When I was in college at Washington & Lee, I had an English professor that often said that we don't really begin the writing process until we begin our first revision. In a similar way, as I've spent the past couple weeks re-reading the Charlie Munger biography Damn Right!: Behind The Scenes with Berkshire Hathaway Billionaire Charlie Munger, I have found a renewed appreciation for the different portfolio allocation decisions that have guided the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B) over the years. I felt as if I were reading about many of Munger's personal allocation decisions for the first time.
Here's one of the most useful things I've recently learned about Munger's approach to capital preservation: for every meaningful investment that he's ever made, he's always had an exit plan. The best example of this came in 1977 when he possibly considered scaling back his financial commitments within Berkshire Hathaway following trouble with The Buffalo News acquisition.
In 1977, Kate Robinson, the heiress owner of The Buffalo News, passed. Her estate decided to sell the company by trying to get The Washington Post (WPO) and The New York Times (NYSE:NYT) to engage in a bidding war over the company. When that failed, Buffett came in and offered $32.5 million, eventually securing control of the company.
At the time, The Buffalo News did not run a Sunday edition, ceding this ground to the town's rival newspaper, The Courier News. Buffett and Munger believed that they could put The Courier News out of business by creating a robust Sunday edition at The Buffalo News, and then receiving a sharp influx in advertising dollars after establishing The Buffalo News as the pre-eminent newspaper in town.
As we all know, that didn't quite work out. The Courier News sued The Buffalo News to block its Sunday newspaper on Sherman-Antitrust grounds, and the judge of the case developed an immediate dislike for Warren Buffett. He did not like that Buffett was an out-of-town operator, curtailed worker bonuses and profit-sharing (Buffett did this on the grounds that shareholders should receive all the profit because it was their capital at risk), and made a comment to The Wall Street Journal about how a one-newspaper town can be a great monopolistic business that effectively charges all advertisers a recurring "toll" fee to advertise. At this point, Munger became convinced that the odds were rigged against Berkshire experiencing long-term success with their Buffalo News investment.
This led to one of the most interesting and rarely discussed moves that occurred during Munger's association with Berkshire Hathaway: Mr. Munger considered scaling back his commitment to Berkshire in the wake of The Buffalo News' ongoing losses. From 1978 to 1982, the Buffalo News lost almost $12 million. Munger was growing increasingly dissatisfied with Berkshire's ownership of the northeastern newspaper. He wanted Buffett to admit it was a mistake, cut their losses, and move on. Buffett refused, believing that the company would eventually become profitable. Although Munger does not reveal the exact figure he calculated, he made a determination about the absolute amount of losses that he would tolerate at The Buffalo News before he would begin to scale back his family's commitment to Berkshire. This never came to fruition because Berkshire eventually won its court case and The Buffalo News became profitable, but it's worth knowing that Munger had mentally drawn a point at which Berkshire wasn't worth compromising his family's interests.
Although the circumstances of the story are unique to Munger, there is a lot that we as investors can learn from Munger in mitigating our own losses. First of all, Munger thought in terms of business losses, not stock price losses. In fact, this is a character trait shared by any worthwhile value investor, be it Munger, Buffett, Marty Whitman, Peter Lynch, John Neff, or the gentlemen at Tweedy, Browne. They never speak in terms of stock price losses. You'll probably never hear Warren Buffett say, "We'll sell our Coca-Cola (NYSE:KO) stock if the price falls by 60%." Instead, they always speak in terms of business performance. In Munger's case, there was a point in which the earnings deterioration of his investments would reach a point that he'd decide to sell out. While he did not disclose the specifics, we do know that he drew a line in the sand somewhere that would not be crossed.
The ultimate lesson from the Munger story is that it is equally important to avoid bad investments (particularly good investments that have the potential to turn into bad investments) as it is to find good investments. This is the most extreme example of Munger's personal risk management that I can find, but he has built his career by avoiding bad deals just as much as finding good deals. In the 1990s, Munger wouldn't hesitate to exit a real estate deal in California if the costs associated with the projects greatly exceeded his expectations. A great quote from Munger that sums up his sentiment on the subject is this, "In Monopoly parlance, you don't want to go back To Go." Munger was not the kind of guy who would set stop-loss orders on his positions. Although that's the standard hedging advice, Munger chose his limits in terms of actual business performance, and that seems to be a much more intelligent and rational way to build and maintain wealth as you navigate the investment waters throughout your life.
Applying Charlie Munger's strategy to your portfolio is much different from the industry standard advice that dominates discussions of diversification and generally regards volatility (read: fluctuations in your net worth) as the driver of the decision making process. With Munger, it was about determining the worst-case scenario for business performance that he would tolerate (a close corollary of this practice occurs when dividend investors automatically sell a stock that cuts its dividend because the business performance falls below their expectations). In Munger's case, the "contemplation to sell" corresponded to the earnings performance of his holdings (as opposed to the dividends). Munger's example is useful in teaching us to not regard volatility as risk, as well as developing a strategy that sets out beforehand the worst earnings performance we would be willing to tolerate from an investment holding.