In 1996, Charlie Munger (Trades, Portfolio) gave a talk titled "Practical Thought About Practical Thought," which was later added to his unofficial biography, "Damn Right: Behind the Scenes With Berkshire Hathaway Billionaire Charlie Munger."
In the talk, Munger focused on trying to explain the success of Coca-Cola Co. (KO, Financial) over the past century as the company has grown from being a small family enterprise into one of the largest beverage companies in the world.
As part of the talk, the investor and right-hand man of Warren Buffett (Trades, Portfolio) also outlined the five simple steps he uses to help him solve problems quickly.
Munger framed these solutions as part of the Coca-Cola story. He said:
"Glotz offers to invest $2 million, yet take only half the equity, for a Glotz charitable foundation, in a new corporation organized to go into the non-alcoholic beverage business and remain in that business only, forever. Glotz wants to use a name that has somehow charmed him: Coca-Cola.
The other half of the new corporation's equity will go to the man who most plausibly demonstrates that his business plan will cause Glotz's foundation to be worth a trillion dollars 150 years later, in the money of that later time, 2034, despite paying out a large part of its earnings each year as a dividend. This will make the whole new corporation worth $2 trillion, even after paying out many billions of dollars in dividends."
He also asked: What should an investor who wants to take a part of this business say to Glotz to convince him that their business idea is the right one?
Munger's five-step process can be used to arrive at a conclusion.
The first step is to simplify the problem. "It is usually best to simplify problems by deciding big 'no-brainer' questions first," Munger said. In this case, the investor should try and think about the nature of the product. Does it appeal to everyone and have a unique brand identity that will stop competitors?
The next stage is to use "numerical fluency to ascertain what our target implies."
In this case, working out how much money the company will have to make every year, and how many servings of product it will have to produce, in order to hit the market value target. "We can occupy half of the new world market, we can sell 2.92 trillion eight-ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion," Munger said.
The third step is to study the basics, understand human consumption patterns and what makes us desire a specific beverage. In the case of Coca-Cola, this step required a solution to the problem of "invention to create universal appeal." Munger went on to explain:
"We can see from the introductory course in psychology that, in essence, we are going into the business of creating and maintaining conditioned reflexes. The "Coca-Cola" trade name and trade dress will act as the stimuli, and the purchase and ingestion of our beverage will be the desired responses."
The next step is to look for lollapalooza factors. Lollapalooza effects will often come only from a large combinations of factors, which include getting the basics right and understanding the core of the problem. On top of this, you've also got to avoid making any serious mistakes.
The final step is to invert the problem. "What must we avoid because we don't want it?" Munger asked. He had four answers to this question, including removing the "cloying, stop-consumption effects of aftertaste that are a standard part of physiology, developed through Darwinian evolution to enhance the replication of man's genes by forcing a generally helpful moderation on the gene carrier."
Disclosure: The author owns no stocks mentioned.
Read more here:
- Buffett and Munger: How to Protect Against Inflation
- What Warren Buffett Learned From Phil Carret's Investment Style
- Warren Buffett, World Book Encyclopedia and Scott & Fetzer
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