Charlie Munger’s 4 Principles of Investing

by Matt Spillar · May 13, 2019

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principles of investing

In the previous post, Mrs. Spills talked about her money journey and how her first experience with learning about value investing came from reading “Invested” by Danielle Town and Phil Town. These are her biggest takeaways from the book.

Danielle begins to learn value investing from her dad Phil Town. He starts by teaching her about Charlie Munger’s 4 principles of investing and why they are important. I really liked how he broke them down into simpler terms and made it easier to understand what each one meant. I feel like this was where I learned the most about investing in a company and how to do it well.

1. It must be a business you are capable of understanding.

Principle #1 seemed simple, make sure the business is something you know about and understand so that you know where your money is going. Its ok to not know everything at the beginning, but if you put in the work it should be something you understand. You should also understand the industry, not just the company. You don’t want to pick a random company in an industry you know nothing about.

The main takeaway I got from this is do your research before you jump into investing in a company and make it something you are interested in. I learned that a good way to figure this out is using Warren Buffett’s circle of competence to find the subject matter that matches my skills or expertise.

2. It must be a business with some intrinsic characteristics that give it a durable competitive advantage (Moat)

When I was reading this principle, my first thought was, “aren’t moats a type of protective water barrier for a castle?” It turns out that this is exactly what a moat is for your money. Just like a moat protects a castle from attacks, I learned that a moat is a type of competitive advantage the business intrinsically has that sets it apart and makes it untouchable by competitors for long-term cash flow. The moat must be something that cannot be separated from the business and must be durable, like brand or price.

3. The business should have management with integrity and talent.

I learned that when picking a company to invest in you want the business to have management that has integrity. You can learn a lot about how candid the CEO is in their shareholder letters. You want a business where its CEO talks openly about when the business is doing well AND when its not. How happy are the employees of the company? You can tell a lot from employee morale on whether its management is doing well. You should also check if the company has any debt and what its plans are for that debt. Do they plan to acquire any debt in the future?

4. The business should be available for a fair price and gives a sufficient “margin of safety.”

For this last principle Charlie Munger says not to pay an infinite price for a company. Wait until the price is reasonable, and then still wait. When the price is more than reasonable, that is the time to buy. Buy the company for a price that make sense, on sale, that builds in a margin of safety. The margin of safety is a price below the company’s value that will protect me from most mistakes, in case I got my price analysis wrong. This last principle was one of the most challenging for me because it requires math and math has never been my thing.

The three calculations to figure out the pricing/ valuation of a company are:

Ten Cap price (based on the Owner Earnings)
Payback Time price (based on the free cash flow)
Margin of Safety valuation (based on earnings)

I found it intimidating learning there were three different calculations. How come there couldn’t be just one easy calculation and that’s it? But I learned that having three different ways to get at the price forces you to understand the company better, and the better you understand the company, the easier it is to choose the right price to pay. I played around with the calculations and practiced just for fun. It wasn’t so bad if the numbers were given to me to plug into the formula, but figuring out the numbers for myself would be more challenging.

Inflation

Another key point in the book is inflation. I was surprised to read that most retirement savings calculations don’t account for 2-3% inflation over time. This means you need to save a lot more money than you think you do. I had never thought about this before. I knew the term inflation and what it meant loosely, but reading about it in this book got me thinking about it more. If I decide to save money in a savings account and don’t do anything with it, overtime I am losing the value of that money and not gaining. That reality hit hard. It helped me to understand the value in investing in stocks and getting a return on my investments.

Final Thoughts

Overall, I learned a lot about value investing through reading this book. It was challenging, but worthwhile to complete it. Before reading this book I had no idea what value investing was, but now I feel like I have a pretty good basic understanding of it. It helped show me that learning about investing is important for everyone, and how important it is for my future.

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