The Education of Warren Buffett

Warren Buffett is said to possess the investing acumen of three legends, namely, Benjamin Graham, Philip Fisher and Charlie Munger. In this chapter, we will learn about the investment philosophies of all three.

Benjamin Graham

Graham is the pioneer of financial analysis. Prior to him, stock analysis was not structured and was not performed professionally. Two of his famous books “The Security Analysis” and “The Intelligent Investor” are world renowned. At age 25 in 1919, he was earning an annual salary of $6,000 (almost $8 million adjusted for inflation). By 1926, he went ahead to form an investment partnership with Jerome Newman and called it Graham-Newman. This was the same firm from which Warren Buffet started his formal investment management career later on. Graham-Newman survived the 1929 crash, the Great Depression, World War II, and the Korean War, before it was dissolved in 1956.

Graham faced financial ruin twice during his lifetime. The first one was when his father died leaving the family little savings. The second one was during the 1929 financial market depression. He is known for having a good memory and therefore was never able to forget the pain of financial ruin. In his investment philosophy as well, he kept a particular focus on not losing money.

Warren Buffett’s famous dialogue about the 2 rules to financial success, i.e. 

1. Rule no 1, Never lose money and 
2. Rule number 2: never forget rule number 1, was coined by Graham himself.

He also gave a formal definition to investment that distinguished between investment and speculation. An investment operation is a thorough analysis, which promises two things:

1. Safety of principal  
2. Satisfactory return. 

Operations not meeting these requirements are speculative.  

Let's break-up the definition to better understand the meaning of investing:

1. Thorough Analysis: Financial analysis is a three-step process-

• Descriptive: This involves collecting all the available facts of a company and presenting them in an intelligent manner.
• Critical: Examining the authenticity of the information collected.
• Selective: This involves judging the attractiveness of the stock. This is the most important step in financial analysis.

2. Safety of Principle: Return “of” capital is more important than return “on” capital. Therefore, select investments that are able to assure safety to the capital invested.

3. Satisfactory Return: This, according to Graham, is subjective. For one, 12% return can be satisfactory while for others even 25% return could be meager. Therefore, based on your analysis select stocks that are able to meet your investment return requirements.

The other contribution of Graham to the investment field was his method of choosing right stocks. His method involved buying while adhering to a Margin of Safety. 

1. Purchase stock when the overall market is trading at low prices (as indicated by a bear market)
2. Purchase a stock when it is trading below its intrinsic value. If the stock price is below its intrinsic value, then it is considered to be undervalued.

Intrinsic value is a subjective concept. Intrinsic as the name suggests is the true value of the company. This true value is determined by an individual based on its perception about the stock and the markets. Therefore, calculation of intrinsic value should be done individually by an investor.

As a simplified version of identifying stocks trading below intrinsic value, Graham suggests looking for companies that are trading below its net assets value. This although is quite reasonable, but it does not give adherence to qualitative aspects like management quality and brand value, etc. and therefore cannot be trusted.

Today, most investors rely on John Burr Williams ’s classic definition of value, as described in his book The Theory of Investment Value (Harvard University Press, 1938): The value of any investment is the discounted present value of its future cash flow.

Philip Fisher

Graham, who taught the investment world about quantitative investing, it was Fisher who emphasized on the fact that a lot of things are hidden in between the lines of the financial statements. Thus, it is not the ratio analysis alone that will help you select the right stocks, but “scuttle butt”. Suttle Butt is a technique of enquiring more and more about the company from people who have knowledge and information about the company and industry.

Fisher believed that in investing superior profits can be made by 

1. Investing in companies with above average potential
2. Investing in companies run by capable managements

In order to identify such stocks, Fisher looked at companies that were able to grow their sales and profits at a rate higher than the industry average. This trend should be looked at over several years. Both sales growth and profit growth are essential for a company’s success. Therefore, Fisher loved companies that were the lowest cost producers in the industry of operation. According to him, a company with a low break-even point and high profit margin is better able to sustain an economic depression.

Apart from this, Fisher also stressed on investing in companies which were run by management of unquestionable honesty and integrity. One way to judge this is by observing how the management communicates with the shareholders. Commonly, when times are good management may speak good things about the company to the shareholders whereas, they might disappear when times are bad. The employee retention and depth of the management team (talented management team) are also critical elements to judge the capability of the management team.

This can be a stressful process, therefore, Fisher focused on holding just a few outstanding companies and tracking them for really long periods of time. 

Charlie Munger

Charlie and Warren, although both were from Omaha and had a few mutual friends, had never met until 1959. It was only when Charlie moved back to Omaha on his father’s death, that a common friend thought of introducing the two. There was an instant connection between the two, as both were fond of common sense investing.

Charlie’s investment style was more of qualitative and less of quantitative. It can thus be said that he was more influenced by Philip Fisher and less by Ben Graham.

Warren, who was influenced more by Ben Graham, always wanted to buy companies that were available at cheap valuations based on conventional matrices like Price to Book <1. This however was not the most appropriate method to identify quality stocks especially when stocks are priced higher due to intangible off balance sheet items like brand value. 

Thus, when Buffett and Munger joined hands in Berkshire Hathaway, it was Munger who influenced Buffett to pay higher for quality stocks. The first instance of such investing was See’s Candy. 

See’s Candy was a Candy store, which was up for sale at a net price of $30 million. It was however quoting at 3 times its book value and hence Buffet was reluctant to overpay. It was then Charlie, who convinced Buffet to pay for quality and resultantly Buffet purchased See’s at a net price of $25 million. It was only 10 years later that they had got a quote of selling See’s Candy for five times their purchase price at $125 million.

Charlie’s investing style can be studied in depth in the book called, “Poor Charlie’s Almanac”. The Blend of Intellectual Influences. 

Buffett is supposed to be a blend of these three individuals – Ben Graham, Philip Fisher and Charlie Munger. All these three had a major influence on Buffet from time to time and shaped his investment philosophy. 

Graham's deep value approach of buying companies that were available below its book value was the basis of Buffett’s investment approach. However, with time Buffett realized that this methodology had been tweaked as when Graham devised this approach, it was a bear market and stocks were available at deep discounts to their book value. The methodology of valuing cheap stocks hence changed but what remained was the principle of Margin of Safety. This approach led Buffett to recognize stocks such as Coca Cola, Sees Candy and Intel, all of which were bought at prices higher than the net assets (book value) but possessed margin of safety. Graham also had taught Buffett to remain unemotional about the stock market fluctuations and instead take it as an opportunity. 

Philip Fisher on the other hand was quite different from Graham. While Graham was more concerned about the financial statements and quantitative characteristics of the company, Fisher looked for off-Balance Sheet items such as brand and management quality. He used to look ahead of the company's financial statements and instead spent time understanding the economics of the business. Fisher also stressed on the hazards of over diversification. Buffet as we know takes big bets on a single stock when he is confident. 

Remember American Express? He took a massive 25% of the total partnership money. Apple, his recent bet also makes up a significant portion of his overall portfolio. The concepts of Fisher were ingrained into Warren Buffet by the book “Common Stocks and Uncommon Profits” and his partner Charlie Munger.