Collection: Charlie Munger - #1 Lesson “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business” <<PART 2>>

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[Transcripts <<PART 2>>]

-THE HUMAN MIND HAS ENORMOUS POWER, BUT IT ALSO HAS STANDARD MISFUNCTIONS-

I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same.

And then when you get into psychology, of course, it gets very much more complicated. But it’s an ungodly important subject if you’re going to have any worldly wisdom.

And you can demonstrate that point quite simply: There’s not a person in this room viewing the work of a very ordinary professional magician who doesn’t see a lot of things happening that aren’t happening and not see a lot of things happening that are happening.

And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren’t there.

Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally — more than equally in fact — likely to be misled. Again, your brain has a shortage of circuitry and so forth — and it’s taking all kinds of little automatic shortcuts.

So when circumstances combine in certain ways — or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction — you’re a patsy.

And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people….

So the most useful and practical part of psychology — which I personally think can be taught to any intelligent person in a week — is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It’s so elementary though that, when it was all over, I felt like a fool.

And yeah, I’d been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me.

The elementary part of psychology — the psychology of misjudgment, as I call it — is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.

Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I’ve done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.

There’s another saying that comes from Pascal which I’ve always considered one of the really accurate observations in the history of thought. Pascal said in essence, “The mind of man at one and the same time is both the glory and the shame of the universe.”

And that’s exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.

Personally, I’ve gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things — which by and large are useful, but which often misfunction.

One approach is rationality — the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions — many of which are wrong.

-ORGANISMS, PEOPLE & COMPANIES WHO SPECIALIZE CAN GET TERRIBLY GOOD IN THEIR LITTLE NICHE-

Now we come to another somewhat less reliable form of human wisdom — microeconomics. And here, I find it quite useful to think of a free market economy — or partly free market economy — as sort of the equivalent of an ecosystem….

This is a very unfashionable way of thinking because early in the days after Darwin came along, people like the robber barons assumed that the doctrine of the survival of the fittest authenticated them as deserving power — you know, “I’m the richest. Therefore, I’m the best. God’s in his heaven, etc.”

And that reaction of the robber barons was so irritating to people that it made it unfashionable to think of an economy as an ecosystem. But the truth is that it is a lot like an ecosystem. And you get many of the same results.

Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world — and get very good because they specialize — frequently find good economics that they wouldn’t get any other way.

And once we get into microeconomics, we get into the concept of advantages of scale. Now we’re getting closer to investment analysis — because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.

For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.

The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That’s an enormous advantage. And it has a lot to do with which businesses succeed and fail….

-AND THERE ARE OTHER ECONOMIES: GEOMETRIC, ADVERTISING, INFORMATION, EVEN PSYCHOLOGICAL-

Let’s go through a list — albeit an incomplete one — of possible advantages of scale. Some come from simple geometry. If you’re building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.

And there are all kinds of things like that where the simple geometry — the simple reality — gives you an advantage of scale.

For example, you can get advantages of scale from TV advertising. When TV advertising first arrived—when talking color pictures first came into our living rooms — it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was — say 90% of the audience.

Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn’t. And there was no way of buying it in part. Therefore, he couldn’t use it. In effect, if you didn’t have a big volume, you couldn’t use network TV advertising which was the most effective technique.

So when TV came in, the branded companies that were already big got a huge tail wind. Indeed, they prospered and prospered and prospered until some of them got fat and foolish, which happens with prosperity — at least to some people….

And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is 40 cents and the other is 30 cents, am I going to take something I don’t know and put it in my mouth — which is a pretty personal place, after all — for a lousy dime?

So, in effect, Wrigley , simply by being so well known, has advantages of scale — what you might call an informational advantage.

Another advantage of scale comes from psychology. The psychologists use the term social proof. We are all influenced — subconsciously and to some extent consciously — by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step.

Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, “Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?”

The social proof phenomenon which comes right out of psychology gives huge advantages to scale — for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it’s available almost everywhere in the world.

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup — which is slowly won by a big enterprise — gets to be a huge advantage…. And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.

-THINGS TEND TOWARD WINNER TAKE ALL. THEREFORE, IT PAYS TO BE #1, #2 OR OUT-

There’s another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm.

The most obvious one is daily newspapers. There’s practically no city left in the U.S., aside from a few very big ones, where there’s more than one daily newspaper.

And again, that’s a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-take-all situation. And that’s a separate form of the advantages of scale phenomenon.

Similarly, all these huge advantages of scale allow greater specialization within the firm. Therefore, each person can be better at what he does.

And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, “To hell with it. We’re either going to be # 1 or #2 in every field we’re in or we’re going to be out. I don’t care how many people I have to fire and what I have to sell. We’re going to be #1 or #2 or out.”

That was a very tough-minded thing to do, but I think it was a very correct decision if you’re thinking about maximizing shareholder wealth. And I don’t think it’s a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there.

-HOWEVER, BIGGER ISN'T ALWAYS BETTER - THERE ARE ALSO DISADVANTAGES OF SCALE-

And there are also disadvantages of scale. For example, we — by which I mean Berkshire Hathaway — are the largest shareholder in Capital Cities/ABC. And we had trade publications there that got murdered where our competitors beat us. And the way they beat us was by going to a narrower specialization.

We’d have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you’re getting a narrower and narrower specialization.

Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn’t have to waste the ink and paper mailing out stuff that corporate travel departments weren’t interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine.

That’s what happened to The Saturday Evening Post and all those things. They’re gone. What we have now is Motocross — which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. But they care about it. For them, it’s the principal purpose of life. A magazine called Motocross is a total necessity to those people. And its profit margins would make you salivate.

Just think of how narrowcast that kind of publishing is. So occasionally, scaling down and intensifying gives you the big advantage. Bigger is not always better.

The great defect of scale, of course, which makes the game interesting—so that the big people don’t always win — is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality — which is again grounded in human nature.

And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. But, of course, it isn’t. It’s not done until AT&T delivers what it’s supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.

They also tend to become somewhat corrupt. In other words, if I’ve got a department and you’ve got a department and we kind of share power running this thing, there’s sort of an unwritten rule: “If you won’t bother me, I won’t bother you and we’re both happy.” So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They’re too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it leads to big, dumb bureaucracy — which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments — because we do. But it’s a terrible problem to get big bureaucracies to behave.

So people go to stratagems. They create little decentralized units and fancy motivation and training programs. For example, for a big company, General Electric has fought bureaucracy with amazing skill. But that’s because they have a combination of a genius and a fanatic running it. And they put him in young enough so he gets a long run. Of course, that’s Jack Welch.

But bureaucracy is terrible…. And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who’d come up by some career path — I don’t know exactly what it was, but it could have been refrigerators or something — and all of a sudden, he’s loaning money to real estate developers building hotels. It’s a very unequal contest. And in due time, they lost all those billions of dollars.

CBS provides an interesting example of another rule of psychology—namely, Pavlovian association. If people tell you what you really don’t want to hear what’s unpleasant — there’s an almost automatic reaction of antipathy. You have to train yourself out of it. It isn’t foredestined that you have to be this way. But you will tend to be this way if you don’t think about it.

Television was dominated by one network — CBS in its early days. And Paley was a god. But he didn’t like to hear what he didn’t like to hear. And people soon learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt — although it was a great business.

So the idiocy that crept into the system was carried along by this huge tide. It was a Mad Hatter’s tea party the last ten years under Bill Paley.

And that is not the only example by any means. You can get severe misfunction in the high ranks of business. And of course, if you’re investing, it can make a lot of difference. If you take all the acquisitions that CBS made under Paley, after the acquisition of the network itself, with all his advisors — his investment bankers, management consultants and so forth who were getting paid very handsomely—it was absolutely terrible.

For example, he gave something like 20% of CBS to the Dumont Company for a television set manufacturer which was destined to go broke. I think it lasted all of two or three years or something like that. So very soon after he’d issued all of that stock, Dumont was history. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss.

So life is an everlasting battle between those two forces — to get these advantages of scale on one side and a tendency to get a lot like the U.S. Agriculture Department on the other side — where they just sit around and so forth. I don’t know exactly what they do. However, I do know that they do very little useful work.

-A CASE STUDY IN ECONOMIES VS. DISECONOMICS - WAL-MART VERSUS SEARS, ROEBUCK-

On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power — which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.

If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he’s going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.

The reverse is demonstrated by the little store where one guy is doing all the buying. It’s like the old story about the little store with salt all over its walls. And a stranger comes in and says to the storeowner, “You must sell a lot of salt.” And he replies, “No, I don’t. But you should see the guy who sells me salt.”

So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise.

It’s quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime — in fact, during his own late lifetime because he was already pretty old by the time he started out with one little store….

He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart — and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.

He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout, knockout — 42 times.

Walton, being as shrewd as he was, basically broke other small town merchants in the early days. With his more efficient system, he might not have been able to tackle some titan head-on at the time. But with his better system, he could destroy those small town merchants. And he went around doing it time after time after time. Then, as he got bigger, he started destroying the big boys.

Well, that was a very, very shrewd strategy.

You can say, “Is this a nice way to behave?” Well, capitalism is a pretty brutal place. But I personally think that the world is better for having Wal-Mart. I mean you can idealize small town life. But I’ve spent a fair amount of time in small towns. And let me tell you you shouldn’t get too idealistic about all those businesses he destroyed.

Plus, a lot of people who work at Wal-Mart are very high grade, bouncy people who are raising nice children. I have no feeling that an inferior culture destroyed a superior culture. I think that is nothing more than nostalgia and delusion. But, at any rate, it’s an interesting model of how the scale of things and fanaticism combine to be very powerful.

And it’s also an interesting model on the other side — how with all its great advantages, the disadvantages of bureaucracy did such terrible damage to Sears, Roebuck. Sears had layers and layers of people it didn’t need. It was very bureaucratic. It was slow to think. And there was an established way of thinking. If you poked your head up with a new thought, the system kind of turned against you. It was everything in the way of a dysfunctional big bureaucracy that you would expect.

In all fairness, there was also much that was good about it. But it just wasn’t as lean and mean and shrewd and effective as Sam Walton. And, in due time, all its advantages of scale were not enough to prevent Sears from losing heavily to Wal-Mart and other similar retailers.

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