When the venerable Charlie Munger died in November, aged 99, it marked the end of the world’s most successful investment partnership with Warren Buffett, aged 93. Although junior in terms of ownership of Berkshire Hathaway, Munger was credited with persuading Buffett to pivot his investment process away from buying “fair businesses at wonderful prices” to instead “wonderful businesses at fair prices”.
But Munger was also the sceptical counterpoint in the 60-year friendship, with Buffett, the “Sage of Omaha” calling his devil’s advocate, who had a veto over improvident Berkshire acquisitions, the “Abominable No-Man.”
The Berkshire Hathaway investment process saw Munger typically evaluate the strength of Buffett’s bullish investment hypothesis, through applying his “inversion” principle: to flip a positive view on its head, understand the opposing arguments, and focus on the downside risk of any new investment.
As he put it: "I never allow myself to have an opinion on anything that I don't know the other side's argument better than they do." Munger thought his own secret to success was “to figure out what’s really stupid and then avoid it.”
Most stock market participants are incentivised solely by rising prices, which often leads to the over-promotion of the mediocre and occasionally the pumping of the downright fraudulent. It is worth remembering that when you make an investment, there is always a willing seller as a counterpart to the trade, who is acting out of opportunism, rather than charity.
Munger told the story of the man with a wonderful horse - “it's got an easy gait, good-looking but occasionally it gets dangerous and vicious” - who asks the vet what he should do? To which the vet replied: “That’s a very easy problem and I’d be glad to help you. The next time your horse is behaving well, sell it.”
As an investor who hedges market risk through short-selling, I have successfully bet against the most notable frauds of recent times (Steinhoff1, Wirecard2 and NMC Healthcare); some of the more egregiously valued fads (such as electric truck maker Rivian3 or vegan food outfits Beyond Meat4 and Oatly5); as well as all four banks6 that went bust last Spring, spotting the balance sheet issues at Silicon Valley Bank7 ahead of its spectacular demise.8
Although shorting is a skill that even most professional investors find difficult, applying the same sceptical discipline to investing decisions is a pre-requisite for all investors to avoid costly mistakes. We all know that “a fool and his money are easily parted” but often think it applies only to somebody else.
Whilst these successful shorts may now look obvious in retrospect, at the time, the average opinion, as expressed by the market price, disagreed. No one should ever confuse scepticism (or short selling) with entering a popularity contest, for true scepticism involves betting against the herd instincts of the crowd, which most people find emotionally uncomfortable.
Jesse Livermore, who briefly became the world’s richest man during the 1929 Wall St. Crash, trading only his own self-made capital, observed: “people want the safety of human company. They are afraid to stand alone because they want to be safely included within the herd, not to be the lone calf standing on the desolate, dangerous, wolf-patrolled prairie of contrary opinion.”
The logical consequence of this is that a popularity seeking personality can be an impediment to the necessary scepticism for investment success. Although I hope readers find my views interesting, this author will never seek to proselytise, since every transaction requires someone with an opposing view, to take the other side of the trade.
Investing is a unique pursuit in that the best opportunities come when others vehemently disagree (and your view proves correct). But unlike other areas of modern society, there are no “subjective truths,”: the outcome of the debate is always determined by the market. As Munger remarked to his partner: “Warren, if people weren’t so often wrong, we wouldn’t be so rich.”
It is also prudent for investors to be sceptical of so-called “expert opinion” upon which there is often still an unhealthy trust, particularly when opinion is overly reliant on “scientific” projections from a mathematical or quantitative model, which are only as good as their human inputs.
It should be anathema for any responsible investor, to outsource wisdom to “professional” opinion, but still retain accountability, without first understanding and questioning the cognitive biases of “experts.” As Munger concluded: “I have never seen a management consultants’ report in my long life that didn’t end with the following paragraph what this situation really needs is more management consulting.”
It is also worth considering what might happen if scepticism was somehow outlawed, and listed companies were not subject to public scrutiny. Stock prices might become detached from the health of the underlying business, which I define as its ability to generate cashflow to reinvest in growth or reward shareholders.
There would be no market mechanism to sort the wheat from the chaff. Bad or dishonest companies might be able to raise money more easily than good ones, only for shareholder funds to be either misappropriated or invested in bad ideas for which there is no sustainable demand. Overvalued stocks make for inefficient capital allocation leading to lower returns for investors and lower growth for the wider economy.
When this column was first suggested as the “Investment Pessimist” I recoiled, since pessimism is an emotion which implies a dogmatic outlook. By contrast, “scepticism” is a rational thought process through which greater wisdom is acquired, leading to better decision making.
Although I do not claim to have a monopoly on investment wisdom, it has allowed me to navigate the vicissitudes of stock market fortune and generate positive double digit returns in each of the last five calendar years, a unique feat in the UK fund management industry.
I intend to write less about specific stocks but instead make more general observations in the hope that the “Stockmarket Sceptic” might offer useful investment insights for readers into the bigger picture.
There are few economic ailments for which the cure is not a healthy dose of scepticism.