Lesson #4: Value Investing Principles – From Graham to Buffett

Value Investing Masterclass - Safal NiveshakWarren Buffett is one name that rings a big bell for value investors worldwide. And why not? Very few people have come close to Warren Buffett’s investment record over the past few decades, and no one has topped it.

Through these decades of market ups and downs, he has continued on a steady course with unmatched success.

So how did Buffett come to his investment philosophy which the world wants to follow now? Who influenced his thinking?

Benjamin Graham was Buffett’s first teacher who opened the doors of value investing for him. Buffett came to know Ben Graham at the age of 19 when he first read The Intelligent Investor. The book had profound effect on WarreGrahamn Buffett’s investment thinking.

Benjamin Graham, known as the “Father of Security Analysis”, taught the world how to invest sensibly and profitably, and also made his fortune by practicing what he preached.

He distilled this work into The Intelligent Investor, a book for the lay investor, whose ideas remain relevant even six decades after it was first published.

“So, what’s the Graham approach?” You may ask.

Graham laid out a very clear and useful definition of investing. According to him, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

I know that we have already seen this definition by Graham in earlier lessons, but it’s such an important idea that it needs to be tattooed hard on your brain. So read it again. 🙂

Graham's Definition

The second principle, says Graham, is “Investment is most intelligent when it is most businesslike.” Which simply means that to be able to invest profitably, you need to think like a businessman. Buffett, based on his experience, confirmed, “I am good investor because I a businessman and a good businessman because I am an investor.”

The next thing which Grahams advices is to make friends with stock price fluctuations. He writes in The Intelligent Investor …

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market.

Graham uses a brilliant metaphor to capture this idea. He asks us to imagine somebody called Mr. Market who is your partner in a business. Sometimes Mr. Market is in extremely good mood and ready to buy your stake in the business for very high price. On other times, he sound very pessimistic and gloomy and is ready to sell his stake to you for very cheap price. Mr. Market comes to your doorstep everyday with a price quote and he doesn’t mind being ignored.

What you need to learn is that Mr. Market is there to serve you, not to guide you.

You will be better off concentrating on the real life performance of the companies whose stocks you own, rather than being too concerned with Mr. Market’s often irrational behaviour.

Overall, through the Mr. Market allegory, Graham’s basic message was that the stock market can be a highly illogical place, where greed and fear — rather than rationality — often prevail and where buyers and sellers from time to time behave in a herd-like manner.

Greed and fear aren’t the only emotions which prevail in stock market. There are host of other behavioural biases that affect investors. We will be discussing in the psychology of investing in future lessons.

Now that you’ve been introduced to Mr. Market, the next thing that Graham teaches is the idea of Intrinsic Value i.e. an estimate of business’s true worth which may be entirely separate from its stock market price. Graham believed that intrinsic value could be estimated from company’s financial statements, namely the balance sheet and income statement.

Intrinsic value is an indefinite and approximate assessment. As Graham wrote…

To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.

The next and probably the most sacrosanct of all principles is Margin Of Safety. Simply stated it means paying only Rs 60 for something you think is worth Rs 100.

By allowing yourself a margin of safety, you provide for errors in your forecasts and unforeseeable events that may alter the business landscape.

In Chapter 20 of The Intelligent Investor, Graham wrote…

Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

Just think, if you were asked to build a bridge over which 10,000-pound trucks were to pass, would you build it to hold exactly 10,000 pounds? Of course not — you’d build the bridge to hold 15,000 or 20,000 pounds. That is your margin of safety.

Margin of Safety is such an important idea and we will be covering it in detail in future lessons.

In Security Analysis, Graham and Dodd advised investors to think independently. Graham wrote…

You are neither right nor wrong because people agree with you.

The ability to think for yourself is one most critical skill that an investor needs to develop for a long term success in stock market. No wonder, Warren Buffett spends 6 to 7 hours everyday just reading and thinking.

Of all the above principles listed above, if you were to remember only three core ideas, they should be following-

  1. The investor should look at stocks as part ownership of a business;
  2. The investor should look at market fluctuations in terms of Graham’s “Mr. Market” example and “make them your friend rather than your enemy by essentially profiting from folly rather than participating in it”; and
  3. The three most important words in investing are “margin of safety”, which means “always building a 15,000 pound bridge if you’re going to be driving 10,000 pound trucks across it.”

“I think those three ideas 100 years from now will still be regarded as the three cornerstones, essentially, of sound investment,” said Buffett. “And that’s what Ben was all about.”

Buffett was the most famous of Graham’s dedicated students, and never missed an opportunity to acknowledge the intellectual debt he owed to his teacher.

When Graham passed away in 1976, Warren Buffett wrote this about his teachings…

In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound — their value often enhanced and better understood in the wake of financial storms that demolished flimsier intellectual structures. His counsel of soundness brought unfailing rewards to his followers — even to those with natural abilities inferior to more gifted practitioners who stumbled while following counsels of brilliance or fashion.

But while working under Graham, Buffett was becoming aware that the latter’s strategy of buying cheap stocks was not ideal, for it did not consider the quality of businesses, and just a stock’s cheapness.

When evaluating stocks, Graham did not think about the specifics of the businesses. Nor did he ponder the capabilities of management. He limited his research investigation to corporate filings and annual reports.

If there was a mathematical probability of making money because the share price was less than the assets of the company, Graham purchased the company, regardless of its business or its management. To increase the probability of success, he purchased as many of these statistical equations as possible.

Buffett was beginning to appreciate the qualitative nature of certain companies, compared with the quantitative aspects of others. And the man who influenced Buffett’s investing philosophy in this direction was Phillip Fisher. Buffett met Philip Fisher in the early sixties, after reading his first Uncommon Profits.

From Fisher, Buffett learned the value of “scuttlebutt”, or the idea of going out and talking to competitors, suppliers, and customers to find out how an industry or a company really operates. Fisher also taught Buffett the benefits of concentration – focusing on just a few investments.

Buffett’s investment approach combines qualitative understanding of the business and its management (as taught by Fisher) and a quantitative understanding of price and value (as taught by Graham).

He once said, “I’m 15 percent Fisher and 85 percent Benjamin Graham.”

In fact it was Charlie Munger who was most responsible for moving Buffett toward Fisher’s thinking of focusing on business quality than just cheap price. Munger has had a great influence on Buffett’s life, both investing and otherwise.

Munger, through his readings in psychology, has developed a framework for human behaviour and decision making. He calls it the “psychology of misjudgement”. To his working relationship with Buffett, Munger brought not only financial acumen but the foundation of business law.

In coming lessons, we will discuss a lot about Charlie Munger and his philosophy, when we study how human behaviour impacts investing.

Munger is passionately interested in many areas of knowledge – science, history, philosophy, psychology, mathematics – and believes that each of those fields holds important concepts that thoughtful people can, and should, apply to all their endeavours, including investment decisions. He calls them “the big ideas,” and they are the core of his well-known notion of “latticework of mental models” for investors.

John Burr Williams was the man who provided Buffett with a methodology for calculating the intrinsic value of a business.

The frequent confusion surrounding Buffett’s investment actions is easily understood when we acknowledge that Buffett is the synthesis of all four men. It is the application that separates Buffett from other investment managers.

The idea of “value investing” has evolved considerably over the years. To say that this evolution has been one of unyielding progress over the century would be simplistic.

In fact, Graham and Buffett each strove to adapt to the nature of the investment problem as it really was during the period in which each operated.

As conditions change in the future, further adaptations will no doubt be required. Yet the strength of the basic Graham framework is such that it will remain sound.

A naive observer of Buffett today would find it difficult to see the Ben Graham influence in many of his activities. However, that influence remains at the core of Buffett’s investment model.

Buffett continues to think about stocks as fractional ownership interests in underlying businesses, he continues to operate under the assumption that there is a distinction between price and value, and he continues to search for the largest discrepancy between those two items.

In other words, he continues to be a “value investor.”

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