Always invert

Book review of Poor Charlie's Almanack

Gesda Capital is born

It took way longer than anticipated to write the next post. Many developments occurred since my last writing. My business partner joined me on 1 April and last week we made it official with a big story in Denmark’s largest business newspaper. Gesda Capital has been born. Our firm is in the process of getting a license as an investment advisor with the local financial regulator Finanstilsynet. As soon as the license has been granted we will become an investment advisor on a global equity fund.

As I described in an earlier post, there are some distinct reasons for why active equity managers fail to outperform the market. Gesda Capital is set to address all these reasons and show that active equity investing can be done in a different way. I also firmly believe that technology will dramatically change the landscape for active equity managers. A unique opportunity exists today for new equity managers that might not exist in 10 years. I will elaborate on this topic in the future.

Why a book review instead of the tariffs shock?

Back to what this post is all about. A book review. You might be thinking, why is he writing a review of a book, when Trump has just created the biggest shock to the global trading system in 100 years? Well, I promised to write the book review and in a surprise turn of events, the lessons in the book are very useful to help your mindset navigating the chaos of Trump’s trade policy.

I might squeeze in my views on tariffs and their impact on equities before I write about Palantir’s valuation that I have also promised. I just want to get my thoughts right first about tariffs, just like I waited with writing about DeepSeek, before submitting my views. It has actually been a benefit to not rush my thinking as Trump’s trade policy is in flux and changing every day.

Munger’s evolution of thinking

I read the fourth edition from 2023 of Poor Charlie’s Almanack by Peter D. Kaufman. It is not as much a book as it is a collection of essays or talks that Charlie Munger has given over the years while he was alive.

Charlie Munger was the long-term partner of Warren Buffett, and I have come to the conclusion over the years that it was Munger that saved Buffett from himself as Buffett was still stubbornly applying Benjamin Graham’s thoughts about deep value stocks. Munger helped Buffett evolve throughout the 1970s appreciating other aspects about businesses including intangibles as a way to survive the stagflation period of the 1970s and early 1980s through better competitive advantages.

Munger starts off in the book with a rebuttal denying my thoughts that Munger was the great enlightener of Buffett. He says that he would have been spectacularly successful regardless of whether he had met him (Munger) or not. Successful yes, but not wildly successful as he has become. If you read the book, you will understand why. Munger has a unique mindset.

There are 11 talks in the book, ranging from 1986 to 2005, highlighting the evolution of Charlie Munger’s thinking over the years. His candid approach, opinions about life, and the stupid decisions we humans make shine through all the time. Instead of making a classic book review, I will zoom in on three key topics from the book and extrapolate those points into other subjects for wider understanding.

Always invert

It is quite clear as you progress through the talks that the early Charlie Munger had a huge appetite for knowledge that he applied when needed. Later, it becomes clear that he developed mental models to understand the world with especially psychology (focus on human decision making) being super important to him. Over time, he also draws more and more parallels to biology seeing that the economy is a highly dimensional, complex adaptive system. Just like biology.

In talk number four, Munger discusses problem-solving and explains that many problems cannot be solved through forward analysis. He leans on the phrase from the great algebraist Carl Jacobi that was famous for saying “invert, always invert”. In Munger’s world, that means risk management (avoiding failure) is more important than maximizing success, which means not applying leverage to investing and buy stocks with a safety of margin. It leads to prioritizing long-term investing over market timing, ignoring market noise, and focusing on fundamental value.

Another way that Munger is using inversion is in life’s decisions. So instead of thinking about doing the right things in life (which can be much more difficult to get right, or even execute on), it is easier to find the things that will fail in life. For example, Munger mentions, sloth, unreliability, intense ideology (he calls it the worst virus a human can get and something that is very destructive for the mind), and a self-serving bias to mention a few.

My own contribution from the inversion principle is to apply it to decision trees. These can be related to a business or your personal life. Navigating a decision tree forward often resembles a random walk, where choices at each node rely on instinct rather than strategy. By “solving” backwards through the decision tree, the decision nodes can be acted upon because you have a plan that is the one that connects the future backwards to your starting point today. Inverting the decision tree forces you to visualize the solution imaginatively and work backward. Most likely from first principles.

On the topic of “invert, always invert”, I also immediately made the connection to the work of Michael Mauboussin and Alfred Rappaport on equity valuation. In their work they also invert the thinking on discounted cash flow (DCF) models. I had always been skeptical of DCF models because of their sensitivity induced by my own input. It just didn’t seem logical to me. But when I read about their inversion of the DCF model, it finally made sense.

The classical DCF model starts with you as an analyst or investor forecasting the business fundamentals into the future and discounting the future free cash flows with a discount rate to get to the valuation of the company. If it is higher than what you observe in the market, you buy, or else you sell. You can essentially make up the valuation to be whatever you want and there are nobody to stop you. Because humans are optimists things quickly go wrong in this methodology.

Mauboussin inverts the model by taking the consensus estimates from analysts for the next couple of years and then forecast the relevant business fundamentals as far into the future as necessary in order to explain the current observable market value. By doing that you remove your own bias in the model process and you get what expectations that are implied in today’s stock price. By inverting the original methodology, you get a much more stable framework and a better thinking about future returns.

I know the inversion of the DCF model was a detour, but I wanted to highlight a practical example from my own experience of inverting and why this idea is so powerful. Another one is something that is useful in today’s market. As volatility and information frequency increases we tend to process the environment faster and make quicker decisions. You should in fact invert. Slow down your thinking to avoid instincts taking over. Be rational.

Psychology as the ultimate mental model

As you read through the talks, you will notice how Munger’s interest and almost love affair with psychology develops. More broadly he develops mental models to analyze the world. This is a quite powerful technique as complex system can never be “solved” correctly. Accompanying his mental models, Munger is also fan of checklists like the flight captain before takeoff. They ensure nothing is overlooked.

In investing checklists are good. You can have checklists on a new investment or on your portfolio. They work wonders to control your emotions when the speculative fever runs high in financial markets. After the 2020 pandemic selloff reversed, I discussed with my former boss about how we could ensure that we would get a crisis like that right in the future. What had we learned from the experience that could form a checklist for the future? I often think back on this discussion with the ongoing uncertainty around the Trump administration’s tariffs game. Markets, like during the Covid-19 pandemic, will turn around long before things get better. As soon as the second derivative goes down, that the craziness is not getting crazier on tariffs, the market will begin to see through the short-term noise and improve.

In talk number four, Munger goes into explaining the lollapalooza effect which creates extreme outcomes when multiple psychological biases or forces interact in the same direction. He uses the framework to explain why Coca-Cola has been so successful including many different psychological biases. There are two things to be said to this story. First, I think his Coca-Cola explanation is a demonstration of a wildly successful person that has convinced himself of the wonders of psychology and mental models, and use it to explain his investment in Coca-Cola. I think the extreme success of Coca-Cola can largely be reduced to industrialized sugar and added flavour ingredients triggering forceful feedback loops in our primodal brains that basically creates addictive behaviour — and that’s typically a profitable business model. Add a lax regulatory oversight and you have an obesity epidemic. Not only because of Coca-Cola but because of the industrialized food industry.

My second observation on the Coca-Cola story is on page 173. Munger demonstrates that even he and Buffett succumb to extrapolation errors. He forecasts, in his own view a reasonable forecast consistent with past experience, Coca-Cola to hit a market value of USD 2 trillion in 2034. With the current market value at USD 313 billion, the stock price would have to increase annualized by 23% to hit that prediction. What happened since his 1996 speech? A general focus on health, competition from PepsiCo, and lately GLP-1 drugs. Coca-Cola may be mispriced if GLP-1 drugs—as they become more effective, affordable, and safer—reduce demand for sugary beverages. A potential case study on why 'buy-and-hold-forever' strategies can fail.

In talk number 10 there are two take-aways that people should take to their heart. Munger talks about Confucius that said acquisition of wisdom is a moral duty. In plain Munger language: “You are not going to get very far in life based on what you already know.” He goes on to tell a story about Salomon Brothers where the general counsel fails to convince the CEO about wrongdoings at the firm. He presented a painful message to a busy man and nothing happened. Munger said, referring to Benjamin Franklin (his big hero): “If you want to persuade, appeal to interest, not to reason.” Basically, the self-serving bias of man is extreme. The general counsel should have said that ignoring the wrongdoings would destroy the CEO. Quick action would likely have followed.

The last talk (number 11) is essentially a combination of three previous talks and a talk that was never made, but included in the book after revisions by Charlie himself. It is titled “The psychology of human misjudgment" and covers 25 human biases which are essential to understand as human in order to thrive. The more self-awareness we can obtain in relation to these human biases the better we can become avoiding the big pitfalls in life.

I have also come to the conclusion like Munger after living 40 years on this planet, that you only have to avoid the biggest mistakes in life for you to be ahead of 98% of all other people. It is inversion at play again. Avoid mistakes and you will be successful, instead of betting the farm in order to get rich as fast as possible. That is not to avoid all risks because that is impossible in business and investing, but just avoid those that can blow you up big time.

Investing philosophy

Talk nine is the talk where Munger fleshes out the wonders of a multidisciplinary approach and investing. His point number four in this talk is that there is too much emphasis on macroeconomics. While I tend to agree, I also think he suffers from selection bias as he invested primarily during the era of American Exceptionalism and I am not sure investors can ignore macroeconomics and geopolitics going forward like Munger subscribes.

He explains in his speeches the famous “sit-on-your-ass” investing which is a metaphor that we are our own biggest enemies. We want to constantly change our portfolio and react to information. Munger emphasizes patience, advising investors to wait for those rare high-conviction opportunities that will come your way in life. Investing is hard and highly competitive, so the very good deals, those you can sit on for decades to let compounding do its wonders, come very rarely. Often they arise during crisis moments, so the period we are in now will likely produce some extraordinary opportunities for the prepared minds.

Overdiversification is also something Munger advocates investors avoid. Great results do not come from spreading your capital across many mediocre ideas. Investors should focus on the very best ideas. In order to implement such a strategy you must be able to be an independent thinker and train yourself to tune out market noise. The way I expressed this lesson in my previous work as a strategist was to completely avoid reading research papers from other investment banks. Reading other people’s ideas will quickly shape your own thoughts making them less original.

He has another interesting idea in investing and that is “destroy your favourite ideas annually” which is to say never fall in love with existing investments. It immediately led me to think about an interview I listened to recently with the co-founder of GQG, a very successful equity manager, Rajiv Jain. In the interview, Rajiv talks about offensive and defensive research with offensive being researching new ideas and defensive research being updating models and analyses of existing investments. His ideal approach was to spend 75% of your time on new ideas. That goes to Munger’s idea of killing your own best ideas.

One thing you discover in the book is that Munger never talks about numbers like valuation multiples etc. There is no formalized checklist, and if there is, it is not one he is willing to talk about. He talks about owners’ earnings, another word for free cash flow, and the margin of safety which is a different framing of not paying too much for a business.

He also has a key learning about management. It is a hugely important factor in your investment decision process, but deciding between a stellar management in a mediocre business or mediocre management in a superb business, you should always choose the latter. Go with business momentum over management acumen.

Charlie Munger was a fascinating individual and his thinking was quite unique. Many investors and business people could learn from his mental models. But if there is one thing I take away from the book, it is to be curious. The more diverse subject fields you read about the better your ability to do synthesis and see the bigger picture. Every field—from biology and physics to psychology—has some key major insights that can be re-used in a different setting and in Munger’s case investing. If you only do numbers in Excel, or statistics in Python, and generally are one-dimensional in your thinking the investment environment is going to be tough for you.

Where can you interact with me?

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