Charlie Munger Built His Fortune By Seeking Income First, Capital Gains Later

Includes: BRK.A, BRK.B
by: Tim McAleenan Jr.

If you're looking for a financial book to read that is both instructive on how to make money as well as incredibly inspirational from a personal standpoint, I highly recommend that you pick up Janet Lowe's Damn Right!: Behind The Scenes with Berkshire Hathaway Billionaire Charlie Munger. It's a heck of a good story. One of the reasons why I have the utmost respect for Mr. Munger is because he's been through it all. When he was just shy of thirty years old, he lost everything. His son died of cancer. His wife left him. He was not advancing in his career at the pace he had previously envisioned. He only had a couple hundred dollars to his name. Yet, within the next fifty years, Munger managed to: remarry, have eight children (counting stepchildren), and became a billionaire despite being nearly penniless almost a third of the way through his life.

For me, I have always wanted to know: How did he do it? We all know that he eventually joined forces with Warren Buffett at Berkshire Hathaway (BRK.B, BRK.A), but I had always been interested in how Munger was able to put himself in a situation to go from broke to Buffett's business partner seemingly overnight.

In Munger's early years, he had a strong desire for both current income and capital appreciation. In practice, this led Munger towards high-quality real estate as well as stock investments. Munger's desire to get rich while he could still enjoy it led him to selectively take on debt to back his best ideas (this decision, by the way, is a marked contrast to Buffett. To put it bluntly, Buffett hated debt, and in early 1970s interviews, would often compare high debt to an economic form of slavery, arguing that intelligent men and women should be able to find a way to become rich without the use of leverage).

First and foremost, Munger sought immediate income to fund other investments. In much the same way that Berkshire Hathaway uses its dividends from Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Nebraska Furniture Mart, GEICO, Dairy Queen, and others to fund acquisitions of firms like Heinz (HNZ) and partial stakes in firms like IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC), Munger was eager to find dependable sources of income that would fund other investments. In his case, he developed real estate and used leverage to buy undervalued stocks (such as Canadian power companies with stable dividends high enough to service the payments on his debt).

The take-home lesson, by the way, is not that you need to employ debt to succeed. Rather, it's the fact that Munger saw the dependable generation of cash (whether it be dividend income or rent income) as something inextricably tied to the creation of wealth through capital gains (i.e. buying undervalued stocks and selling them after favorable price movement). Charlie Munger structured his business life in such a way that he acquired cash-generating assets so that he could always have money coming in to buy other undervalued assets, which were often cash-generating as well. Although Munger has never labeled himself a dividend investor, it was his ability to always have streams of cash coming through the door that enabled him to make capital appreciation investments.

By the time Munger opened his fund (which, by the way, generated 19.8% annual returns from 1962 to 1975), he had resorted to openly mocking those who worried about lower stock prices. Even though many of his individual and fund holdings fell by 60-75% during the bear market crash of 1973-1974, Munger did not engage in any panic selling and, in Janet Lowe's book, mentioned that the thought of "selling out" never crossed his mind at any point in his investing career. What I find useful is keeping in mind why Munger was able to be this way. Although his portfolio holdings fell dramatically during the 1973-1974 crash, he did not flinch because at this time, he had monthly income coming in from: an Amoco oil partnership, real estate, and some high-paying dividend stocks to satisfy all of his personal needs. By having an income-generating foundation, Munger was able to put up with the wild fluctuations that often accompany the pursuit of investing for high total returns.

A conventional approach to investing would imply seeking out capital appreciation first, and then turning it into income when necessary. We've all read articles that talk about finding ways to get a million-dollar net worth, and then, once retirement comes, finding a way to turn it into a $40,000 annual income stream. Munger's path to wealth, however, regarded income and capital gains as something joined at the hip. By finding undervalued opportunities that had a strong potential to generate current and future income, he could accomplish two things: (1) he could ride out wild price fluctuations because he was generating enough private income to tolerate the storms in the stock market, and (2) he could use the regular income to fund investment in undervalued stocks that would provide rapid capital accumulation.

Munger became a billionaire by admittedly doing things that many of us mere mortals cannot. He was successful in his lucrative real estate ventures, used his debt to pick the right stocks, and got bargain deals on his oil partnerships. Those things are hard for many of us to do, and can often lead to disastrous consequences if not done correctly. But when you look at Munger's early life and look at what fueled his rise, it's clear that he did not view the pursuit of capital gains and income as something at odds with each other (unlike those today who view a dividend growth strategy as something in conflict with a total return strategy). In Munger's case, he built a regular income infrastructure that allowed him to always have money coming in to make the types of investments that would generate 15-20% annual total returns. That's the million-dollar lesson from Munger's early life.

Disclosure: I am long PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.