Charlie Munger on the Art of Stock Picking

One of the most excellent investing resources out there on the internet is an 18-page document of Charlie Munger (Trades, Portfolio)’s famous speech on the “Art of Stock Picking.”

If you have not read the document, I highly recommend finding a copy and taking the time to study the advice this billionaire investor gives to his audience.

The main thrust of the speech is Munger’s belief that there are only a few great stocks on the market. Therefore, investors should concentrate their time, effort and money on the handful of companies that fall into this bracket.

This is the strategy Munger and Warren Buffett (Trades, Portfolio) have been following at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) for the past few decades. However, it is something that many Wall Street wealth managers (and wealth managers in general) advise against. They are more interested in building complex portfolios with a vast range of different strategies and styles.

Munger took aim at this approach in his speech. He noted that Berkshire’s system of buying large chunks of its favorite businesses is not “bonkers,” and that “It makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times.”

Munger drove this point home by asking his audience, “How many of you have 56 brilliant ideas in which you have equal confidence? Raise your hands, please. How many of you have two or three insights that you have some confidence in?”

From his response, “I rest my case,” it seemed that there was a lack of hands raised in the audience in response to the “56 brilliant ideas” question.

From here, Munger explained that, over the years, Berkshire had “made the [most] money out of high-quality businesses.” This was based on an analysis of the conglomerate’s best-performing investment.

The same was true of other major investors. “Other people who’ve made a lot of money have done so in high-quality businesses.”

The best way to find these companies, the billionaire went on to say, is to look for enterprises that have a high return on capital:

“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 a fine result. So the trick is getting into better businesses.”

Improving the process

It is usually misleading to say that any one particular statement or comment can help simplify an investment strategy. However, these comments from Munger can, in my opinion, help any investor improve their process.

If we look back at the track records of the best-performing investors of all time, they all made their money in a handful of businesses. These companies usually fell within their circle of competence and had a long runway for growth in front of them.

Hardly anyone can get rich by owning a struggling, shrinking business in a sector they know nothing about. If they do, it is by sheer luck.

The art of stock picking is all about finding high-quality businesses you understand and loading up on stock when the time is right.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.