The Art of Stock Picking

 | Jan 16, 2013 | 1:00 PM EST
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The title of this column comes from a talk by esteemed investor Charlie Munger to a group of business students several years ago. Munger, for those unaware, is the vice chairman of Berkshire Hathaway (BRK.A, BRK.B). But that title gives him little credit. Munger has been partners with Warren Buffett for decades, and Buffett will be the first to tell you that Berkshire wouldn't be what is today without Charlie Munger.

Although Munger's transcribed talk spans 18 pages and devotes a good portion of the discussion to the value of understanding mental models in disciplines such as psychology, mathematics and biology as they relate to stock picking, he uses this framework of knowledge to understand business problems.

For example, how is it that a commodity product like an airline seat, which provides so much benefit to society -- faster and safer travel, more time with family -- be such a value-destroying product for investors? If one were to aggregate the cumulative profits of the airline industry since the days of Kitty Hawk, the net result would be negative. The airline business, despite being essential to today's way of life, has been a disastrous investment that has worsened with deregulation. On the other hand, another commodity, breakfast cereal, not only competes with hundreds of other cereals but dozens of other breakfast items, yet cereal produces massive returns on equity for investors. Kellogg's (K) return on equity has consistently been above 40% for the past decade, and General Mills (GIS) operates with an average ROE of about 20%.

What accounts for the difference between cereal and airline seats? Psychology. Once deregulated, the airline companies aggressively pursued profits and the entire industry's willingness to do whatever it took to sell that one extra airline ticket all but ensured that airlines, in the aggregate, would not make money. Kellogg, on the other hand, could decide tomorrow to slash cereal prices by 50% to grab market share. Kellogg would still profit from its cereals but, in the end, would start a pricing war that would lead to a reduction in all cereal prices, thus lowering profits for all cereal makers. Understanding this human psychology, Munger says, allows an investor to understand why airlines are such a terrible investment.

So what are the keys to successful stock picking? You will be disappointed to know that it's no big secret. Make big, infrequent bets, says Munger. The smartest investor can't possibly know everything about 40 different companies, so why hold a lot of different stocks? The transactional costs of trading are also very expensive. If you invest in a stock that returns 15% and hold it for 30 years, thereby triggering a one-time tax of 35%, your annual rate of return comes out to something like 13%. On the other hand, if you own a stock that returns 15% a year and sell it every year at the same tax rate, your annual return comes out just under 10% a year. The 3% difference in returns is astronomical over that 20-year period.

The market, by and large, is efficient. On average, your stock market results will be average. Not everyone can simply beat the market. But what Munger is saying is that the key to successful stock picking is not batting 1.000 or even 0.500. Rather, it's investing patiently at attractive prices and letting the power of compounding swell your gains.

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