By Krisztian Fekete and Kermit C. Zieg, Ph.D.
Great investors usually have different views on the investment
field from average traders. They have thinking patterns or thinking
models in their heads. If a company is under their magnifying
glass, they discover the key elements of its business and notice a
connection that the average trader would not be able to discover.
In this article we will demonstrate this process with some of the
patterns or models of investing legend Charlie Munger, the right
hand of the world's most successful value investor, Warren Buffett.
Munger is the vice-chairman of Berkshire Hathaway, a diversified
investment corporation. His breadth of view, combined with his
sharp mind, gives many lessons to investors all around the
world.
The models Munger uses are not difficult to understand or use if
someone decides to adapt them to his or her search for investment
opportunities. Munger is a long-term investor. He looks for solid
companies that are strong and could be hiding a great investment
opportunity for those who can read between the lines.
Before he invests, Munger has to prove that the company will be worth billions of dollars in the long run. This self-proving process has simple steps, with many years of collected wisdom behind his notions.
First notion: think simply. To arrive at the right solution, Munger simplifies the problem. If the problem is simplified, one finds it easy to determine a simple question regarding the solution to the problem. Simplification is the first step toward solving a problem.
Second notion: use the language of math, the language of the trading world. Munger emphasizes this when he talks about Galileo Galilei, the famous 16th-century Italian physicist, astronomer, and philosopher. Galileo was closely associated with the scientific revolution and believed that math also worked in practical life. Munger tries to use it as often as possible in the trading world.
Third notion: think in reverse. To be able to solve problems and make good decisions, an investor has to learn to think in reverse. No matter if one goes back just to the source of a problem or back in time, one has to be able to think this way and then recognize when to use this application.
Fourth notion: elementary academics. One needs to have practical knowledge or the wisdom of elementary academics. Since no trader can always rely on the advice of the smart man, his wisdom has to cover a wide range of the academic world: history, chemistry, religion, physics, and other fields.
Fifth notion: the "lollapalooza effect." With critical mass, you get a nuclear explosion. Munger believes there are rules governing the world similar to the nuclear explosion in every field. You can find this "lollapalooza effect," for example, in a personal relationship. If a woman does not tell her partner what bothers her or what she thinks about his behavior, the relationship will fail. The woman will reach a point where she can't tolerate any more, and will explode…like an atomic bomb.
Munger's Notions in Practice
Let's look at Munger's notions in practice by testing them on a real-life company. I chose The Hershey Company, leading snack-food company and largest North American manufacturer of quality chocolate and non-chocolate confectionery products, as well as chocolate-related grocery products.
Our question: Is Hershey's a good investment? Let's see how it fits Munger's notions.
There is simplicity in The Hershey Company business. Everyone can understand how this company works. They use quality ingredients and have an old and proven recipe. It is simple. They make the same chocolate that they did many years ago. Even the machines are the same. Their distribution system works well. There is no high tech research needed here. Furthermore, Hershey's has a strong trademark; it is a simple and understandable business. Everybody likes chocolate! Milton S. Hershey, founder of The Hershey Company, spent several years working day and night to produce exactly the right flavor. The other important thing is that Hershey's uses the same formula today.
The Hershey Company first grew to be the best chocolate manufacturer in Chicago. Next, it became the largest North American manufacturer of chocolate and non-chocolate confectionery products. Today it sells its products in more than 90 countries worldwide.
Next, let's work with numeric fluency (the second notion—speaking the language of math) to see our target for the next 30 years. Hershey's numbers can show us the possibilities. The last six years tell us that the company's sales grew 4.8 percent. To understand the attractiveness of the stock, one has to know that the yearly dividends were 11.5 percent. Dividends reached $4.835 billion in 2005 (according to the data of Yahoo Finance.) If the increased dividends are continuous, one can assume a reasonable target for 2036 would be $18.83 billion.
If we think in reverse (the third notion), we can realize that The Hershey Company manufactured its chocolates with the same machinery 30 years ago. This fact helps us understand that they don't have to invest in new technology to keep up their production. They can use their old technology because their magic is in the Hershey's flavor and not in extravagant equipment.
Added to that fact, if we are thinking about investing in Hershey's, we don't have to be afraid of a war or a recession because the past has shown that during World War II, Hershey's produced the same amount of chocolate and sold it for a higher price. During those years in wartime, people who lived in the United States saw the price of sugar go up to the sky. Hershey's just raised the prices of their chocolate and people were still buying the ultimate joyful resource. In Europe during World War II, the value of chocolate was higher than it had ever been before.
We also need to consider the possibility of a lollapalooza effect (fifth notion) in the sales of Hershey's chocolates. To see this possibility, let's return to the Hershey trademark. We need to understand the essence of the business in elementary academic terms (fourth notion). Munger knows from his psychology courses that Hershey's is doing business by producing chocolate and maintaining conditioned reflexes through operant stimulating and conditioning. The packaging of the chocolate and the Hershey name are the stimulators. The buying and eating of the chocolate are the desired responses. Hershey's reaches these reflexes with classical Pavlovian conditioning.
The Hershey product has to have the elements—that is, the quality of the product's ingredients—that can effect this conditioning. Hershey's cares about all parts of the product. For example, they built their own milk-processing plant.
The other operant conditioning category is the shape of the chocolate and its texture. Hershey's packaging could condition most buyers. Munger would agree that, to get a lollapalooza result, Hershey's would need to compete with the best from every category. As long as Hershey's can continue to create a permanent obsession for its product, the company's growth will continue.
Finally, advertising—expensive, yet direct stimulation—is a helpful tool to condition Pavlovian reflexes to Hershey's. When we see its advertising images, we will want to eat Hershey's chocolate to experience this ultimate joy.
Reality Check
In his book, Poor Charlie's Almanack, Charlie Munger analyzed Coca-Cola and used reverse thinking to consider what to avoid. Four answers came up:
1. Avoid Coke's cloying aftertaste. Well, Hershey's chocolate
has no aftertaste so this isn't an issue.
2. Coke had to avoid losing even a small part of its powerful
trademark. For The Hershey Company, in 2006 for the nine-month
period, under Generally Accepted Accounting Principles (GAAP), the
net sales increased about 3 percent, coming in at $3.6 billion.
Operating income increased approximately 25 percent to $712.5
million (according to Motley Fool's "Hershey Needs a Chocolate
Fix," October 20). Net income appreciated by almost 26 percent to
$403.1 million, or $1.68 per diluted share. Since Hershey's had
grown, it was able to buy out the smaller quality companies. CEO
Richard H. Lenny recently said he wanted to refresh the business
and he believed that acquisitions could help. His release talks
featured the purchase of Dagoba Organic Chocolate. He also
mentioned previous acquisitions, such as Scharffen Berger and Cacao
Reserve. These were great signs of defending the company's
trademark.
3. With realizing huge success, a company has to avoid envy. To
avoid envy, The Hershey Company had to sincerely deserve its
success. It had to be fanatic about delivering reasonable prices,
nice packaging, quality in its chocolate, and harmless pleasure to
its consumers.
4. If Hershey's wishes to continue to dominate the new markets, it
has to be able to resist the desire to change the flavor of its
chocolate. Hershey's competitors can't copyright its old taste.
Added to that philosophy, Munger thinks that the "take-away"
syndrome could cause huge damage to Hershey's trademark, even if
the new flavor shows better results during the testing period.
Hershey's needs to preserve its trademarked flavor.
Conclusion
Considering these factors, we can get a better understanding of the many important factors of The Hershey Company. The conclusion is that it is a good investment (if the price is reasonable). Hershey's manufactures and sells "pure joy" in an edible form. The product is good and the company can deliver it to many people. The constant use of its advertising vehicle can stimulate the potential buyer perfectly. Hershey's can easily pay back its debt and the company pays a fantastic dividend. It is growing year after year and doesn't have to spend money on new technology or upgrading its current machines. It has used the same machines for 20 years and will use the same ones in the future. For the next 30 years, the product can captivate new markets and Hershey's has the potential to become a legendary firm.
Krisztián Fekete, a Ph.D. student at Rushmore University, is the author of Habits of the Master Traders [ITAL BG] (iUniverse Inc., 2007). His e-mail address is mentalhabits@gmail.com .
Kermit C. Zieg, Ph.D., is a professor of finance and
management at Florida Institute of Technology, and is a nationally
recognized expert in the fields of finance, investments, and
management. He is author of The Complete Guide to
Non-Directional Trading (Traders Press, 2006)
and The Complete Guide to Point-and-Figure Charting: The
New Science of an Old Art (Harriman House Ltd.,
2003).
