READING TIME: 4 MINUTES

Investing is hard, but that doesn’t mean we can’t simplify the ideas behind an investment philosophy and come to understand it. As Naval Ravikant (@naval on Twitter) reminds us:

It’s the mark of a charlatan to try and explain simple things in complex ways and it’s the mark of a genius to explain complicated things in simple ways.

Charlie Munger is a genius, and so he is able to breakdown his investing philosophy in a manner we can understand. In an interview with the BBC in 2012, Charlie outlines the four filters a company must pass through if he and Warren Buffett are going to make an investment. You can watch a version of the interview on YouTube here:

The entire video is worth watching, but the quote below is from the 6-minute mark where Charlie walks through his 4 filters. I’ve added the numbers for clarity:

1) We have to deal in things that we’re capable of understanding, and then once we're over that filter,

2) we have to have a business with some intrinsic characteristics that give it a durable competitive advantage.

3) And then of course we would vastly prefer a management in place with a lot of integrity and talent, and finally,

4) no matter how wonderful it is it's not worth an infinite price. So we have to have a price that makes sense and gives a margin of safety considering the natural vicissitudes of life.

Let’s walk through these one at time.

1) We Have to be capable of understanding the business

This is the first filter for a reason. Charlie says that if you don’t understand the business, you shouldn’t buy it. With enough effort and research, and if you are a person of reasonable intelligence, you can likely come to understand many businesses. How it makes money, how the industry that it competes in works, the company’s risk factors, etc. But, Charlie and Warren are incredibly good at staying within their circle of competence, and you should too.

I don’t understand the insurance and reinsurance business, but Warren Buffett has made his fortune in it. What’s right for him may not be right for me. I don’t invest in banks because they’re too hard for me to understand. No matter the amount of research, I’m not going to invest in Wells Fargo. Apple, on the other hand, I can understand - I own and use its products and services, understand where the company has been and generally where it’s going, have a handle on the smartphone market generally, etc.

The key here is to stay within your circle of competence, and don’t buy stock in a business you don’t understand.

2) The business has to have a moat

A company’s moat is the intrinsic characteristics that give it a durable competitive advantage. I wrote an article on moats a few months ago - feel free to read it here.

For a company like Coca-Cola, its moat is its recipe (kept secret for more than 100 years), as well as its brand (you don’t ask for a cola, you ask for a Coke). For a company like Apple, its moat is its brand and its network effect (Apple Store, Apple Pay, iCloud, etc. all selling you convenient services you want - and the more people who use it, the more valuable these services become). For a company like Walmart, its moat is its low-cost acquisition of goods, meaning it can sell things to you cheaper than the competition.

3) We Prefer a management team with integrity & Talent

In my view, and based on Warren Buffett’s letters to Berkshire Hathaway shareholders over the years, this refers to a management team that thinks like an owner, tells shareholders the truth, and works to widen the company’s moat over the longterm. I am looking for Chief Executive Officers (preferably founding CEOs) who have skin in the game, own stock, and put the longterm well-being of the company over their bonus checks. They should buy-back shares only when the share price is below intrinsic value, spin off parts of their business to shareholders, work diligently to keep debt at a minimum, and reinvest free cash flow intelligently to grow the business.

4) The stock price has to give a margin of safety

I’m sure Charlie does make some (read ‘very few’) mistakes, but he rarely loses money on those mistakes because he purchases stocks only when there is a significant margin of safety. A margin of safety price is one that he considers well below the intrinsic value (or fair value) of the business. How do we figure out intrinsic value? We learn as much as we can about the company, its competitors, the industry it’s in, and then analyze its financials to try to come to a range of intrinsic value. Then, you discount it significantly to a margin of safety price, just in case you’re wrong about the business. The margin of safety price ensures protection from “the vicissitudes of life,” as Charlie puts it. Stock valuation is not an exact science, but when you incorporate a significant margin of safety, it doesn’t have to be.

There you go, 4 of Charlie Munger’s stock filters when he’s considering an investment. As a reminder, always do your own research, and find the investment approach that works best for you.

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Watch the entire BBC interview with Charlie Munger here.