The Greatest Lesson Charlie Munger taught Warren Buffett.

Berkshire Hathaway’s Vice Chairman, Charlie Munger, has been Warren Buffett’s right-hand man for over 42 years. Ever since his childhood, Charlie seemed to surround himself with the Buffetts, working at Warren’s grandfather’s grocery store named Buffett and Son when he was just a young lad. But even though the two were in close proximity, it was not until later in life that the two would finally be introduced to each other.

Before Charlie joined Berkshire in 1978, he too had a fruitful investment career managing his own investment firm. Munger earned annual returns of 19.8% during the 1962-75 period, compared to an average annual return of approximately 5.0% for the Dow Jones (DJIA). But early in their careers, both Warren and Charlie had come to develop very different investment styles. Strategies which KeyStone intends to exemplify for clients.

Warren’s strategy, inspired by his mentor Benjamin Graham – who is widely known as the grandfather of value investing – came to rely on uncovering stocks that were trading at deep discounts to the market. Frequently gravitating toward small-cap or thinly traded stocks where opportunities were potentially being overlooked because these thinly traded stocks were not followed by analysts. But given a cheap valuation and positive underlying fundamentals, Warren believed that the market would eventually come to see the value that he saw in these unloved gems.

At KeyStone we see the wisdom in this strategy. A real-world example of one of these small-cap opportunities recently uncovered by our analysts was Photon Control (PHO: TSX). A thinly traded small-cap that posted great financial results while increasing backlog. In early 2020, the share price was trading near similar levels that could be found back in 2018. The discounted share price was in spite of the fact the company reported that its backlog had increased by 59% from the same quarter last year. Twelve days after Photon reported this increase in backlog and while the stock continued to trade near all-time lows, we recommended the stock to our clients on March 30th, 2021. The rest is history. Photon Control was recently bought out for $3.60 per share and over the past week the cash payout was received by clients and all shareholders. Not all recommendations will work out exactly like Photon, however, by adding stocks that are trading at discounted valuations to their future growth – you are setting your portfolio up for success!

Charlie’s Strategy was not terribly different when it came to valuing the businesses, but focused on good stocks that were trading near or at fair value. These businesses may not be extremely cheap, but the technology or economic moat that the company maintains is far superior to others and could provide investors solid returns over the long term.

An example of a great business like this would be Coca-Cola (KO:NYSE), because of its world-renowned brand recognition which could be classified as an “economic moat”. By the mid 20th century, Coca-Cola became the world’s most prominent cola, and for over 70 years the company maintained its market-leading advantage, where today it continues to hold approximately 45% of the American carbonated soft-drink market in the U.S., according to Statista. The cash flow generation for a company that can stay relevant and maintain a leading market share position since the mid 1900’s is quite impressive. And Coca-Cola’s stock price has mimicked the growth of these cash flows since its IPO, up over 8,000% which does not include the hundreds of dividends received by shareholders.

A great business with an economic moat that trades at a fair price from our research is Alphabet Inc. (GOOGL:NASDAQ). When someone pulls out their phone to answer a question like; how old is Brad Pitt? Or when was the last time the Leafs won the cup? Most people navigate to Google’s search function, which is why the company maintains 90% market share of the global search market. This advantage could be seen as part of its economic moat. Add in its control of YouTube, the largest and one of the only social outlets giving content creators control of their own destiny, one can see the overall competitive advantage of the business on a global scale. In May 2020, our original recommendation, the stock traded at 32 times earnings, which would not be considered cheap by traditional valuations. However, given its growth, it was reasonably priced in relation to the other FAANG stocks. At the time, the stock traded at $1,413.17 per share. Today that great company, which traded at a fair valuation, has continued to perform excellently. Alphabet now trades at over $2,700 per share, for a return of over 91% in just under 16 months since our initial recommendation.

This economic moat investment strategy of buying great businesses at fair values rather than discounted prices was what Warren came to learn early in his relationship with Charlie. Arguably, as Berkshire Hathaway grew to a multi-billion dollar holding company, Warren would have been pushed into buying fewer low liquidity stocks and purchase excellent businesses at fair prices. Now it’s not that Warren is unable to uncover larger stocks trading at a deep discount to the market, but it is a much more difficult process to find when you are trying to allocate hundreds of millions of dollars into an investment position.

What’s the bottom line? Both Charlie and Warren’s valuation principles were the same, never purchasing over-valued stocks in relation to their cashflows. But ultimately, the stocks that they gravitated to at the beginning of their careers had a very different profile. To achieve a diversified mix of stocks in your portfolio, the key is to add stocks with the profile of each strategy to gain exposure to a multitude of market opportunities. Be it the good business trading at a deep discount to the market, or a business with an economic moat at a fair price that will compound cash flow into the future.

This article was inspired by the 2017 HBO Documentary called “Becoming Warren Buffett”, which can be watched for free on YouTube here:

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