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Charlie Munger's 3 Rules on How to Become a Successful Investor

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I was fortunate enough to interview value investor Mohnish Pabrai at his office in California last month. Pabrai is a great investor to talk to not only because of his success, but also because of his experiences. In 2007 he paid $650,000 to have dinner with Warren Buffett (the proceeds went to charity), and he followed up with several dinners with Charlie Munger.

Most of what anyone would want to know about Buffett and Munger is public information and repeated ad nauseam. So when Pabrai said "I don't think Charlie's talked about this publicly" and proceeded to cite three rules that could create investment results "vastly better than the rest," I listened up.

Ready? Here are Charlie Munger's three secret rules for investment success.

1. Follow the great investors
Munger's first rule is to "carefully look at what the other great investors have done," Pabrai told me. "So, in fact, Charlie was endorsing copying off the 13-Fs, right?"

The 13-F is a regulatory disclosure that requires all large investors to publicly disclose what they're investing in -- a legally mandated fly on the wall that gives us a look into great investors' minds.

You can search for investors' 13-F filings here. They're an incredible resource. Using the search tool, you can see that Pabrai's investment fund owned shares of Berkshire Hathaway (NYSE: BRK-B  ) , Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and Goldman Sachs (among others) at the end of 2011. Or that David Einhorn's hedge fund owned puts on Chipotle Mexican Grill (NYSE: CMG  ) at the end of September.

Pabrai says most of his investment ideas come from other great investors -- though I think he's being modest. "God bless the SEC for their 13-F requirements," he said. "In fact, Nov. 14 was the last time when the 13-Fs came out, and you know, I'm like a pig in [expletive]. It's just great because there's so much to look at. That keeps me busy for a few weeks, and then the next 13-Fs come out."

2. Look at the cannibals
Munger's second rule is to pay close attention to cannibal companies. "What he meant by 'look at the cannibals,'" Mohnish said, "is, look carefully at the businesses that are buying back huge amounts of their stock." 

Take IBM (NYSE: IBM  ) . It has repurchased $107 billion of its own stock in the past decade, reducing its shares outstanding by more than a third. As value investor Bill Miller noted two years ago: "IBM is the only one of the megacap stocks that were popular in the late 1990s to go to an all-time high. The reason for that is, IBM has an absolutely unequal record in capital allocation."

AutoZone (NYSE: AZO  ) is another good example. This $12 billion company has repurchased $11.7 billion of its stock in the past decade, reducing shares outstanding by more than 60%. That's helped push shares to a 412% gain since 2002.

Many, maybe most, companies have a poor track record of buybacks, gorging on their stock when it's expensive and backing away when it's cheap. But those that get it right can create tremendous value for shareholders.

3. Carefully study spinoffs
Munger's last rule is to focus on spinoffs. "Of course, you know Joel Greenblatt has a whole book on spinoffs: You Can Be a Stock Market Genius," Pabrai reminded me.

Successful investing is about finding situations of mispricing, or companies selling below their true worth. And spinoffs, when a company divests one of its divisions, are a great place to dig for those situations.

My colleague David Meier wrote about spinoffs several years ago:

One reason companies spin off certain businesses is to get rid of redheaded stepchildren. That way, the unloved or "bad" business can stop taking time and resources away from the crown jewel. But, as Greenblatt points out, sometimes that is exactly what the bad boy needs in order to straighten his life out.

Another reason spinoffs can create mispricing is that shareholders of the new company might be forced to sell, either for tax reasons or because they are institutional investors prohibited from owning a company with certain characteristics. When Kraft decided to spin off its snack division, it warned shareholders (emphasis mine):

Kraft ParentCo shareholders receiving shares of our common stock in the Distribution generally may sell those shares immediately in the public market. Although we have no actual knowledge of any plan or intention of any significant shareholder to sell our common stock following the Spin-Off, it is possible that some Kraft ParentCo shareholders, including some of our larger shareholders, will sell our common stock received in the Distribution if, for reasons such as our business profile or market capitalization as an independent company, we do not fit their investment objectives, or -- in the case of index funds -- we are not a participant in the index in which they are investing. 

I'm not an expert on spinoffs, but I'd highly recommend Greenblatt's book if you're interested in learning more.

I'll leave you with a classic Munger quote:

This is really crucial: Warren is one of the best learning machines on this earth. The turtles who outrun the hares are learning machines. If you stop learning in this world, the world rushes right by you.

Motley Fool analyst Joe Magyer has created a premium research report on Berkshire Hathaway. Claim a copy by clicking here now.

Read/Post Comments (11) | Recommend This Article (136)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 16, 2013, at 8:38 PM, OceanJackson wrote:

    The Spinoff lesson is also in Peter Lynch's "One Up On Wallstreet."

  • Report this Comment On January 18, 2013, at 1:05 PM, StevesStox wrote:

    I believe munger said to avoid the cannibal companies.,

  • Report this Comment On January 18, 2013, at 6:10 PM, chris293 wrote:

    Somewhat general knowledge we should know, sometimes I feel that this information is use to promote stocks for some end. However this article is very useful to help us be on guard and not skip down the yellow brick road.

  • Report this Comment On January 18, 2013, at 6:36 PM, NickD wrote:

    I bet they were drinking Coke.

  • Report this Comment On January 19, 2013, at 12:59 AM, Clint35 wrote:

    I recently read the Greenblatt book mentioned in the article. I highly recommend it.

  • Report this Comment On January 19, 2013, at 10:25 AM, Mathman6577 wrote:

    A good spinoff that has performed well is VIRTUS INVT PARTNERS (NASDAQ:VRTS).

  • Report this Comment On January 19, 2013, at 3:09 PM, Libor8erBlake700 wrote:

    FOLLOW MY LEADER. When my father told me (1981) to start manajing my own savings, my 1st move was to kopy my hero Tiny Lonrho by buying a stake in Arthur & Fraser (founded 1849), which by now owned big shops like Harrod's. But why this works is more Piggy-Bakk Ride than Pig-in-Pokket, because you trust your teacher - because he has what you want (key to wealth).

    Caveat, tho', is don't be lazy, and still do your arithmetik. E.g, is Viktor Kiam buying a share @ 30 years-worth of past profits (instead of, say, 10x) bekause he knows how to grow the firm or just bekause he likes its produkt?

    SPIN-BOWLER. Like merjers, de-merjers even more so: so many variables OFF the radar, only experiense & perseverense will tell if the new parties fare well. Norse Hydro-Elektrik set up (1905) to frakk Nitrojen from air & make fertilizer. Its power-plant features in the Telemark Heroes film (1965, I've not seen the 1948/2003 versions). By (1927) this was unekonomik versus the Haber-Bosch method, which you learn in school chemistry, & the firm virtually taken over so it would have lisense to use the new method: but power jeneration kontinued too.

    In (2004) it span off the orijinal (fertilizer) buziness as Yara - so the parent bekame the daughter! Yara's something different in every languaje but here it's Sea-Sprite, so the Hydro-konnexion's maintained, although the motif on its tanker/hopper-lorry is a Viking row-boat. My orijinal (1984) stake in Hydro-Yara ten-tupled by (2006), when I banked a profit & 12 years' dividends.

    But I re-bought both shares a year ago, & while Hydro floundered a bit, Yara gained a further ¼ (25%) & paid 2% (post-tax) dividend. like the Nymph on your pond, Yara found a new lease of life under separate manajement.

  • Report this Comment On January 20, 2013, at 10:56 PM, chris293 wrote:

    Sounds like the normal self-promotion that you and I hear a lot from many companies.

  • Report this Comment On January 21, 2013, at 1:43 PM, tomd728 wrote:

    Great advice from a great investor...and we must also include John Vogel's mantra...

    "Buy right and sit tight".

  • Report this Comment On January 25, 2013, at 6:51 PM, beechtree1 wrote:

    Try the correct spelling: ad nauseum.

  • Report this Comment On January 28, 2013, at 4:01 AM, pankajjain wrote:

    I find the spinoff part to be really interesting. Believe, it must have been a great experience for Pabrai to chat all this with the Masters. From the Indian context (since am from India), I also found an interesting section dedicated to Charlie Munger... you can find it here -

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