5. Invert, always invert

Part 9 of 19 in The Patient Owner: Charlie Munger’s Ideas, as Rakesh Jhunjhunwala Might Have Taught Them to an Indian Investor← Part 8Part 10 →

This chapter explores the concept of inversion, a strategy favored by Charlie Munger, as discussed by Rakesh Jhunjhunwala. It explains how approaching problems by considering potential failures can lead to better decision-making in business and investments.

Aniruddha. Jacobi’s line, which Munger loved: invert, always invert. Many hard problems are solved backwards. In medicine we do this without naming it. Before I am impressed by a treatment, I ask how it harms. Before I am impressed by a pregnancy rate, I ask which patients were never counted. How do you run that on a business?

Rakesh. You stop asking ‘how do I make money here?’ and you ask ‘how does this die, and would I see it in time?’ The second question is less glamorous and much more profitable. A business plan is a fantasy about success. An inversion is a budget for failure. I trust the budget.

The Indian obituary

He had a short list, built from scars the market had already issued.

The cash is not there. Reported profit is a journal entry; the bank balance is a rumour. Satyam was the national lesson, and it has been forgotten on schedule. In January 2009 the chairman wrote to the board and admitted that the accounts had been invented to the extent of something like ₹7,000 crore — cash that was not cash, margins that were not margins, a hole filled by pledging a story. The inversion had been available earlier, to anyone who asked a rude question: if the cash is real, why this related-party hunger, why this deal, why can the auditor not simply confirm the bank? Politeness was expensive.

The incentive is pointed at the wrong person. A lender rewarded for growth will grow. A rating paid by the issuer will feel the warmth of the issuer. A doctor paid by the scan will scan. You do not need a conspiracy. You need a bonus plan. Yes Bank’s collapse into a moratorium in March 2020, and the wreck of DHFL beside it, were not mysteries of finance. They were mysteries only if you refused to read the incentive. Fast growth in a credit book is not evidence of genius until the cycle has asked for the money back.

The popularity is the product. One97 Communications, the company behind Paytm, listed in November 2021 at an issue price of ₹2,150. The story was a payments habit, a merchant network, a future bank, a country going digital. Parts of the story were real. The price required all of the parts, at a scale and a margin the business had not earned. Within a year most of that price was gone. The inversion, available in the red herring, was simple: who is the residual claimant if the payment itself is a commodity, the licence is a regulator’s pen, and the competition is a bank with a balance sheet? Popularity had answered a different question.

Aniruddha. I see the same shape in a bad medical paper. The abstract is the IPO. The methods are the cash flow. People quote the abstract at dinner.

Rakesh. Then you already have the tool. For every business you want to own, write the methods section. How is cash collected? Who can stop it? What happens if the talented person leaves? What is pledged? What does the auditor change, the credit rating change, the related party, the pledge of promoter shares? If the answer is ‘nothing material’ and you have not looked, you have not inverted. You have hoped.

Inversion for the angel

Aniruddha. A founder will tell me how the company wins. I have started asking him to spend the last ten minutes on how it fails. The good ones relax. They have already done it in private. The dangerous ones look betrayed, as if I had insulted the baby.

Rakesh. Betrayal is information. A person who cannot discuss the death of his own plan is asking you to supply the adult in the room, and then to pay for the privilege. Charlie’s version was moral as well as practical. Inversion keeps you from being the fool in a story someone else is selling. If you invest as an angel, make it a house rule. No cheque before the obituary. Ten ways this dies, written by the investor, not pasted from the deck. If you cannot write them, you are not early. You are late to someone else’s enthusiasm.

Failures are part of life. If you don’t fail, you don’t learn. If you don’t learn, you’ll never change. — Rakesh Jhunjhunwala, public interviews

Aniruddha. He was willing to be publicly wrong. That is rarer than being publicly rich.

Rakesh. Public error is a tuition fee. Hidden error is a lifestyle. Invert so that the error shows up on a piece of paper while it is still cheap.

Evening question. Write the obituary of your favourite holding in half a page. Date it. If the facts in it start to come true, you are not allowed to renegotiate the obituary with yourself.