Charlie Munger's Legacy: ROIC, Quality, and Berkshire's Success

Dear Shareholders of Berkshire Hathaway, join us in honoring the legacy of the esteemed Charlie Munger, whose investment philosophy has shaped the company's success. Explore the enduring relevance of ROIC and business quality, exemplified by Berkshire's investment in Apple, and discover how Munger's wisdom continues to illuminate the path for prudent investing.

Introduction

The investment world recently bid farewell to one of its most esteemed figures, Charlie Munger, who passed away on November 28th, 2023 ↗. As the vice chairman of Berkshire Hathaway, Munger's profound wisdom and investment philosophy have been instrumental in shaping the company's trajectory and the broader investment landscape ↗. His legacy is etched in the principles of investing in high-quality businesses and the critical metric of Return on Invested Capital (ROIC), which he championed as a cornerstone of evaluating a company's enduring value.

Munger's investment strategy was never about chasing short-term gains or succumbing to market hysteria. Instead, it focused on the long-term potential of businesses, emphasizing that the quality of a business is far more significant than the price of its stock ¹. This philosophy has not only guided Berkshire Hathaway to remarkable success but has also left an indelible mark on the minds of investors worldwide.

As we stand at the threshold of a new year, it is an opportune moment to reflect on how Munger's principles of ROIC and business quality have contributed to the creation of long-term shareholder value ↗. Berkshire Hathaway's current market position and its performance over the past year ⁶ are testaments to the enduring relevance of Munger's insights.

In this article, we will delve into the essence of Charlie Munger's investment philosophy, dissect the importance of ROIC, and examine how these elements have influenced Berkshire Hathaway's success. We will particularly focus on Apple Inc. as an exemplary case of high ROIC and its profound influence on Berkshire's portfolio. As we evaluate Berkshire Hathaway's performance at the year's end, we honor the legacy of Charlie Munger, whose thoughts on ROIC continue to illuminate the path for prudent investing.

The Philosophy of Charlie Munger

Charlie Munger's investment philosophy is a beacon of clarity in the often murky waters of the stock market. He famously eschewed the practice of over-diversification, which he deemed as madness, advocating instead for a concentrated portfolio of high-quality businesses ¹. Munger's approach was not about owning a piece of everything but about understanding a few things deeply.

His preference for investing in quality businesses over stock prices is a testament to his belief that a company's intrinsic value is paramount ¹. Munger often spoke of "intelligent fanatic" management—leaders who are not only exceptionally capable but also deeply passionate about their businesses. These rare individuals, according to Munger, can significantly impact a company's success ².

Munger's speeches, such as the one at the University of Southern California Marshall School of Business, have become almost scriptural for investors. He emphasized the importance of focusing on the micro aspects of a business rather than getting distracted by macroeconomic predictions ¹. This approach has been a guiding principle for Berkshire Hathaway, steering clear of investment decisions based on macroeconomic forecasts.

The essence of Munger's strategy was to avoid dumb mistakes, a seemingly simple yet profoundly impactful approach to investing ¹. His influence on Berkshire Hathaway's investment decisions is evident, with the company's portfolio reflecting a clear preference for businesses with strong fundamentals and excellent management teams.

As we reflect on Munger's legacy at Berkshire Hathaway, it is clear that his philosophy continues to guide the company's investment strategy, ensuring that his wisdom endures even after his passing.

Understanding ROIC

Return on Invested Capital (ROIC) is a metric that stands at the heart of Charlie Munger's investment philosophy. It measures the after-tax profits a business generates annually relative to the capital required to run the business, providing a clear picture of the efficiency and profitability of a company's operations ³.

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -- even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result.

ROIC is a powerful indicator of a company's health and future performance. It reflects how well a company is using its capital to generate profits, which is a crucial consideration for any investor looking for sustainable returns. Historical trends show a strong correlation between high ROIC and superior shareholder returns, underscoring the importance of this metric. Charlie said ¹:

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -- even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result.

The case of AT&T Inc. serves as a cautionary tale, with its ROIC declining from 16% in 1998 to an average of 1% from 2020 to 2022, leading to stagnant or declining revenue, profits, and free cash flow ³. In contrast, Old Dominion Freight Line, Inc. saw its ROIC improve from 8% in 1998 to 33% in 2022, resulting in significant outperformance of the broader market in shareholder returns ³.

A company's competitive advantage and industry structure are critical factors in assessing the future path of ROIC. Companies that are protected from competition due to network effects, regulatory barriers, scale advantages, and unique brands typically enjoy high and stable ROICs ³. Thoughtful capital allocation also plays a pivotal role, as many high-ROIC businesses generate substantial cash that can be reinvested to strengthen operations and reward shareholders.

Understanding and prioritizing ROIC is not just about recognizing the current profitability of a business but also about predicting its capacity to continue generating value for shareholders in the long run. Charlie Munger's understanding of quality and associated insights has been a key factor in driving the success of Berkshire Hathaway, and it remains an essential tool for investors seeking to emulate his investment acumen. Note that Charlie Munger disliked any kind of too arithmetic approach ⁹:

There isn’t a single formula. You need to know a lot about business and human nature and the numbers…It is unreasonable to expect that there is a magic system that will do it for you.

In turn, ROIC may serve as a suitable first step to investigate the future prospects of a stock. But the mere metric does not replace a thorough understanding of the underlying business. There is "no magic system" or magic metric for that matter.

The Apple Example

When examining the landscape of high-quality businesses with exceptional returns on invested capital (ROIC), Apple Inc. stands out as a paragon, boasting an ROIC that exceeds 900% ⁴⁷. This figure is not just a testament to Apple's operational efficiency but also a reflection of Charlie Munger's investment philosophy, which has significantly influenced Berkshire Hathaway's decision to invest heavily in the tech giant ⁵.

Apple's strategy of maintaining minimal fixed assets and operating with negative working capital is a masterstroke that has allowed the company to generate massive profits from relatively modest investments ⁴. With only $52 billion in fixed assets and a negative working capital of $44 billion, Apple produced around $100 billion in after-tax operating profits in fiscal 2022 ⁴. This lean approach, combined with a design-focused business model where the supply chain shoulders much of the heavy lifting, contributes to Apple's unmatched ROIC.

Comparing Apple's ROIC to other tech titans like Microsoft and Amazon reveals the extent of its outperformance ⁷. While these companies are successful in their own right, Apple's ability to create substantial profit from minimal investment sets it apart and may help explain its high price-to-earnings (P/E) multiple of 29x forward earnings ⁴.

Berkshire Hathaway's significant stake in Apple, which constitutes 50.43% of its stock portfolio, underscores the conviction in Munger's principles ⁵. The investment, which cost Berkshire $36.3 billion, has grown by 386%, showcasing the power of aligning with high-quality companies that demonstrate extraordinary ROIC ⁵. This is particularly noteworthy given the rarity of finding such companies with huge market caps, an advantage that retail investors can leverage ².

Berkshire Hathaway's minimalistic Year in Review

The year 2023 has been another chapter of success for Berkshire Hathaway, marked by a robust performance that reflects the enduring wisdom of Charlie Munger's investment philosophy. As of December 29, 2023, Berkshire Hathaway's market capitalization stood at a formidable $776.891 billion, with its stock price closing at $356.66, up from $308.09 at the end of 2022 ⁶. This growth is not only a result of the company's diverse portfolio but also a significant contribution from its largest holding, Apple, which has continued to deliver outstanding returns.

The investment strategy of Berkshire Hathaway, deeply rooted in Munger's teachings, has consistently favored quality over quantity, shunning over-diversification in favor of concentrating on businesses with high ROIC and enduring competitive advantages ¹. This approach has proven to be a bulwark against the economic and political headwinds of 2023, allowing Berkshire to maintain its trajectory of growth and resilience.

Looking ahead, the post-Munger era presents both challenges and opportunities for Berkshire Hathaway ↗. The company's unwavering commitment to the principles that have served it well in the past will be crucial as it navigates the evolving landscape of global finance.

Of course, all shareholders of Berkshire Hathaway are eagerly waiting for the detailed annual report 2023 to be released roughly at the end of February 2024 on BerkshireHathaway.com. ↗

ROIC in the Investment Process

Identifying businesses with high ROIC is a cornerstone of a successful investment process, a fact that Charlie Munger emphasized throughout his illustrious career. ROIC measures the efficiency with which a company utilizes its capital to generate profits, and it is a critical indicator of a business's quality and long-term viability ³.

In the quest for high ROIC investments, competitive advantages such as network effects, regulatory barriers, scale advantages, and unique brands play a pivotal role ³. These factors create moats that protect companies from competition, allowing them to sustain superior returns over time. The quality of management is also paramount, with Munger favoring "intelligent fanatics" at the helm—leaders who are passionate, visionary, and capable of driving their companies to new heights ².

Osterweis Capital Management, among others, has embraced Munger's insights by building portfolios concentrated on Quality Growth companies—those with high and stable or materially improving ROIC ³. These firms are often characterized by thoughtful capital allocation, leveraging their robust cash flows to fortify operations and reward shareholders.

For retail investors seeking to apply Munger's principles, the focus should be on identifying such high ROIC businesses, which may start small but have the potential to grow sustainably over many years ². Patience and a long-term perspective are critical, as the true benefits of investing in high ROIC companies often unfold over extended periods.

The investment landscape is ever-changing, and maintaining high ROIC can be challenging amidst economic shifts. However, by adhering to the tenets of Munger's philosophy and prioritizing the micro over the macro in investment decisions, investors can navigate these changes and continue to achieve substantial returns ¹.

The Legacy of Charlie Munger

In the grand tapestry of the investment world, few figures loom as large as Charlie Munger, the vice chairman of Berkshire Hathaway. Munger's legacy is one of profound insights, wit, and a steadfast commitment to a philosophy that has shaped a generation of investors and business leaders. His passing on November 28th, 2023, marked the end of an era, but his teachings continue to resonate with clarity and relevance ↗.

Munger's investment philosophy was elegantly simple yet deeply profound. He emphasized the importance of focusing on the quality of a business rather than the price of its stock, a principle that steered Berkshire Hathaway towards unprecedented success. His aversion to over-diversification, encapsulated in his belief that "the idea of excessive diversification is madness," has been a guiding light for investors seeking to build concentrated portfolios of high-quality businesses ¹.

Central to Munger's investment strategy was the metric of Return on Invested Capital (ROIC). He believed that, over the long term, a stock's return is tethered to the underlying business's ability to generate profits from its invested capital. Munger's focus on ROIC as a key determinant of a company's quality and its long-term success has become an indispensable tool for discerning investors ³.

His influence extended beyond ROIC; Munger was known for his appreciation of "intelligent fanatics" in management—leaders whose rare combination of intelligence and passion drives companies to exceptional heights. This appreciation for exceptional leadership is reflected in Berkshire Hathaway's portfolio, which includes companies known for their strong management teams ².

As we reflect on Munger's enduring legacy, it is clear that his principles will continue to guide Berkshire Hathaway and the broader investment community. His wisdom, particularly his focus on quality and simplicity, remains a beacon for those navigating the complexities of the market. The cultural and economic shifts of our time may pose new challenges, but the fundamental truths of Munger's philosophy are likely to withstand the test of time, continuing to inform and inspire personal and professional investment decisions.

Conclusion

As we close the chapter on 2023, the legacy of Charlie Munger stands as a testament to the power of a disciplined and principled approach to investing. His teachings on the significance of ROIC as a metric that matters have been borne out by the success of Berkshire Hathaway's investment strategy, particularly the monumental investment in Apple. This single decision, influenced by Munger's philosophy, has contributed significantly to the company's portfolio, with Apple shares comprising over half of its stock portfolio and delivering a staggering 386% gain ⁵.

The continued relevance of ROIC as a metric is undeniable, especially in an era where quality investing has become more crucial than ever. The outperformance of companies with high ROIC, such as Apple, underscores the wisdom of Munger's approach. Berkshire Hathaway's market valuation, with a market cap closing at $776.891 billion on December 29, 2023, reflects another year of success and the enduring value of Munger's principles ⁶.

As shareholders and admirers of Charlie Munger's work, we are reminded of the importance of adhering to sound investment principles, even amidst market uncertainties. The lessons from Munger's approach to investing—prioritizing business quality, understanding the significance of ROIC, and the importance of strong management—remain as relevant today as they were during his tenure.

In conclusion, Charlie Munger's legacy is not merely a historical footnote but a living framework that continues to drive Berkshire Hathaway and influence the investment decisions of countless individuals. His wisdom, characterized by a relentless pursuit of simplicity and quality, is a beacon that will continue to guide investors through the vicissitudes of the market. As we look to the future, we do so with a sense of gratitude for the insights Munger has provided and with a commitment to uphold the principles that have made Berkshire Hathaway a paragon of investment success. Charlie Munger's legacy is indeed timeless, and his investment wisdom will continue to be a gold standard for generations to come.

Let's close the article with a quote on life from Charlie that he shared with Becky Quick from CNBC in 2019 ⁸:

You don’t have a lot of envy, you don’t have a lot of resentment, you don’t overspend your income, you stay cheerful in spite of your troubles. You deal with reliable people and you do what you’re supposed to do. And all these simple rules work so well to make your life better.

In this sense, may each day in the new 2024 bring you joy and success!

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