Warren Buffet's Investment Partner - Top Three Stock Picking Tips
Charlie shares not only his opinions, but his through process behind his belief system and stock picking strategy. Here are some insights into his thought process.
Circle of Competence
While we do have knowledge at the tip of our fingertips, we are still not advanced enough to process it as fast a computers can. In other words, even with all this information available to us, it is impossible to know everything about everything. When investing, Charlie Munger sticks with what he knows and businesses that are simple and understandable. In addition, these businesses need to be able to thrive under different market environments. Among those that are difficult to understand include pharmaceuticals and technology companies. Not surprisingly, Munger excludes highly promoted "deals" and IPOs from his potential investment list. In order to value a business, you need to understand it. If you can't do that then you have no business in investing in that company.
Find Companies with Moats
Few businesses survive over generations. Metaphorically speaking, companies that have "moats" are those are able to hold a durable competitive advantage over others. Thereby they would be businesses that have a higher probability of surviving in the future. While each year may not be more profitable than the last, the fact that the company's competitive advantage widens year after year is a sign of a great business. An example of a company with little to no moat at all is Groupon (GRPN). Since Groupon was released to the public a number of different competitors have entered the market including Amazon's Living Social and Google Offers. The discount coupon business model relies on vendors to provide discounts such as coupons to users. These coupons are then sold to users. A portion of the profits would then be allocated to Groupon themselves. However, customers are not loyal to Groupon. If there was a better deal offered on Living Social they would purchase that discount or coupon from that site. Sites like Living Social and Google Offers reached out to the same vendors as Groupon and essentially obtain the same deal for its members. As a result, Groupon's sales have taken a huge dip losing $81M in the September 9 months ended 2014 compared to $14M loss in the prior year comparable period.
Margin of Safety
Having a "margin of safety" is basically having a cushion to allow for errors in calculation. For example, suppose an elevator was built to hold five tons with a maximum capacity of 5 people. That would mean you would need five people who weighted in total five tons for the elevator to not be able to hold. You build the elevator to handle this amount of weight, just in case even if you know you will most likely not need it. Compare this with purchasing shares in a company, if you believe a stock is worth $20 and you buy it at $15, you give yourself a margin of safety of $5 in case you analysis is incorrect and it's actually worth $17.