Why did Charlie Munger oppose a mechanical low P/E ratio investment strategy?

The core reason behind Charlie Munger's strong opposition to mechanical low price-to-earnings (P/E) ratio investment strategies lies in the evolution of his investment philosophy and his profound insight into the essence of business. He believes that relying solely on quantitative metrics like low P/E to screen stocks is an overly simplistic, "Graham-and-Doddsville" approach that often fails in the modern business environment.

Munger's objections are primarily based on the following key reasons:

1. Shift in Core Philosophy: From "Cigar Butts" to "Buying Wonderful Companies"

Munger's most famous tenet is: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

The Nature of Mechanical Low P/E Strategies: This approach is an extension of Benjamin Graham's "cigar butt investing." It seeks companies that are extremely cheap, like discarded "cigarette butts" on the roadside, hoping to get one last free puff. These companies are typically mediocre businesses with no growth prospects; their only virtue is being "cheap."
Munger's Evolution: Munger recognized that buying mediocre companies, no matter how cheap, offers little potential for intrinsic value growth. Investors can only hope for price recovery driven by market sentiment shifts, requiring constant buying and selling, which is both effort-intensive and uncertain. Conversely, buying a wonderful company with a strong competitive advantage (an "economic moat"), even at a "fair" rather than "extremely cheap" initial price, allows the compounding effect of time to generate astounding returns. The intrinsic value of such a company grows continuously alongside its business, forming the fundamental source of wealth creation.

2. Overlooking the Critical Role of "Quality" and the "Moat"

Mechanical low P/E screening systematically filters out many high-quality companies while directing investors towards numerous inferior businesses.

What Might Lie Behind a Low P/E?
- Cyclical Industry Downturns: Industries like steel or chemicals may have low P/Es during severe downturns, but their future is highly uncertain.
- Sunset Industries: Businesses in decline, where the market holds little hope for their future.
- Poor Management: Chaotic corporate governance and low returns on capital.
- Facing Disruptive Threats: Risk of being rendered obsolete by new technologies or business models.
- Accounting Fraud or Hidden Debt: Earnings are artificial, distorting the P/E ratio.
Characteristics of High-Quality Companies: Wonderful companies typically possess strong brands, patents, network effects, or cost advantages, enabling them to sustain high returns on invested capital (ROIC) over the long term. The market usually assigns these companies higher valuations (i.e., higher P/Es) because investors anticipate sustained and stable earnings growth. Mechanically excluding high P/E companies means forfeiting the opportunity to invest in these exceptional enterprises.

3. Underestimating the Compounding Power of "Growth"

Munger deeply understood that compounding is the eighth wonder of the world in investing, and growth is its core engine.

Static vs. Dynamic Perspective: The low P/E strategy is a static valuation method, focusing only on the current relationship between earnings and price. Munger adopts a dynamic perspective, focusing on a company's earning power 5, 10, or even more years into the future.
Growth Can "Digest" High Valuations: A company growing at 20% annually, even with an initial P/E of 30, will see its earnings increase approximately 1.5 times in five years (1.2^5 ≈ 2.49, more than doubling earnings). Relative to its earnings five years later, the initial purchase P/E effectively drops to about 12 (30 / 2.49). Conversely, a zero-growth company with a P/E of 10 will still have a P/E of 10 five years later. Clearly, over the long term, the former is the superior investment.

4. Prone to Falling into "Value Traps"

A "Value Trap" is a stock that appears cheap but whose intrinsic value is persistently eroding, leading to a continuously falling or stagnant stock price. Mechanical low P/E strategies are prime breeding grounds for value traps because they cannot distinguish between a "temporarily distressed prince" and an "inherently weak enterprise." Without qualitative analysis of the business model, competitive landscape, and management capability, investors easily buy companies with fundamentally deteriorating prospects, ending up with investments that get "cheaper as they fall."

5. Misaligned with Modern Economic Structure and Large-Scale Capital Management

Importance of Intangible Assets: In Graham's era, company value was primarily tied to tangible assets like plants and equipment. In the modern economy, intangible assets—brands, patents, software, user data—have become crucial. Traditional metrics like P/E and P/B (price-to-book) struggle to accurately value these intangibles. Applying simplistic low P/E criteria to tech giants like Google or Microsoft, whose core value lies in intangibles, is futile.
Scale Limitations: For firms managing enormous capital, like Berkshire Hathaway, the "cigar butt" strategy is impractical. They cannot deploy billions of dollars into countless small, cheap stocks, and the management costs and market impact costs of frequent trading are prohibitively high. Therefore, they must concentrate capital in a select few wonderful companies capable of absorbing large investments and being held for the long term.

Summary

Charlie Munger did not oppose "value" itself, but rather a narrow definition of "value." He elevated value investing from Graham's focus on "liquidation value" and "low statistical metrics" to a new dimension: the long-term sustainable earning power and growth in intrinsic value of a business.

In his view, mechanical low P/E strategies represent a lazy and dangerous mental shortcut that:

Substitutes "cheap" for "quality".
Replaces insight into the "dynamic" evolution of business with "static" numbers.
Overlooks the immense power of compounding and growth.

Therefore, he advocated for a more comprehensive and profound investment methodology: deeply understanding the essence of business, seeking wonderful enterprises with durable competitive advantages, and holding them for the long term at reasonable prices, partnering with them as they grow.