Charlie Munger, Mental Models, and How to Build a $50T Company
Nosa Edoimioya
Founder & CEO
I recently read Poor Charlie’s Almanack by Peter D. Kaufman, which is a series of transcribed talks by the late Charles T. Munger (of Berkshire Hathaway). In these talks, Charlie lays out a peculiar process for structured thinking that he used throughout his life (in all his business and personal affairs). If you think about thinking for any amount of time, it becomes clear that most of us don’t have a structured way for general thinking. In specific domains, such as sales at a company ABC, we train employees to use certain processes when solving problems. However, when confronted with a new, complex, and interdisciplinary problem, it’s challenging to extrapolate because we don't have a latticework for general structured thinking.
Charlie sought out a structured process to think clearly. His solution was an interdisciplinary checklist that espoused all the major ideas from the major disciplines, many of which he learned on his own. The checklist includes ideas from mathematics (e.g., compound interest, Bayesian probability, inversion, etc.), science and engineering (e.g., critical mass, Darwinian evolution, backup systems, etc.), and psychology (e.g., social proof, sunk cost fallacy, etc.). When he encountered a new investment opportunity, he’d use a two-track analysis to evaluate it. First, he’d ask himself: “What are the factors that really govern the interests involved, rationally considered?” which considers the ideas that apply to the real interests, the real probabilities, and so forth. Second, he’d ask: “What are the subconscious influences where the brain is automatically making connections–which, by and large, are useful but often malfunction?” which evaluates the subconscious conclusions that people will come to due to psychological tendencies. Using his checklist, he thought about how each “big idea” might be affecting the real interests or subconscious conclusions.
This way of thinking served him well professionally and personally–to the tune of a $2.6B net worth at the time of his death. But most people don’t have a process like this. Worse, Charlie argues that most of the big ideas are really easy to grasp. Furthermore, most of them are taught in freshman (introductory) classes. Therefore, the main blocker to most people thinking in this way is that we haven’t made the effort to organize the ideas into a form that makes it easy to practice using them. Training oneself to learn all the major ideas in all the major disciplines and organize them in a latticework like Charlie’s seems like a worthwhile pursuit. We learn the best of what other people have already figured out (oftentimes through tremendous toil). Who wouldn’t want to have that? It’s like a shortcut through life and all that is required is reading, organization, and practice. What’s not to like?
The task of organizing my own latticework is one of the major intellectual pursuits of my life. This essay is my attempt to apply this thinking to Reforge Robotics. The rest of the essay follows a similar format to Talk Four in Poor Charlie’s Almanac, in which Charlie poses the hypothetical problem of starting and scaling a non-alcoholic beverage company with a $2 million investment in 1884 to be worth $2 trillion in 2034. This context allows Charlie to display his general thinking framework to answer the question of why the Coca-Cola company has been a tremendous success. I believe Charlie could have completed the same analysis to create the business plan for the Coca-Cola company in 1884 using his checklist without having the answer (i.e., the real Coca-Cola company) to analyze. In this essay, I attempt the same analysis for Reforge Robotics using the big ideas on my checklist. As with most lifelong pursuits, this analysis will be updated as I learn more. Okay, here’s the problem:
It is 2024 in Oakland. You are brought, along with 20 others like you, before a rich and eccentric Oakland citizen named Phitzer. Both you and Phitzer share two characteristics: first, you routinely use, in problem-solving, five helpful notions (shared below), and second, you know all the elementary ideas in all the basic college courses. Phitzer offers to invest $5 million, yet only take half the equity for a Phitzer Charitable Foundation, in a new corporation organized to go into the metal manufacturing business and remain in that business only, forever.
The other half of the equity will go to the person who most plausibly demonstrates that their business plan will cause Phitzer’s foundation to be worth $25 trillion 150 years later, in the money of that later time, 2174, despite paying out part of its earnings each year as a dividend. This will make the whole new corporation worth $50 trillion, even after paying out many trillions of dollars in dividends.
To get to a solution, we will use five helpful notions that Charlie uses in Talk Four.
It is usually best to simplify problems by deciding the big no-brainer questions first.
Use numerical fluency and mathematical principles to ascertain what the quantitative targets are.
It is not enough to think problems through forward. You must also think in reverse.
The best and most practical wisdom is elementary academic wisdom taken together in a multidisciplinary manner.
Really big effects (lollapalooza effects) come from a large combination of factors.
Here is my solution, my pitch to Phitzer, using the five notions and what every bright college sophomore should know:
"Well, Phitzer, the big no-brainer decisions that, to simplify our problem, should be made first are as follows: First, we are never going to create something worth $50 trillion by making a new machine tool that is similar to existing machine tools and fighting for market share in a brutally competitive market, so we’ll have to focus on something completely different. Today, in the metal manufacturing business, there is a large focus on selling software licenses and services. However, software and services are also not enough because many companies sell software and services for existing machine tools and none of them have achieved the level of success we desire nor demonstrate the potential to reach that level of success in the future. Therefore, we have to combine new software with a different hardware design for manufacturing machines. When combined, the software and hardware need to work together to exceed customer expectations at a significantly lower cost. This will accomplish two results that we want: 1) our customers, contract manufacturers, who are also in a very competitive market, will feel that they are missing out on a competitive advantage if they do not buy our new and different hardware and software combination; and 2) since the combined software and hardware leads to a lower cost, our competition, the existing machine tool companies, will be slow to change because selling more expensive machines results higher revenues, higher sales commissions, higher system integration fees, etc. If we quickly make and distribute our products, we will establish a large lead with our software and hardware by the time they realize that they need to copy our products. At that point, it might be too late to turnover their businesses to compete with us. It will take a long time and consistent effort to accumulate this lead, but if we are successful, the knowledge we gain will give us an advantage for some time to come.
To considerably lower costs for our customers, it’s clear that we need to make both our own hardware and software. By making our own hardware, we retain three low-hanging fruit advantages: 1) we don’t need to pay the profit margin that other companies place on their products or the taxes for each transaction; 2) we become independent and don’t need to rely on the hardware provider to give us increasing access to their software to improve our product; and 3) we can design our hardware to have the technologies necessary to maximize the usefulness of our software. Making both hardware and software has been a no-brainer strategy for some of the most profitable companies. Others, who only make software, have strong monopolies from being early entrants into the software market and setting the software standards for the hardware manufacturers. We unfortunately do not have such favorable conditions in the century-old market of manufacturing.
One argument against this integrated hardware and software approach is that building new factories to make hardware requires a lot of upfront investment. To this, I pose two rebuttals: (a) it is short-sighted to focus on the millions we save today at the expense of the billions we will save tomorrow, and (b) as we significantly reduce the cost of manufacturing machines for our customers, we can use those same machines to reduce our cost. This creates a flywheel effect: our machines help to make copies of themselves, reducing the cost of our products, which further reduces the cost of our hardware.
It’s worth mentioning that, when we start the company, we will work on the software first and use commercial hardware instead of building our own hardware immediately. This choice will enable four things: 1) we can sell the packaged software and commercial hardware to early customers that fit into our target demographic to begin learning from the market; 2) we begin earning revenue quicker and limit the burden (both in time and equity) to raise more financing; 3) we can select the best qualities of the existing hardware(s) and combine them to design our own hardware, while solving for deficiencies; and 4) we solve most of the software challenges first and understand the areas where hardware provides a better solution than software. If we build the hardware first or both at the same time, it would be impossible to achieve the aforementioned qualities. In the software-only phase of the business, we will be capital efficient by working with robot integrators and financers, to provide the integration and financing services to our customers, while we serve solely as the software provider. Although we sacrifice profits from the high-margin integration and financing businesses, this trade-off will allow us to focus more resources on designing and manufacturing our hardware prototypes and iterating quickly to a useful solution, which will be more beneficial to us in the long term.
Accordingly, the characteristics of the hardware platform to accomplish our result are that it 1) is low-cost; and 2) can be combined with software to improve performance. Industrial robot arms have these characteristics and there are many case studies that have shown their efficacy in manufacturing when general purpose robot arms are combined with advanced software. They can both increase the efficiency of overall operations by automating repetitive processes and they can be used to conduct a subset of the metal manufacturing work. Scaling these case studies broadly will be achieved iteratively through research and development. Additionally, the robot arms we design specifically for manufacturing will further improve manufacturing performance.
Now that we’ve answered the no-brainer questions, we will next use numerical fluency to ascertain what our target of $50 trillion implies. It’s difficult to make estimations about the market 150 years from now. Nevertheless, there are two reasons why the 150-year target is useful: 1) we want to work towards conditions that allow the company to long outlive us, and 2) human demand for manufactured metal products is guaranteed to be conserved and very likely to grow significantly. Today, the United States has a median individual annual income of about $40,000 per year and its people enjoy many manufactured metal goods to obtain a relatively superior quality of life compared to the rest of the world. In contrast, the median annual global income is about $3,000 and, of the 8 billion people in the world, more than 7 billion live on lower incomes than the median US income. We can guess reasonably that by 2174, the fraction of people at the equivalent of a US median income in 2024 will be greater, which guarantees sustained demand for the current level of manufacturing machine tools, likely with periods of extreme demand as one region or another experiences significant growth. Today, approximately 500,000 CNC machines are sold annually at a growth rate of 4-6%. Assuming the growth is conserved, we can expect 1.5 billion units to be shipped in 2174. Thus, if our new machine, and other imitative machines in our new market, can supply over 25% of machine tools worldwide, and, with our fanaticism about low cost, we can occupy 40% of the new market, we can sell 150 million units in 2174. Assuming a profit of only $25,000 on each unit, we can reach $3.75 trillion of free cash flow on a revenue run rate of $37.5 trillion (assuming an average unit price of $250,000). This will be enough, given our business is still growing at a good rate, to make it easily worth $50 trillion.
A big question, of course, is whether $25,000 is a reasonable profit target for 2174. And the answer is yes if we can create a product with strong universal appeal. One hundred and fifty years is a long time and the dollar will almost surely suffer monetary depreciation. Concurrently, real purchasing power of the average consumer in the world will go way up. Her proclivity to purchase manufactured goods to improve her quality of life will go up considerably faster. Meanwhile, as technology improves, the cost of our product, in units of constant purchasing power, will go down. All four factors will work together in favor of our $25,000 per machine profit target. We also expect the cost of labor to rise with the purchasing power of the average consumer and the software that comes along with our machine will help replace a portion of labor from efficiency gains. The history of software teaches us that manufacturers will be willing to pay for the increased efficiency. Therefore, even if the hardware profit is only $10,000, the rest can be made up from the price of the software. Altogether, worldwide machine tool purchasing power in dollars will probably multiply by a factor of at least 5 over 150 years. Thinking in reverse, this makes our profit-per-machine target, under 2024 conditions, a mere one-fifth of $25,000, or $5,000. This is an easy to exceed target as we start out if our new product has universal appeal.
To create a product with universal appeal, we must tackle the two intertwined challenges of large scale. First, over 150 years, we must cause a new machine tool market to assimilate about one-fourth of the world’s machine tools. Second, we must operate so that 40% of the new market is ours while our competitors are left to share the remaining 60%. These results are lollapalooza results. Accordingly, we must attack our problem by causing every favorable factor we can think of to work for us. Plainly, only a powerful combination of many factors is likely to cause the lollapalooza consequences we desire.
Let’s start by exploring the consequences of our simplifying no-brainer decision that we need to combine software with a new hardware design for machine tools. This conclusion automatically leads to an understanding of our business in proper terms. We can see from the introductory course in psychology that, in essence, we are going into the business of creating and maintaining social proof by demonstrating the benefit of the new hardware and causing a large number of conversions to our machine tool system. It is not enough for our product to perform better than legacy products. Those products benefit from social proof and the change resistance inherent in man. The only solution to create behavior we seek is a new cult-like movement with a zealous missionary following. A movement with this characteristic is the only way to convince a large group of people to do something differently who have grown accustomed to doing things a certain way. We have to employ many characteristics of other successful movements (like religions):
A mission that transcends the individuals/products, coupled with a missionary mandate which strongly encourages people in our movement to tell others about it.
Strong admiration for people who use our products.
Automatic word-of-mouth sharing, in social circles, about our movement. Telling a friend about our movement should be a no-brainer, universal benefit to both the teller and the hearer.
Special classes of community members who have some status or benefit. For example, a special class for people who exclusively use our machines and get special benefits for this exclusivity. Classes will be prominently featured so that members aspire to reach status by, for example, exclusively using our machines.
Physical communal aspects (e.g., a friendly feeling) by creating opportunities for our members to interact with each other and make new friends within the community, and bring their friends to meet others in the community.
To generate strong admiration for people who use our products, we will elevate their positive and moral character qualities, most of which have nothing to do with our product. We will profile qualities like their family life and their community contributions in an effort to get others to admire them greatly. We will also find already publicly admired figures and incentivize them to endorse our community. Additionally, if the qualities we focus on are associated with the larger mission of the community, the mission will be reinforced within the community. These activities will also support word-of-mouth sharing as admired persons will be talked about in circles where their values and the mission find resonance.
An important note is that the positive association must be created between admired persons and the movement/community, not our product or the company. Our product will simply benefit from an association with the movement, but it will need to demonstrate its merits to each customer independent of the movement.
Similarly, the community will have benefits (preferably free benefits) that are completely unrelated to the company or product, in addition to ones related to the company (e.g., discounts). On the company side, benefits will be integrated into a showroom as one of the physical spaces where community members interact with one another. Other benefits can include free meals, drinks, and gifts.
Since we’ve discussed forces that would favor the universal appeal of the company and product, we must now think in reverse to find forces that oppose it. What would make it more difficult to change the manufacturer’s mind? How can we ensure failure to introduce a new product and further entrench the incumbents? As usual, let’s start with the no-brainers:
Our technology does not live up to existing machine tool performance or is worse.
Our combined hardware and software system is more difficult to use than the existing manufacturing systems, creating puzzlement and stress.
We attempt to force new manufacturers to make a fast decision about adopting our system and we don’t give them time to think through the decision and learn about how the system works. When forced to make a fast decision, the system with social proof will be chosen over ours.
We focus on making comparisons to the existing systems instead of focusing on what our system can uniquely do, thereby pounding in the existing machines’ favorable qualities in user’s minds and creating avenues for debate.
We display our product as having weak qualities and weak associations instead of displays of strength, which are associated with rigidity and precision.
We highlight people who are using the existing machines and are successful and we ensure a mental association between their success and their existing machines.
We first focus on getting older people, who tend to hate change, to change their behavior instead of focusing on younger people who are more likely to try something new.
Over time, we maintain existing machine programming and workflow paradigms which makes it easy for customers to switch back to their older machines or for the old companies to create competing machines and use their reputation to recapture market share.
Avoiding factors 1-3 favors a slower rollout strategy where we validate the technology before rolling it out and give manufacturers the opportunity to gain familiarity with it. We will eliminate factors 4-6 with careful messaging to: (a) highlight only the unique features of our system and avoid making comparisons; (b) use strong names and strong qualities to describe our products; and (3) never advertise a positive story with machines that are not ours. Factor 7 is easy to eliminate by focusing on recruiting younger people first to join our movement and convincing them that our products are the future of manufacturing. Factor 8 is the most difficult to eliminate because we must lower the software adoption barrier (factor 2) for new users but quickly move existing customers to a new and improved programming and workflow paradigm. We will achieve this by maintaining multiple versions of software which change from the old to new paradigm one version at a time. The software will be compatible across versions and a process will be developed and updated to move users from the old complex software to the new simpler software over time. We may find that the new software is so simple and intuitive that our users are able to grasp it quickly, but the more likely outcome is that it will require training over time.
Well, that is my solution, Phitzer, to the problem of turning $5 million into $50 trillion even after paying out trillions of dollars in dividends. The correct strategies are clear after being related to elementary academic ideas brought into play by the helpful notions."
"The big money is not in the buying and selling, but in the waiting"
Charlie Munger
American Investor
Charlie sought out a structured process to think clearly. His solution was an interdisciplinary checklist that espoused all the major ideas from the major disciplines, many of which he learned on his own. The checklist includes ideas from mathematics (e.g., compound interest, Bayesian probability, inversion, etc.), science and engineering (e.g., critical mass, Darwinian evolution, backup systems, etc.), and psychology (e.g., social proof, sunk cost fallacy, etc.). When he encountered a new investment opportunity, he’d use a two-track analysis to evaluate it. First, he’d ask himself: “What are the factors that really govern the interests involved, rationally considered?” which considers the ideas that apply to the real interests, the real probabilities, and so forth. Second, he’d ask: “What are the subconscious influences where the brain is automatically making connections–which, by and large, are useful but often malfunction?” which evaluates the subconscious conclusions that people will come to due to psychological tendencies. Using his checklist, he thought about how each “big idea” might be affecting the real interests or subconscious conclusions.
Nosa Edoimioya
Founder & CEO
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Nosa Edoimioya, Founder & CEO
