investing capital since the 1967 buyout of National Indemnity that got tucked into Berkshire’s textile operations. Most people reading this do not own insurance companies. But you can maximize the per hour value of what your time generates, and you can structure your life so that you don’t incur high-interest debt that would force you to spend your life paying off credit card and banking companies. In other times, it makes sense to get your hands on a cash generator that provides you with an ongoing ability to invest for free. That’s what I was hinting at in the Realty Income example above. It’s a way to passively get money coming your way that you can choose to invest elsewhere so that you get to spend your life as a capital allocator that funnels money into whatever you find attractive each month. These new investments pay dividends of their own, which you can pool together for the next month/quarter investments. The theme of Munger’s letter involved virtuous cycles, and it is worth spending time to figure out how you can create those in your own life.