#29: The Man Who Whispered To Warren Buffett

In memoriam to Charlie Munger, originally published in Spanish in the EFPA magazine in December 2023

On January 1st, Charlie T. Munger (1926-2023), Warren Buffett's right-hand man and historic Vice President of Berkshire Hathaway, would have turned 100. He passed away on November 28th. Munger was a reference in the investment community, and immediately after the news of his passing, social media platforms were flooded with messages recognizing him as a legendary figure in investing. 

Originally from Omaha, like Buffett, although he lived most of his life in sunny California unlike his more ascetic partner, he graduated from Harvard Law School, although he was never passionate about the profession. He had a challenging start, with a complicated divorce and the tragic premature death of a son from leukemia, two chapters that also drained his finances in his 30s and did not anticipate what was to come. Munger channeled these experiences to forge a strong stoic character, not lacking in sharp humor, which undoubtedly served him well for his later successes and thinking. Unlike Buffett, always focused on the investment field, Munger was a multidisciplinary thinker – Buffett sometimes referred to him as his "West Coast philosopher" – with a strong contrarian mindset (especially critical of many of Wall Street's reprehensible behaviors) and a person of enormous honesty and integrity. Undoubtedly, along with Ben Graham, the dean of value investing, he was the person who most influenced Buffett's investment style. 

The richness of Munger's thinking, for whom educating oneself was a moral duty, is condensed in the book Poor's Charlie Almanack (available to anyone in PDF, the copyright is transferred to a foundation), titled in reference to Ben Franklin, Munger's great hero. It is a multifaceted text where one can read the teachings of this modern educator, a sharp connoisseur of the human condition – for example, his speech "The Psychology of Human Misconduct" is one of the best written on behavioral economics – containing valuable observations on how to succeed in life, the business world, and investments, where he developed one of the most comprehensive thought frameworks articulated from today's celebrated "mental models," theoretical miniatures to better operate in complex systems, followed by several generations of investors.  

Regarding his role as an investor, Munger goes down in history for his important role as VP and right-hand man to Buffett at the conglomerate Berkshire Hathaway, one of the world's most unique and admired companies. Although his paths crossed with Buffett's in the late 1950s through their respective families, connecting from the beginning, it wasn't until the 1970s that their professional relationship was fully consolidated with the merger between Berkshire Hathaway, then basically an insurance and construction investment group, as Buffett was gradually abandoning the textile business (Berkshire's founding purpose) and recycling this capital into more profitable investments with better prospects; and Blue Chip Stamps, the parent company that then grouped Munger's various investments. Munger is the key person to understand the evolution in Buffett's investment style, which went from being purely quantitative ("value"), supported by accounting analysis, and influenced mostly by Graham's teachings – highly determined by the market context of the 1930s, depressed after the 1929 crash and the subsequent Great Depression – toward one where the qualitative – the quality of the business/fundamentals – would end up weighing more than the valuation itself. The acquisition of See’s Candies perfectly illustrates this shift. 

In 1971, a Blue Chip executive (Munger's holding company partly owned by Berkshire since the late 1960s) presented the idea to Buffett. It was a family-owned, third-generation company that had established a franchise for manufacturing, distributing, and selling quality chocolates and candy boxes. By the late 1960s, as often happens in many family businesses, they wanted to sell their stake (then close to 70%) partly due to lack of a clear succession plan and partly due to the consolidation occurring in the sector. The family asked for $30 million – a bit less if adjusted for cash – against an operating profit of $4.2 million and a net profit of $2 million; which meant an EV/EBIT multiple of 7x and a P/E ratio of 15x, a considerable premium compared to Buffett's standards in similar operations with unlisted assets. However, Munger convinced Buffett that it was more than a fair price given the quality of the asset, a business that required relatively little capital, with pricing power (the previous year the chocolate group reported a gross margin of 54%), and great room for growth as they then only operated stores and franchises in a few Midwestern states. It would be the group's most profitable investment over the next decade with an annualized profit growth of 20.9%; since 1972, See's Candy has paid about $1.7 billion in dividends to Berkshire; a "100x bagger" considering only these payments. Given these results, it seems obvious that paying 5 or 7x operating profit was of little importance. Munger laid the groundwork for one of Berkshire's creeds since then: "it's better to buy an excellent business at a fair price than a fair business at an excellent price." This quality premium will later be key in subsequent operations such as Coca-Cola, Amex, or, more recently, Apple, without which Berkshire Hathaway's amazing long-term results would be impossible to understand. 

Financials of See's Candies Operation Summary: 

- Price $25 million (adjusting cash) 

- Sales $30 million 

- Net assets (tangible) $8 million 

- EBIT (operating profit) $4.2 million 

- Net profit $2 million 

- P/E 12.5x 

- EV/EBIT 6x 

The other key acquisition (we could mention some others) is that of Wesco Financial, in this case both for the quality premium mentioned earlier and for the integrity and reputation issues, subjects in which Munger and Buffett have always excelled. Wesco Financial was a "savings bank" for American army veterans; a traditional, prudent, and profitable business model, with a controlling shareholder oriented towards the long term, in this case the Casper family. Blue Chip, in which Berkshire was already a shareholder since 1967, had an 8% stake in Wesco when in 1973 it considered merging with the Financial Corporation of Santa Barbara. Both Munger and Buffett considered the exchange ratio unfair, undervaluing Wesco and overvaluing FCSB, which motivated them to convince the family to withdraw the merger and explore other alternatives. A move that caused the stock to drop from $18 to $11. In that turbulent time, many would have taken advantage of the opportunity to buy Wesco shares at a discount. However, Munger, supported by Buffett, started placing buy orders at $17, paying much more than necessary. Finally, Blue Chip acquired 80% of Wesco Financials, with Munger persuading the competent management team to continue. An operation that raised suspicions at the SEC and forced an investigation that would eventually lead to the full absorption and consolidation of Blue Chip into Berkshire in 1975, making Charlie Munger Vice President of the latter. 

Why this overprice? To maintain the integrity and reputation of both. With this move, Munger/Buffett sent a signal to the market of how they liked to do business: paying a fair price, respecting the management team, and with a genuine long-term orientation. This would give credibility incontestable to Berkshire that it will become in the “preferred buyer” (White Knight) for many Family businesses. A prime in price that, in long term, had a very important economic value for Berkshire future endeavors.

Financials of Wesco operation:

- Price $31.2 M ($25 for 80%) 

- Net profit $4.3 M 

- P/E 7.3x 

- Risk-free 6.8% 

A legend in investment disappears, whose example and trajectory will surely remain a reference and useful anchor for future generations of investors for many years to come. Rest in peace.