Charlie Munger: “Invert, Always Invert”

Key Concepts

Invert, Invert, Always Invert: A principle of avoiding what is known to be problematic or foolish.
Understanding Earning Power and Competitive Position: The ability to reasonably forecast a company's future profitability and market standing over a 5-10 year horizon.
New Issues: Securities offered for sale for the first time, often associated with high commissions and promotional activity.
Declining Businesses: Industries or companies experiencing a decrease in revenue or market share.
Growing Businesses: Industries or companies experiencing an increase in revenue or market share.
Cigar Butt Approach: A strategy of extracting a small, final benefit from a declining asset.
Diversified Retailing: A historical example of a failed business that ultimately generated significant wealth.

What to Avoid in Investment

The discussion centers on applying Charlie Munger's principle of "invert, invert, always invert" to identify what to avoid in the investment world. The primary criteria for avoidance are things that are not understood, are priced excessively, or are inherently flawed.

1. Lack of Understanding

A fundamental principle is to avoid investments that are not understood. This goes beyond simply knowing what a business does. True understanding, as defined by the speakers, involves having a "reasonable fix" on the company's earning power and competitive position over the next five to ten years, including an understanding of industry development and the company's place within it. This filters out a significant portion of potential investments.

2. Crazy Pricing

Even if a business is understood, if the price is deemed "crazy," it is also avoided. This emphasizes that valuation is a critical component of investment decisions.

3. New Issues

The speakers express a strong aversion to investing in new issues. Their reasoning is that a seller choosing to bring a security to market, especially one accompanied by significant "hoopla," is unlikely to be the "single cheapest thing to buy" among the vast universe of global businesses. The presence of high commissions, often 7% or more, further reinforces this view, making new issues seem inherently unattractive. They argue that the seller's timing choice, rather than market forces, suggests a less optimal entry point for investors.

4. Industries with Unclear Winners

The speakers also avoid industries with a potentially wonderful future if they have "no idea who the winners will be." This highlights a preference for clarity and a focus on identifying specific companies with a discernible path to success.

5. High Commission Investments

A "rule of thumb" is to avoid anything with a "really large commission." The logic is that the probability of someone paying a very high commission to offer a significant advantage is very low.

6. Declining Businesses (with caveats)

Generally, the speakers advise staying away from declining businesses, stating they are "not worth nearly as much as growing businesses." They acknowledge that declining businesses can still be valuable if they generate significant cash flow, but emphasize that it is "very hard" to succeed in them.

The "Cigar Butt" Analogy: They describe the attempt to extract value from declining businesses as the "cigar butt approach," where one might get "one free puff." This implies a limited and often inefficient return on effort.
Exceptions and Historical Context: While generally avoided, the speakers admit to being involved in several declining businesses, such as the newspaper industry, where they "pay a price to be in that" because they "understand it pretty well." However, they stress that "real money" at Berkshire Hathaway is made in growing businesses.
Past Experiences: They recount past investments in declining businesses like textiles, US-made shoes, and department stores, which ultimately failed. Despite these failures, they highlight that significant wealth was generated from these seemingly poor starting points.

7. The Value of Observing Smart Investors

As a positive "sorting device for opportunities to consider," the speakers suggest looking at "things that other smart people are buying." They cite Warren Buffett's practice of reviewing Graham Newman reports, recognizing that if Graham was investing in something, it was "certainly worth my time to look at."

Case Studies and Real-World Applications

Diversified Retailing and the Howard Street Department Store

A significant case study presented is the investment in a department store on Howard and Lexington Street in Baltimore. This was part of a company called "Diversified Retailing," which initially only had one operation.

Initial Investment: $6 million was put into the company in 1966 by Sandy Goddisdman, Charlie Munger, and Warren Buffett.
Context: At the time, there were four department stores on Howard and Lexington Street, and all four are now gone.
Outcome: Despite being a "failed business" initially, this $6 million investment turned into approximately $30 billion. This illustrates how even ventures that appear to be failures can, under certain circumstances and with long-term perspective, yield extraordinary returns.

Blue Chip Stamps and Berkshire Hathaway (Textile Business)

These are mentioned as other examples of companies that were in declining industries. While the focus is on avoiding such businesses for future growth, the historical context shows that Berkshire Hathaway itself originated from a declining textile business.

A Specific Declining Business Example

One speaker recounts presiding over a business that had sales of $120 million in 1967 or 1968, which had dwindled to about $20,000 in the previous year. Despite its decline, Charlie Munger remains in charge, and the speaker humorously suggests making an offer to buy it. The point is that while they are not actively seeking such opportunities, past ventures in declining businesses have, paradoxically, generated immense wealth for Berkshire.

Step-by-Step Processes and Methodologies

The speakers describe a filtering process for investment ideas:

Initial Filter (Understanding): Does the investment pass the test of understanding its future earning power and competitive position? If not, it's immediately discarded.
Second Filter (Pricing): Is the price "crazy"? If so, it's discarded.
Third Filter (Commissions): Does it involve "big commissions"? If so, it's avoided.
Fourth Filter (Industry Clarity): If it's an industry with an uncertain future and unclear winners, it's avoided.

This multi-stage filtering process is described as happening "very quickly" and is sometimes perceived as "rude" by those presenting ideas that don't pass the initial filters.

Key Arguments and Perspectives

The Power of Avoidance: The core argument is that successful investing often hinges more on what one avoids than what one actively pursues. By sidestepping obvious pitfalls, investors can significantly improve their odds of success.
Long-Term Perspective is Crucial: The case of Diversified Retailing demonstrates the importance of a long-term view, where initial failures can be precursors to massive success.
Focus on Growth: While acknowledging past successes in declining businesses, the primary focus for future wealth creation is firmly placed on growing businesses.
Simplicity and Discipline: The investment philosophy emphasizes a disciplined approach, sticking to what is understood and avoiding complexity or speculative ventures.

Notable Quotes and Significant Statements

"Using Charlie's principle of invert, invert, always invert, maybe you can help us by suggesting what to avoid and stay away from."
"We try to stay away from the things to start with that we that we don't understand."
"I can't recall any time in the last 30 years at least that we've bought a new issue."
"The idea that somebody is bringing something to market today... is going to be the single cheapest thing to buy out of thousands and thousands and thousands of businesses in the world is nonsense."
"If it's got a really large commission in it, forget it. Don't read it."
"Looking at things that other smart people are buying. That is not a crazy search method as a sorting device for opportunities to consider."
"Generally speaking, it pays to stay away from declining businesses."
"The cigar butt approach where you get one free puff out of the cigar butt that you find."
"The real money is going to be made by being in in growing businesses."

Technical Terms, Concepts, and Specialized Vocabulary

Earning Power: The ability of a business to generate profits.
Competitive Position: A company's standing relative to its rivals in the market.
New Issue: A security being offered for sale for the first time.
Hoopla: Excessive publicity or excitement.
Commission: A fee paid to an agent or broker for a transaction.
Declining Business: A business experiencing a decrease in its operational scale or profitability.
Growing Business: A business experiencing an increase in its operational scale or profitability.
Cigar Butt Approach: A metaphor for extracting a small, final benefit from a depleted asset.
Diversified Retailing: A business strategy involving multiple retail operations.

Logical Connections Between Different Sections and Ideas

The entire discussion is logically structured around the "invert, invert, always invert" principle. Each point about what to avoid (new issues, declining businesses, high commissions, lack of understanding) is presented as a direct application of this principle. The case studies of Diversified Retailing and other past ventures serve as evidence or counterpoints to the general rules, illustrating the complexities and historical context of applying these avoidance strategies. The connection between avoiding mistakes and achieving success is a recurring theme.

Data, Research Findings, or Statistics

Commission Rates: Mention of 7% or higher commissions on new issues.
Sales Figures: A declining business example with sales of $120 million in 1967/68 down to $20,000 in a recent year.
Investment Growth: The $6 million investment in Diversified Retailing turning into approximately $30 billion.

Clear Section Headings

The summary is structured with clear headings to delineate the different aspects of what to avoid and the underlying principles.

Synthesis/Conclusion

The main takeaway is that a disciplined and contrarian approach, heavily focused on avoiding common investment pitfalls, is a highly effective strategy. By rigorously filtering out investments that are not understood, are overpriced, or are inherently flawed (like new issues and generally declining businesses), investors can significantly reduce their risk and increase their probability of long-term success. While past experiences show that even "failed" ventures can yield immense wealth, the emphasis for future growth is on understanding and investing in businesses with clear competitive advantages and strong growth prospects. The principle of "invert, invert, always invert" serves as a powerful guiding framework for this disciplined avoidance.