Not everyone is lucky enough to study under a certified guru, and their eventual mentor, in graduate school, but Warren Buffett did just that when he went to Columbia, home to Ben Graham and David Dodd, the powerful twosome who’d literally written the book on value investing. Buffett was quickly thrust into a world that was heaven to him. Analyzing companies, reading everything he could get his hands on, and having the chance to sit in classrooms and have discussions and debates with Graham was like coming home for Buffett.
He soaked up everything he could while he was there, and made connections with Graham and other like-minded students that would carry on long past the closing school bell. From Graham, he built the core of his investing philosophy: Always buy with a margin of safety. As we talked about earlier, in the chapter on risk, Buffett considers these three words—“margin of safety”—to be the “cornerstone of successful investing.”1
Buffett also learned the basics of value investing from Graham. He learned about calculating intrinsic value, figuring out how much a company was currently worth, and how much it should be worth in the future. He learned about the vagaries of the market, especially the character Graham loved to talk about, Mr. Market, and all his associated capriciousness.
Buffett, it’s safe to say, idolized Ben Graham and most likely continues to idolize him to this very day. Buffett wouldn’t have become the investor he is today without Graham’s foundation.
And yet, Buffett, as he began his investing career and started learning more about business and what makes companies successful, slowly started shifting his orientation. He was still solidly in the value camp (although he’s actually argued in his shareholder letters that the value-versus-growth distinction is a meaningless one, as you need both in order for a company to turn into a winning investment), but he began looking at more qualitative factors, as opposed to the strictly quantitative ones Graham focused on.
You see, for Graham, it was all about the numbers. It didn’t even matter much what the company did, or who was on its executive team, or what its future prospects held. While he firmly believed in the fact that buying a stock was buying a piece of an actual, living and breathing company, he was also more concerned with tallying up a company’s assets and liabilities and seeing what the whole shebang was worth, and then seeing what it was trading for in the market.
This was the “cigar butt” school of investing we covered earlier. The goal was to stumble across a cigar that had just one more puff in it, and take advantage of that. Buffett, however, was destined to become something more than a mere cigar butt aficionado. He was to see that just because something’s exceedingly cheap, that doesn’t by default make it good.
The first person to open Buffett’s eyes to this was Charlie Munger. Munger took more nebulous factors into consideration when he invested. While he also didn’t like overpaying for businesses, the fact that something was cheaper than dirt was not the be-all and end-all for him. That in and of itself was not enough of a reason to buy.
He believed that management mattered, that having a competitive advantage mattered, and that sometimes you had to pay a little bit more than you would have liked to own a piece of a promising business. Instead of hunting around for nasty old cigar butts to suck one last puff from, Munger’s philosophy was, essentially, “Why don’t we look for great businesses run by good folks and buy those?”2
For Buffett, this was something of a revelation. He slowly began to see that Munger was right, and that he could take the best of Graham and add in some more qualitative factors to come up with a comprehensive investing philosophy that was his own.
The work of investment writer Philip Fisher was also important here. Fisher wrote a highly influential book, Common Stocks and Uncommon Profits, where he laid out his approach to investing. This involved something he dubbed “scuttlebutt,” which meant the research into a company’s prospects an investor could engage in on his own.3 It could mean talking to management, or a company’s suppliers, or its customers, or its employees, or just generally being alert to picking up new information.
This fit beautifully with Buffett’s feelings that research was something you never got enough of. And he’d already engaged in scuttlebutt himself by that point. Showing up as a grad student at GEICO’s offices on a Saturday and talking to a vice president jumps right to mind. (Scuttlebutt’s something you can do, too. It’s an excellent way to learn more about your investments.)
In addition to giving the world scuttlebutt (which, incidentally, is also the name of a “gentlemen’s club” in Slidell, Louisiana), Fisher’s investing masterpiece also focused, in large part, on the more qualitative factors Buffett was picking up from Munger. Fisher’s book provided a fifteen-point list of things to look for when analyzing a company. Among them were several points devoted to the importance of having open, honest management, as well as questions about the strength of the company’s product line and its viability versus its competitors.
By 1989, Buffett had fully turned the philosophical corner and in his letter to shareholders that year said, “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit. Unless you are a liquidator, that kind of approach to buying businesses is foolish.”4
He went on to talk about his experience with the Baltimore department store he and Munger bought, Hochschild-Kohn, which gave them such fits. It was cheap as cheap could be when he bought it. It even had good people running it. But those fine folks weren’t enough to overcome plain old bad economics. As an example of why pure cigar butt investing didn’t work, that was a good one.
Buffett also differed from Graham on the issue of diversification. Graham owned lots and lots of companies, while Buffett believes in focusing on just a few. He believes that owning lots of stocks is a sign that you don’t fully understand what you’re doing, while Graham believed (as do we here at The Motley Fool) that it reduces your risk.
Writing in the 1993 letter to Berkshire shareholders, Buffett addressed this point, saying, “Charlie and I decided long ago that in an investment lifetime it’s too hard to make hundreds of smart decisions. . . . Therefore we adopted a strategy that required our being smart—and not too smart at that—only a few times. . . . The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as ‘the possibility of loss or injury.’ ”5
Buffett’s investment in GEICO when he was a grad student, and after he went down in person to the company’s D.C.-based office (scuttlebutt!), provides a good example of the difference between Graham and Buffett on the issue of diversification. While Graham owned small stakes of many companies, Buffett was such a profound believer in GEICO already that the young student invested three-quarters of his portfolio in it.6 Concentrating like this in one stock is pure Buffett.
So, while it’s important to learn from those who’ve gone before you, don’t be afraid to ask if the way they are going about things is the best way possible. Remember:
• The learning never stops, so even after you think you’ve figured out the best way to invest, keep studying.
• Just because someone’s an acknowledged investment guru or master doesn’t mean there isn’t a better way.
• You aren’t committing blasphemy when you question anybody, Warren Buffett included.