If you get around to reading Janet Lowe's biography of Charlie Munger titled Damn Right!: Behind The Scenes With Berkshire Hathaway Billionaire Charlie Munger, you will come across a fantastic passage written by Lowe in which she explains the difference between Benjamin Graham and Charlie Munger.
To paraphrase it, Graham often thought in terms of a company as a "dead" entity. Graham would try to calculate the liquidation value of the firm by calculating what each company would be worth if it sold off all of its assets and paid off all of its liabilities. This approach, given the low valuations in the post-Depression stock market and the natural inefficiencies that existed due to the prevailing technology at the time, created a great framework for Graham to generate nearly 20% annual returns (before fees) through his work with the Graham-Newman fund.
But Munger took a different approach to investing, "daring to wonder", as Lowe coyly put it, what a company would be worth if it remained "alive" for the next five to ten years. Munger's ability to think like this allowed him to sidestep the biggest trap that lures value investors: a high starting earnings yield. I'll give you an example of the kind of thought process that can ruin a value investor: "The American stock market returned 10% annually throughout the 20th century. I just found a company trading at around 9x earnings, giving me a starting earnings yield of 11%. If the company can merely meet the low hurdle of keeping earnings consistent, I'll be fine."
Munger trashed that kind of thinking because it did not take into consideration the future growth of the firm, and a high starting yield can easily lull investors into a false sense of security because they mistakenly believe they have bought a company with a margin of safety, when in reality, they are merely walking into a value trap.
Pitney Bowes (NYSE:PBI) is a great example of this. In 2008, an investor could have seen Pitney Bowes trading at $24.30 per share after it fell from $40 per share. Considering that the company was earning $2.78 annualized at that time, a value investor could have believed that he was getting a good deal, buying a company with an earnings yield of 11%.
Flash forward five years, and look at what happened: the $24.30 price in 2008 fell to $15.38 today. Of course, the investor would have collected substantial dividends along the way: two payments totaling $0.70 in 2008, $1.44 in 2009, $1.46 in 2010, $1.48 in 2011, $1.50 in 2012, and $0.375 in the first quarter of 2013. That's a total of $6.95 in dividend payments. Add that $6.95 to the prevailing share price of $15.38 today, and we see that a $24.30 investment in 2008 would have turned into a grand total of $22.33 today, granting an investor a loss of nearly 10% over a five year investing stretch. The dividend and nice starting earnings yield did provide a margin of safety, but not enough in this case to protect an investor from a small loss in total five years later.
The appeal of the Munger approach is that you shift your starting point as an investor. Traditional value investing means usually hinges on finding favorable valuations first, and from there, whittling the process down to a suitable company.
But when Munger ran WESCO, he mentioned five stocks in particular that were permanent parts of the portfolio: Kraft (NASDAQ:KRFT), US Bancorp (NYSE:USB), Wells Fargo (NYSE:WFC), Coca-Cola (NYSE:KO), and Procter & Gamble (NYSE:PG). US Bancorp and Wells Fargo had a few more bumps on the road than the other three, but each of those five companies have remarkably durable business models (in fact, each of those two banks generated higher earnings in 2011 than the pre-crisis year of 2007). When describing his rationale for owning those five companies, Munger mentioned that he first searched for companies that had business models that lent themselves to long-term earnings growth, and after that, he determined a reasonable valuation.
That sounds more like the language of a growth investor than a value investor. It sounds like a small distinction, but the Munger approach ensures a margin of safety in terms of business quality that eliminates from consideration many of the poor-quality companies that would show up in stock screens by traditional value investing metrics. Most value investors find stocks trading at attractive valuations, and then from there, they determine the stock to buy. The Munger approach encourages you to find a list of the companies with the best growth prospects adjusted for risk first, and from there, you whittle your list down to find a stock trading at an attractive valuation.
The appeal of the Munger approach is that a company like Pitney Bowes would never show up on any investor's list of "companies most likely to generate high-quality growth" going forward. The only way you come across a company like Pitney Bowes is if you screen only by traditional value metrics. That's why you should find the business model first, and then focus on valuation second. Most value investing says something to the effect of, "Okay, these are the cheapest 50 businesses in the world, and I'm going to buy one of them." In contrast, the Munger approach encourages you to screen for stocks like this, "These are the best 50 businesses in the world, and I'm going to buy the one at the best valuation." The Munger approach is nice, because it automatically prevents you from dealing with trash in the first place.