Why Warren Buffett Considers Benjamin Graham the Second Most Important Person in His Life

(This is a brief study of Benjamin Graham’s value investment approach. If you’re looking for a more modern version of successful investing principles please read 11 Habits of Successful Investors)

You must have heard the phrase “standing on the shoulders of giants”, Warren Buffet stood on the shoulder of a giant, Benjamin Graham, and now he is one. To him, the second most important person in his life – after his father – was Graham, the father of value investing.

Graham was born in London in 1894, moved to New York with his family when he was a year old. He lost his father when he was nine. This tragedy sent his family into financial turmoil.

I mentioned in an earlier article how Graham’s childhood influenced his investment approach. He was cautious with his finances from an early age, always looking for buying cheap with a margin of safety.

On buying shares of a company, he used to live by the rule that if you had the money and were not willing to buy the company you shouldn’t buy a share of its stock either. To him, a true investment has to have a true margin of safety that can be demonstrated through figures, persuasive reasoning and actual experience.

It’s not surprising why he emphasized on margin of safety. The financial setbacks his family suffered and later his own losses during the Great Depression made it mandatory for him to differentiate between price and value. In Buffett’s words,

From 1929 to 1932 Graham’s partnership lost 70%. Rising from such a loss and then dominating the financial markets takes special courage and strategy. Such an experience made him wiser and he got a much deeper understanding of market behavior. He evaluated companies through;

  • Quantitative techniques; he’d examine the value of existing assets (property, inventory, cash etc.) through company’s financial statements and also use other resources of that time such as Moody’s manual 
  • Then he’d look at current earnings
  • And lastly, future profits, but only in core competence area of a firm having sustainable competitive advantage

Broadly speaking, if a company has survived a couple of recessions it might be a good investment. Graham was aware of growth stocks but he deemed them too risky, and thought they might blow up. For instance, internet stocks such as Webvan and CMGI went bankrupt when the bubble burst.

During Graham’s time many growth stocks, such as computer and car companies, lost most of their values despite growth in their respective industries. He thought that the odds of finding the next Google or Amazon are the same as the odds of winning the lottery.

Graham believed that ‘an’ investor could pick the next blockbuster stock but the average investor is better off not giving in to this temptation.

An important concept in value investing is mean reversion, which means that past winners often become past losers, while past losers often become future winners. The value of companies and their share prices generally revert to the mean.

Why does that happen?

Competition.

Think about it, if you’re the top dog in your industry, everyone will try to take your market share. Chances are your company might be trading at high valuations, and when things go wrong the fall is very steep.

Reverse is also true; if your firm is not doing well you don’t have much competition either. And investors don’t expect much from your unknown brand. But once you fix the problems there are plenty of upsides.

The logic of value investing works because of how the market ‘behaves’. Psychological forces have more to do with the price than we’d like to think. Greed and fear moves the prices away from their equilibrium prices.

Graham has left an admirable legacy. His value investing family has some of the biggest names in the world.

(source Business Insider)

Resources

  • Graham’s Books The Intelligent Investor and Security Analysis
  • Free ETF Portfolio Management Tool Ways2Wealth

If you’re new to investing you might think that successful investors must have exceptionally high IQ. I used to think that but I was wrong. Although intelligence is helpful but you also need skill, strategy, and temperament.

Perhaps this is why successful investors such as Warren Buffett call investment, part science, part art. Irrespective of your talent or IQ, you have to pair these abilities with hard work and honing investment skills. Buffett compares a successful investor to Tiger Woods in his prime; Woods was born with an aptitude for playing golf but he honed it by hitting 500 golf balls a day.

The majority of us have some idea about the science part of investments. In an oversimplified world, it comprises of calculating ROI, while accurately reading and interpreting the balance sheet of a company. It might also venture into areas such as time value of money: How soon can an investor get the return.

But the art part is abstract. Successful investors have investment philosophies, where their primal instincts govern their cold calculations. This results in investment as an art form.

For instance, Benjamin Graham – Buffett’s mentor – has his philosophy of value investing. His father ran a successful retail business and they were doing well financially. But tragedy struck as Benjamin’s father died when was just a boy. Later his mother lost almost every penny during the crash of 1907. He grew up during the panic of 1907, and witnessed the consequences of the Great Depression.

Benjamin’s circumstances shaped how he approached investing later on. He always looked for ‘value’ in companies. In my limited understanding, his approach frugal. Maybe he was the first legit hustler of Wall Street as he always looked for companies to buy at a steep discount, coupled with the ‘margin of safety’. Cash flows of a company mattered but stability mattered much more.

He wrote The Intelligent Investor and Security Analysis, where the former is considered the bible of investing. Bear in mind that trading stocks was not considered a respectable profession during those days, and using inside information was legal.

He compared owning the stocks in a company to having an ownership in the company; If you don’t want to buy the business you shouldn’t buy its stocks. He generated consistent profits for decades not just because of his IQ, but because of his investment philosophy.

 

The reason I stress on this is because there is so much more that goes into investing besides intelligence. If you have a great IQ but you’re greedy or too aggressive, you might not get consistent profits.

The same is true if you’re too risk-averse or scared of putting money in the market. Or you might be lazy enough to not acquire the necessary information or not to act when you should.

It’s truly helpful to study the techniques and strategies of successful investors. If it were only a matter of calculations or IQ, quants would have been the most successful.

How is that helpful?

Studying great investors helps in making sense of the market. There is a reason why they are able to generate consistent profits. Regardless of the IQ, the average Joe suffers from schizophrenia; He gets greedy when the market is up and panics when it’s down.

If you can formulate an investment strategy where your calculations are governed by a higher power i.e. a philosophy, you can generate returns successfully. In my brief experience, there is no single way to become a successful investor, but a golden rule is to formulate a strategy that matches your personality and skill set.

Either you manage your own money or pay someone else to do it for you, you must do your due diligence. Be ruthless on yourself and try to answer certain questions before investing. For instance;

  • Do you want to invest actively (trying to outperform the market) or passively (buying low-cost index funds)?
  • What kind of assets are you looking to invest in? Are you looking for value investing (Graham’s main strategy) or growth investing (like Philip Fisher and Peter Lynch)?
  • Are you good with or are interested in studying patterns in the market?

These are just the basics but the point is to figure out your investment strategy instead of mere tactics (reacting to the market). Once you have figured out your plan according to your skill set, the next step is to follow through. Profitable investment requires ‘some’ intelligence but to think that someone with a higher IQ will profit more than a person with a lower IQ is wrong.

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” – Warren Buffett

Further reading

A short book with to-the-point advice on money A Few Lessons for Investors and Managers from Warren E. Buffett

 

 

Advertisements