Unlocking Buffett’s Billions: Understanding his Investment Philosophy
You don’t have to be a reader of the Wall Street Journal to recognize the name Warren Buffett. The “Oracle of Omaha,” as Buffett is sometimes endearingly referred to due to his residence in Omaha, is known as one of the greatest investors of modern times and as one of the richest people in the world. But what about Benjamin Graham, ever heard of him? How about value investing? Without Benjamin Graham and his value investing philosophy, Warren Buffett would not be on the Forbes 400 list. I am not going to cite a biography of Warren Buffett- that’s what Wikipedia is for. What I do hope to provide is a sufficient understanding of the investment philosophy that Buffett and many other legendary investors have used to create significant amounts of wealth for themselves and their investors.
Let us take a trip back to the 1950’s, to the classroom of Columbia Business School, where a professor named Benjamin Graham taught a group of students about the investing philosophy known as value investing. Many students who took this class went on to become some of the most successful investors of the past century.
Graham’s teachings have been around since the 1920’s. At that time, speculation with financial markets was alive and well, and investing in stocks was deemed too risky for the average American. Graham believed in a more constructive approach to buying securities (stocks and bonds) and holding them for the long-term. He preached a method of due diligence and investing for significant periods of time as the optimal path to achieving investing success. As confidence in financial markets dwindled following the Great Depression, Graham refined his philosophy and wrote a textbook on value investing called Security Analysis to teach students how to identify and evaluate the highest quality businesses selling at the most attractive discounts to the market. In 1949, Graham wrote a book titled The Intelligent Investor, which is now known within investing circles as the “bible of value investing”. Many investors have used Graham’s methods to become successful, but no one was like Buffett. With the assistance of his long-time partner, Charlie Munger, and by adhering to Graham’s teachings, albeit with his own refinements, Buffett became the world renowned value investor we know him as today.
What was this recipe that these investing trailblazers implemented that made them so successful? Was there a secret code or club required to become a successful value investor? The answer is NO. The basic idea behind value investing is as simple as this: buy a security when the intrinsic value of the security’s assets is above the price being quoted by the market. Properly executing this idea and value investing in general can be broken down into three fundamental principles.
As the first principle of value investing, Graham emphasized that to avoid speculation, investing must be done with the mindset that when buying a stock, one really is purchasing a portion of the company. An investor is not simply buying something that shows up on his online brokerage account. He is buying a claim on the future performance of the company. There are two reasons one would buy this claim on a company: either because he believes that the company's eventual success will result in price appreciation, or because he has reason to expect dividend income (left over profits which a company will sometimes give back to the shareholders). Basically, the reason to buy into this business is because the market, or as Graham referred to it “Mr. Market,” is offering an investor a low price for a business that is actually worth much more than today’s market price.
You might ask, why would a profitable business be undervalued? Well, the answer is that markets are largely made up of millions of human participants. Since humans are involved, decisions are occasionally made without rational logic. In other words, people often overreact to news and trends. Because many market participants move in herds (a.k.a. peer pressure), the effects on market prices are often exaggerated in the short-term. This is where a value investor would swoop in and buy a great company with strong long-term prospects for cheaper than its actual worth. But notice how I said the prices are affected, not the value. This is an essential distinction for understanding the value investing philosophy. If one buys a stock of Apple at $100, that is the price of the current market offering. The true intrinsic value of that stock is based on many variables (that I will leave for a different time), but is essentially the sum of all the future earnings of the company plus the fair value of all the company’s assets.
This is where the second principle of value investing comes in. The difference between the intrinsic value of the stock and the current market price is called the margin of safety. Benjamin Graham in The Intelligent Investor, Chapter 20 calls the margin of safety “the secret of sound investment”. The second principle which Graham taught was that whenever one buys an undervalued stock, it is vital to make sure there is a decent margin of safety to prevent downside risk. This provides the investor a humbling reminder that his estimate of intrinsic value is often subjective. Graham knew that investors would also be influenced by their own mental biases when calculating the value of a company, so he instituted the margin of safety, leaving a person with wiggle room if the stock isn’t as highly valued as originally thought.
As an example, let’s say an investor did his research and analysis of Company X, and concluded that the intrinsic value of the company (an estimate of the worth of all of the company’s assets and future profits) is $100. To his joy and excitement, due to recent negativity about the economy, the price of Company X trades at $75. This discount from the intrinsic value is what makes this company a legitimate bargain. After making sure nothing fundamentally has changed with Company X, he buys some shares. He then remembers Graham’s margin of safety principle, and assigns a 30% margin of safety. This discounts the intrinsic value of $100 to a $70/share price. Now, let’s say this estimation of intrinsic value was totally off because this is a young investor who is new to this and it takes making mistakes to learn a new craft. The margin of safety buffer essentially protects this investor from buying a company that wasn’t a bargain after all.
Let’s review: We have learned two out of the three major principles of value investing. One, an investor is supposed to buy and hold profitable companies that are underpriced in the market as a result of short-term market sentiment. Two, only buy these “bargain” companies when there is a decent margin of safety, so there’s sufficient room for error. The third principle is the selling of value stocks, an essential rule to value investing for the long-term. Leaving a time horizon gives time for the stock to converge on its intrinsic value. Usually, a catalyst or event will increase the probability of this convergence occurring. If not, there’s always the question of what will move a company’s stock price up to its intrinsic value. Having a potential catalyst in mind is important to think about even before purchasing a stock. Patience and conviction in investment ideas are an imperative when investing because often the market will go through many potentially painful fluctuations.
As long as the fundamentals and the investment thesis are in place, there really shouldn’t be a reason to sell at a loss, but rather, one should consider buying more at the lower price, or averaging down (buying additional shares at the lower price, bringing down the average price of all the shares you’ve bought thus far). An important philosophy of Graham regarding the movement of the markets was, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” In other words, fundamentals are what drives a company’s stock performance over a number of years. Therefore, the key to being a successful investor is to have the patience to tough out the market downturns.
These three principles are just a taste of what’s required to be a successful value investor. The reason value investing is so important is because with it, anyone is capable of being successful, whether a seasoned banker or a college student. Although research and analysis will increase one’s odds of success, luck will also play a role and will lead certain people to failure and lead others to success. Regardless of who is playing the market, it is important to keep in mind that aside from the dedication, having an area in which one is knowledgeable through experience (i.e. medicine, technology, retail, telecommunications, etc.) can offer a tremendous advantage and warrants the focus of the investor. This circle of competence allows one to identify top companies in an industry better than someone who lacks industry knowledge.
Finally, in addition to adhering to the three aforementioned principles, when doing research, always be sure to keep a long-term outlook, focus on what you know, and use critical thinking skills to analyze why a company is doing well or why it’s not. Over 10-30 years, if you consistently find the winners, you won’t only have amassed tremendous knowledge about companies and the world, but you will also be able to enjoy the fruits of your investing labor.