Even a five-sigma phenomenon with a stunningly powerful intellect must rely on the teachings of those who came before him, for not even he can skip the process of learning his trade. Warren Buffett’s education is, as we shall see, a synthesis of three distinct investment philosophies from the minds of three powerful figures: Benjamin Graham, Philip Fisher, and Charlie Munger.
The Graham influence on Buffett is well known; in fact, some consider it all-encompassing. This is not altogether surprising, considering the entwined histories of the two men. Buffett was first an interested reader of Graham, then a student, an employee, a collaborator, and, finally, Graham’s peer. Graham molded Buffett’s untrained mind. However, those who consider Buffett to be the singular product of Graham’s teachings are ignoring the influence of two other towering financial thinkers: Philip Fisher and Charlie Munger. We will study both of them in this chapter.
Graham is considered the dean of financial analysis. As Adam Smith notes, “Before him there was no [financial analysis] profession and after him they call it that.”1 Today he is best known for two celebrated works: Security Analysis, coauthored with David Dodd and originally published in 1934, and The Intelligent Investor, originally published in 1949. Part of the enduring significance of Security Analysis is its timing: This seminal book appeared just a few years after the 1929 stock market crash, a world-changing event that had a major impact on the author and profoundly influenced his ideas. While other academicians sought to explain this economic phenomenon, Graham helped people regain their financial footing and proceed with a profitable course of action.
Ben Graham earned a bachelor of science degree from Columbia University in 1914, at the age of 20. He was fluent in Greek and Latin and had a scholarly interest in mathematics and philosophy. However, despite his no-business education, he began a career on Wall Street. His first job was as a messenger at the brokerage firm of Newburger, Henderson & Loeb, posting bond and stock prices on a blackboard for $12 a week. From messenger, he rose to writing research reports and soon was awarded a partnership in the firm. By 1919, at age 25, he was earning an annual salary of $600,000—almost $8 million in 2012 dollars.
In 1926, Graham formed an investment partnership with Jerome Newman. It was this partnership that hired Buffett some 30 years later. Graham-Newman survived the 1929 crash, the Great Depression, World War II, and the Korean War, before it was dissolved in 1956.
Few people know that Graham was financially ruined by the 1929 crash. For the second time in his life (the first being when his father died, leaving the family financially unprotected), Graham set about to rebuild his fortune. He found inspiration at his alma mater, where he had just started teaching night courses in finance. The haven of academia allowed Graham the opportunity for reflection and reevaluation. With the counsel of David Dodd, also a professor at Columbia, Graham produced what became the classic treatise on conservative investing.
Between them, Graham and Dodd had over 15 years of investment experience. It took them four years to complete Security Analysis. When the book first appeared, in 1934, Louis Rich wrote in the New York Times: “It is a full-bodied, mature, meticulous and wholly meritorious outgrowth of scholarly probing and practical sagacity. If this influence should ever exert itself, it will come by causing the mind of the investor to dwell upon securities rather than upon the market.”2
In the first edition, Graham and Dodd dedicated significant attention to corporate abuses. They had plenty of material. Before the Securities Act of 1933 and the Securities Exchange Act of 1934, corporate information was totally inadequate and often misleading. Most companies refused to divulge sales information, and the valuation of assets was frequently suspect. Corporate misinformation was used to manipulate the prices of securities, both in initial public offerings and in the aftermarkets. After the Securities Acts, corporate reforms were slow but deliberate. By the time the third edition of the book appeared in 1951, references to corporate abuses were eliminated and, in their place, Graham and Dodd addressed the problems of stockholder-management relations, principally management’s competence and the policy of dividends.
The essence of Security Analysis is that a well-chosen diversified portfolio of common stocks, based on reasonable prices, can be a sound investment. Step by careful step, Graham helps investors to see the logic of his approach.
The first problem that Graham had to contend with was the lack of a single universal definition for investment. Quoting Justice Louis Brandeis, Graham pointed out that “investment is a word of many meanings.” The issue, Graham noted, does not turn on whether the item is a stock (and therefore speculative by definition) or a bond (and therefore an investment). A poorly secured bond cannot be considered an investment just because it is a bond. Neither can a stock with a per-share price that is less than its net current assets be considered a speculation just because it is a stock. Intention is what counts, Graham said. Buying a security with borrowed money, in hopes of making a quick profit, is speculation, regardless of whether the security is a bond or a stock. Considering the complexities of the issue, Graham proposed his own definition: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”3 That simple sentence is densely packed with ideas, and they deserve our careful attention.
First, what did he mean by “thorough analysis”? He started with a succinct definition: “the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic.”4 And then he went further, describing analysis as a three-step process: (1) descriptive, (2) critical, and (3) selective. The first phase involves gathering all the facts and presenting them in an intelligent manner. The second involves examining the merits of the standards used to communicate information: Have the facts been represented fairly? The final phase requires the analyst to pass judgment on the attractiveness of the security in question.
Next, Graham insists that for a security to be considered an investment, two conditions must be present: some degree of safety of principal and a satisfactory rate of return. As to the first, he cautioned that safety is not absolute; a highly unusual or improbable occurrence can put even a safe bond into default. Rather, he said, the investment should be considered safe from loss under reasonable conditions.
Satisfactory return—the second necessity—also earned a caution, because satisfactory, as Graham correctly noted, is a subjective term. He did say that the return can be any amount, however low, as long as the investor acts with a degree of intelligence and adheres to the full definition of investment. Someone who conducts a thorough financial analysis based on sound logic and makes a choice for a reasonable rate of return without compromising safety of principal would be, by Graham’s definition, an investor, not a speculator.
Throughout his career Graham continued to be disturbed by the issues of investment and speculation. Toward the end of his life, he watched with dismay as institutional investors embraced actions that were clearly speculative. Shortly after the 1973–1974 bear market, Graham was invited to attend a conference of money managers hosted by Donaldson, Lufkin, and Jenrette, and was deeply shocked by what he heard. “I could not comprehend,” he said, “how the management of money by institutions had degenerated from sound investment to this rat race of trying to get the highest possible return in the shortest period.”5
Graham’s second contribution—after establishing a clear and lasting distinction between investment and speculation—was a methodology for buying common stocks that would qualify them as an investment rather than speculation. His methodology turned on a concept he called margin of safety, and here too his thinking was driven by the 1929 crash.
The danger of 1929 was not that speculation tried to masquerade as investing, but rather that investing fashioned itself into speculation. Graham noted that optimism based on history was rampant—and dangerous. Encouraged by the past, investors projected forward an era of continued growth and prosperity, and began to lose their sense of proportion about price. Graham said people were paying prices for stocks without any sense of mathematical expectation; stocks were worth any price that the optimistic market quoted. At the height of this insanity, the line between investment and speculation blurred.
As an antidote to such risky behavior, Graham proposed a way of selecting stocks that relied on what he called the “margin of safety.” In this approach, investors who are optimistic about a company’s future growth have two techniques for adding the stock to their portfolios: (1) purchase shares when the overall market is trading at low prices (generally, this occurs during a bear market or a similar type of correction), or (2) purchase the stock when it trades below its intrinsic value even though the overall market is not substantially cheap. In either technique, said Graham, a margin of safety is present in the purchase price.
The first technique—buying only at market lows—has some built-in difficulties. It entices the investor to develop some formula that indicates when the market is expensive and when it is cheap. The investor then becomes a hostage to predicting market turns, a process that is far from certain. Also, when the market is fairly valued, investors are unable to profitably purchase common stocks. However, waiting for a market correction before purchasing stocks may become tiring and, in the end, self-defeating.
Graham suggested that an investor’s energies would be better applied to the second technique: identifying undervalued securities regardless of the overall market price level. For this strategy to work systematically, Graham said, investors need a way to identify stocks that are selling below their calculated value. It was his goal to outline such a strategy, and to do so he developed a quantitative approach that was unknown before Security Analysis.
Graham reduced the concept of sound investing to the concept he called the margin of safety. With it, he sought to unite all securities—stocks and bonds—in a singular approach to investing.
Establishing a margin of safety concept for bonds was not too difficult. If, for example, an analyst reviewed the operating history of a company and discovered that, on average, for the past five years, a company was able to earn annually five times its fixed charges, then the company’s bonds possessed a margin of safety. Graham did not expect investors to accurately determine the company’s future income. Instead, he figured that if the margin between earnings and fixed charges was large enough, investors would be protected from an unexpected decline in the company’s income.
The real test was Graham’s ability to adapt the concept for common stocks. He reasoned that a margin of safety existed for a common stock if its price was below its intrinsic value. And the obvious next question is: How does one determine intrinsic value? Again Graham starts his answer with a succinct definition: intrinsic value is “that value which is determined by the facts.” These facts include a company’s assets, its earnings and dividends, and any future definite prospects.
Of those, Graham believed the single most important factor is future earnings power. That led him to a simple formula: A company’s intrinsic value can be determined by estimating the future earnings of the company and multiplying those earnings by an appropriate capitalization factor. This capitalization factor, or multiplier, is influenced by the company’s stability of earnings, assets, dividend policy, and financial health.
He added a strong caution: The success of this approach is limited by our ability to calculate a company’s economic future, a calculation that is unavoidably imprecise. Future factors such as sales volume, pricing, and expenses are difficult to forecast, which makes applying a multiplier that more complex.
In spite of that, Graham believed that the margin of safety could work successfully in three areas: (1) in stable securities such as bonds and preferred stocks; (2) in comparative analysis; and (3) in selecting stocks, provided the spread between price and intrinsic value is large enough. Graham asked us to accept that intrinsic value is an elusive concept. It is distinct from the market’s quotation price. Originally, intrinsic value was thought to be the same as a company’s book value, or the sum of its real assets minus its obligations. This notion led to the early belief that intrinsic value was definite. However, analysts came to know that the value of a company was not only its net real assets but also the value of earnings that these assets produce. Graham proposed that it was not essential to determine a company’s exact intrinsic value; even an approximate value, compared against the selling price, would be sufficient to gauge the margin of safety.
Financial analysis is not an exact science, Graham reminded us. To be sure, certain quantitative factors lend themselves to thorough analysis: balance sheets, income statements, assets and liabilities, earnings, and dividends. We must not, however, overlook certain qualitative factors that are not easily analyzed but are nonetheless essential ingredients in determining a company’s intrinsic value. Two of these are management capability and the nature of the business. The issue for Graham was: How much attention should be paid to them?
He had misgivings about the emphasis placed on qualitative factors. Opinions about management and the nature of a business are not easily measured, and that which is difficult to measure can be badly measured. Optimism over qualitative factors often found its way to a higher multiplier. Graham’s experience led him to believe that, to the extent investors moved away from hard assets and toward intangibles, they invited a potentially risky way of thinking. If, on the other hand, a greater amount of a company’s intrinsic value is the sum of measurable, quantitative factors, Graham figured that the investor’s downside was more limited. Fixed assets are measurable. Dividends are measurable. Current and historical earnings are measurable. Each of these factors can be demonstrated by figures and becomes a source of logic referenced by actual experience.
Make sure of your ground, said Graham. Start with net asset values as the fundamental departure point. If you bought assets, your downside was limited to the liquidation value of those assets. Nobody, he reasoned, can bail you out of optimistic growth projections if those projections are unfilled. If a company was perceived to be an attractive business and its superb management was predicting high future earnings, it would no doubt attract a growing number of stock buyers. “So they [investors] will buy it,” said Graham, “and in doing so they will bid up the price and hence the price to earnings ratio. As more and more investors become enamored with the promised return, the price lifts free from underlying value and floats freely upward, creating a bubble that expands beautifully until it must finally burst.”6
Graham said that having a good memory was his one burden. The memory of being financially ruined twice in a lifetime led him to embrace an investment approach that stressed downside protection versus upside potential.
There are two rules to investing, said Graham. The first rule is: Don’t lose. The second rule is: Don’t forget the first rule. Graham solidified this “don’t lose” philosophy into two specific, tangible guidelines that cemented his margin of safety: (1) buy a company for less than two-thirds of its net asset value, and (2) focus on stocks with low price-to-earnings ratios.
The first approach, buying a stock for a price that is less than two-thirds of its net assets, fit neatly into Graham’s sense of the present and satisfied his desire for some mathematical expectation. Graham gave no weight to a company’s plant, property, and equipment. Furthermore, he deducted all of the company’s short- and long-term liabilities. What remained were the current assets. If the stock price was below this per-share value, Graham considered this to be a foolproof method of investing. He did clarify that the results were based on the probable outcome of a group of stocks (diversification), not on the basis of individual results.
There’s just one problem with this approach: Stocks that fit the criteria can be hard to find, especially during bull markets. Acknowledging that waiting for a market correction might be unreasonable, Graham turned to his second idea: to buy stocks that were down in price and sold at a low price-to-earnings ratio. He hastened to add that the company must have some net asset value; in other words, the company must owe less than its worth.
Throughout his career, Graham worked with several variations of this approach. Shortly before his death in 1976, he was revising the fifth edition of Security Analysis with Sidney Cottle. At that time, Graham was analyzing the financial results of stocks that were purchased based on these criteria: a 10-year low price-to-earnings multiple, a stock price that was equal to half its previous market high, and of course, a net asset value. Graham tested stocks back to 1961 and found the results very promising.
Over the years, many other investors have searched for similar shortcuts for determining intrinsic value. And while Graham’s low price-to-earnings ratio approach is still generally favored, we have learned that making decisions based solely on accounting ratios is not enough to ensure profitable returns. 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. We will learn more about the dividend discount model in Chapter 3.
For now, we should note that both Graham’s methods—buying a stock for less than two-thirds of net asset value, and buying stocks with low price-to-earnings multiples—had a common characteristic. The stocks that he selected based on those methods were deeply out of favor with the market and, for whatever reason, were priced below their value. Graham felt strongly that these stocks, priced “unjustifiably low,” were attractive purchases.
Graham’s conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks, usually because of the human emotions of fear and greed. At the height of optimism, greed moves stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moves prices below intrinsic value, creating an undervalued market. His second assumption was based on the statistical phenomenon known as reversion to the mean, although he did not use that term. More eloquently, he quoted the poet Horace: “Many shall be restored that now have fallen, and many shall fall that now are in honor.” However stated, by statistician or poet, Graham believed that an investor could profit from the corrective forces of an inefficient market.
While Graham was writing Security Analysis, Philip Fisher was beginning his career as an investment counselor. After graduating from Stanford’s Graduate School of Business Administration, Fisher began work as an analyst at the Anglo London & Paris National Bank in San Francisco. In less than two years, he was made head of the bank’s statistical department. From this perch, he witnessed the 1929 stock market crash. Then, after a brief and unproductive career with a local brokerage house, Fisher decided to start his own counseling firm. On March 31, 1931, Fisher & Company began soliciting clients.
Starting an investment counseling firm in the early 1930s might have appeared foolhardy, but Fisher figured he had two advantages. First, any investor who had any money left after the crash was probably very unhappy with his or her existing broker. Second, in the midst of the Depression, businesspeople had plenty of time to sit and talk with Fisher.
At Stanford, one of Fisher’s business classes required him to accompany his professor on periodic visits to companies in the San Francisco area. The professor would get the business managers to talk about their operations, and often helped them solve an immediate problem. Driving back to Stanford, Fisher and his professor would recap what they observed about the companies and managers they had visited. “That hour each week,” Fisher later said, “was the most useful training I ever received.”7
From these experiences, Fisher came to believe that superior profits could be made by (1) investing in companies with above-average potential and (2) aligning oneself with the most capable management. To isolate these exceptional companies, Fisher developed a point system that qualified a company according to the characteristics of its business and management.
The characteristic of a company that most impressed Fisher was its ability to grow sales and profits over the years, at rates greater than the industry average.8 To do that, Fisher believed that a company needed to possess “products or services with sufficient market potential to make possible a sizable increase in sales for several years.”9 Fisher was not so much concerned with consistent annual increases in sales. Rather, he judged a company’s success over a period of several years. He was aware that changes in the business cycle would have a material effect on sales and earnings. However, he believed that two types of companies would, decade by decade, show promise of above-average growth: (1) those that were “fortunate and able” and (2) those that were “fortunate because they are able.”
Aluminum Company of America (Alcoa) was an example, he said, of the first type. The company was “able” because the founders of the company were people of great ability. Alcoa’s management foresaw the commercial uses of its product and worked aggressively to capitalize the aluminum market to increase sales. The company was also “fortunate,” said Fisher, because events outside of management’s immediate control were having a positive impact on the company and its market. The swift development of airborne transportation was rapidly increasing the sales of aluminum. Because of the aviation industry, Alcoa was benefiting far more than management had originally envisioned.
DuPont was a good example of a company that was “fortunate because it was able,” according to Fisher. If DuPont had stayed with its original product, blasting powder, the company would have fared as well as most typical mining companies. But because management capitalized on the knowledge it had gained by manufacturing gunpowder, DuPont was able to launch new products—including nylon, cellophane, and Lucite—that created their own markets, ultimately producing billions of dollars in sales for DuPont.
A company’s research and development efforts, noted Fisher, contribute mightily to the sustainability of its above-average growth in sales. Obviously, he explained, neither DuPont nor Alcoa would have succeeded over the long term without a significant commitment to research and development. Even nontechnical businesses need a dedicated research effort to produce better products and more efficient services.
In addition to research and development, Fisher examined a company’s sales organization. According to him, a company could develop outstanding products and services but, unless they were “expertly merchandised,” the research and development effort would never translate into revenues. It is the responsibility of the sales organization, Fisher explained, to help customers understand the benefits of a company’s products and services. A sales organization, he added, should also monitor its customers’ buying habits and be able to spot changes in customers’ needs. The sales organization, according to Fisher, becomes the invaluable link between the marketplace and the research and development unit.
However, market potential alone is insufficient. Fisher believed that a company, even one capable of producing above-average sales growth, was an inappropriate investment if it was unable to generate a profit for shareholders. “All the sales growth in the world won’t produce the right type of investment vehicle if, over the years, profits do not grow correspondingly,” he said.10 Accordingly, Fisher sought companies that not only were the lowest-cost producers of products or services but were dedicated to remaining so. A company with a low break-even point, or a correspondingly high profit margin, is better able to withstand depressed economic environments. Ultimately, it can drive out weaker competitors, thereby strengthening its own market position.
No company, said Fisher, will be able to sustain its profitability unless it is able to break down the costs of doing business while simultaneously understanding the cost of each step in the manufacturing process. To do so, he explained, a company must install adequate accounting controls and cost analysis. This cost information, Fisher noted, enables a company to direct its resources to those products or services with the highest economic potential. Furthermore, accounting controls will help identify snags in a company’s operations. These snags, or inefficiencies, act as an early-warning device aimed at protecting the company’s overall profitability. Fisher’s sensitivity about a company’s profitability was linked with another concern: a company’s ability to grow in the future without requiring equity financing. If the only way a company can grow is to sell shares, he said, the larger number of shares outstanding will cancel out any benefit that stockholders might realize from the company’s growth. A company with high profit margins, explained Fisher, is better able to generate funds internally, and these funds can be used to sustain its growth without diluting shareholders’ ownership. In addition, a company that is able to maintain adequate cost controls over its fixed assets and working capital needs is better able to manage its cash needs and avoid equity financing.
Fisher was aware that superior companies not only possess above-average business characteristics but, equally important, are directed by people with above-average management capabilities. These managers are determined to develop new products and services that will continue to spur sales growth long after current products or services are largely exploited. Many companies, Fisher noted, have adequate growth prospects because their lines of products and services will sustain them for several years, but few companies have policies in place to ensure consistent gains for 10 to 20 years. “Management,” he said, “must have a viable policy for attaining these ends with all the willingness to subordinate immediate profits for the greater long-range gains that this concept requires.”11 Subordinating immediate profits, he explained, should not be confused with sacrificing immediate profits. An above-average manager has the ability to implement the company’s long-range plans while simultaneously focusing on daily operations.
Fisher considered another trait critical: Does the business have a management of unquestionable integrity and honesty? Do the managers behave as if they are trustees for the stockholders, or does it appear they are only concerned with their own well-being?
One way to determine their intention, Fisher suggested, is to observe how managers communicate with shareholders. All businesses, good and bad, will experience a period of unexpected difficulties. Commonly, when business is good, management talks freely, but when business declines, some managers clam up rather than talking openly about the company’s difficulties. How management responds to business difficulties, Fisher noted, tells a lot about the people in charge of the company’s future.
For a business to be successful, he argued, management must also develop good working relations with all its employees. Employees should genuinely feel that their company is a good place at which to work. Blue-collar employees should feel that they are treated with respect and decency. Executive employees should feel that promotion is based on ability, not favoritism.
Fisher also considered the depth of management. Does the chief executive officer have a talented team, he asked, and is the CEO able to delegate authority to run parts of the business?
Finally, Fisher examined the specific characteristics of a company: its business and management aspects, and how it compares to other businesses in the same industry. In this search, Fisher tried to uncover clues that might lead him to understand the superiority of a company in relation to its competitors. He argued that reading only the financial reports of a company is not enough to justify an investment. The essential step in prudent investing, he explained, is to uncover as much about the company as possible, from people who are familiar with the company. Fisher admitted that this was a catchall inquiry that would yield what he called “scuttlebutt.” Today, we might call it the business grapevine. If handled properly, Fisher claimed, scuttlebutt will provide substantial clues that will enable the investor to identify outstanding investments.
Fisher’s scuttlebutt investigation led him to interview as many sources as possible. He talked with customers and vendors. He sought out former employees as well as consultants who had worked for the company. He contacted research scientists in universities, government employees, and trade association executives. He also interviewed competitors. Although executives may sometimes hesitate to disclose too much about their own company, Fisher found that they never lacked an opinion about their competitors. “It is amazing,” he said, “what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from one representative cross-section of the opinions of those who in one way or another are concerned with any particular company.”12
Most investors are unwilling to commit the time and energy Fisher felt was necessary for understanding a company. Developing a scuttlebutt network and arranging interviews are time-consuming activities; replicating the scuttlebutt process for each company under consideration can be overwhelming. Fisher found a simple way to reduce his workload—he reduced the number of companies whose stock he owned. He always said he would rather own shares in a few outstanding companies than in a larger number of average businesses. Generally, his portfolios included fewer than 10 companies, and three or four companies represented 75 percent of his entire equity portfolio.
Fisher believed that, to be successful, investors needed to do only a few things well. One was investing in companies that were within the circle of competence. Fisher said his earlier mistakes were “to project my skill beyond the limits of my experience. I began investing outside the industries which I believed I thoroughly understood, in completely different spheres of activity; situations where I did not have comparable background knowledge.”13
When Warren Buffett began his investment partnership in 1956, he had just over $100,000 in capital. One early task, therefore, was to persuade additional investors to sign on. Buffett was making his usual and carefully detailed pitch to his neighbors, Dr. and Mrs. Edwin Davis, when suddenly Dr. Davis interrupted him and abruptly announced they’d give him $100,000. When Buffett asked why, Davis replied, “Because you remind me of Charlie Munger.”14
Even though both men grew up in Omaha and had many acquaintances in common, Buffett and Charlie did not actually meet until 1959. By that time, Charlie had moved to southern California. When he returned to Omaha for a visit when his father died, Dr. Davis decided it was time the two young men met, and brought them together for dinner at a local restaurant. It was the beginning of an extraordinary partnership.
Charlie, the son of a lawyer and grandson of a federal judge, had established a successful law practice in Los Angeles, but his interest in the stock market was already strong. At the first dinner, the two young men found much to talk about, including stocks. From then on, they communicated often, with Buffett frequently urging Charlie to quit law and concentrate on investing. For a while, Charlie did both. In 1962, he formed an investment partnership, much like Buffett’s, while maintaining his law practice. Three very successful years later, he left the law altogether, although to this day he has an office in the firm that bears his name.
We will briefly examine the performance history of Charlie’s investment partnership in Chapter 5. For now, it’s revealing to note that his partnership in Los Angeles and Buffett’s in Omaha were similar in approach; both sought to purchase at some discount to underlying value and both had outstanding investment results. It is not surprising, then, that they bought some of the same stocks. Charlie, like Buffett, began buying shares of Blue Chip Stamps in the late 1960s, and eventually became chairman of its board. When Berkshire and Blue Chip Stamps merged in 1978, Charlie became Berkshire Hathaway’s vice chairman.
The working relationship between Charlie and Buffett was not formalized in an official partnership agreement, but it has evolved over the years into something perhaps even closer and more symbiotic. Even before Charlie joined the Berkshire board, the two made many investment decisions together, often conferring daily; gradually their business affairs became more interlinked.
Today, Charlie continues as vice chairman of Berkshire Hathaway. In every way, he functions as Buffett’s acknowledged co-managing partner and alter ego. To get a sense of how closely the two are aligned, you only have to count the number of times Buffett has reported that “Charlie and I” did this, or decided that, or believe this, or looked into that, or think this—almost as if “Charlie and I” were the name of one person.
To their working relationship, Charlie brought not only financial acumen, but also the foundation of business law. He also brought an intellectual perspective that is quite different from Buffett’s. Charlie is passionately interested in many areas of knowledge—science, history, philosophy, psychology, mathematics—and believes each of those fields holds important concepts that thoughtful people can, and should, apply to all their endeavors, including investment decisions. To achieve “worldly wisdom,” said Charlie, you must build a latticework of mental models that unites all the big ideas in the world.15 Those who want to fully appreciate the depth and breadth of Charlie’s knowledge should read his wonderful book Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger (Donning Co. Publishers, 2005).
Together, all these threads—financial knowledge, background in law, and appreciation of lessons from other disciplines—produced in Charlie an investment philosophy somewhat different from Buffett’s. Whereas Buffett, unwaveringly dedicated to Ben Graham, continued to search for stocks selling at bargain prices, Charlie was moving toward the principles outlined by Phil Fisher. In his mind, it was far better to pay a fair price for a great company than a great price for a fair company.
How Charlie helped Buffett cross over the Rubicon of deep-value investing and begin to consider purchasing higher-quality companies is found in the story of Berkshire’s acquisition of See’s Candies.
In 1921, a 71-year-old grandmother named Mary See opened a small neighborhood candy shop in Los Angeles, selling chocolates made from her own recipes. With the help of her son and his partner, the business slowly grew into a small chain in southern and northern California. It survived the Depression, survived sugar rationing during World War II, and survived intense competition, through one unchanging strategy: Never compromise the quality of the product.
Some 50 years later, See’s had become the premier chain of candy shops on the West Coast, and Mary See’s heirs were ready to move on to the next phase of their lives. Chuck Huggins, who had joined the company 30 years earlier, was given the job of finding the best buyer and coordinating the sale. Several suitors came calling, but no engagement was announced.
Late in 1971, an investment adviser to Blue Chip Stamps, of which Berkshire Hathaway was then the majority shareholder, proposed that Blue Chip should buy See’s. The asking price was $40 million, but because See’s had $10 million in cash, the net price was actually $30 million. Still Buffett was skeptical. See’s was valued at three times book value, a very steep price according to Graham’s value-based precepts.
Charlie convinced Buffett that paying what he thought was a steep price was actually a good deal. Buffett offered $25 million and the sellers accepted. For Buffett, it was the first major move away from Graham’s philosophy of buying a company only when it was underpriced in relation to its hard book value. It was the beginning of a plate-tectonic shift in Buffett’s thinking, and he acknowledges that it was Charlie who pushed in a new direction. “It was,” Charlie later remarked, “the first time we paid for quality.”16 Ten years later, Buffett was offered $125 million to sell See’s—five times the 1972 purchase price. He decided to pass.
One reason Buffett and Charlie’s partnership has lasted so long is that both men possess an uncompromising attitude toward commonsense business principles. Both exhibit managerial qualities necessary to run high-quality businesses. Berkshire Hathaway’s shareholders are blessed in having managing partners who look after their interests and help them make money in all economic environments. With Buffett’s policy on mandatory retirement—he doesn’t believe in it—Berkshire’s shareholders have benefited not from one mind, but two, for over 35 years.
Shortly after Graham’s death in 1976, Buffett became the designated steward of Graham’s value approach to investing. Indeed, Buffett’s name became synonymous with value investing.17 It is easy to see why. He was the most famous of Graham’s dedicated students, and Buffett himself never misses an opportunity to acknowledge the intellectual debt he owes Graham. Even today, Buffett considers Graham to be the one individual, after his father, who had the most influence on his investment life.18 He even named his firstborn son after his mentor: Howard Graham Buffett.
How, then, does Buffett reconcile his intellectual indebtedness to Graham with stock purchases like the Washington Post Company (1973), Capital Cities/ABC (1986), the Coca-Cola Company (1988), and IBM (2011)? None of these companies passed Graham’s strict financial test, yet Buffett made significant investments in all of them.
As early as 1965, Buffett was becoming aware that Graham’s strategy of buying cheap stocks had limitations.19 Graham, he said, would buy a stock so low in price that some “hiccup” in the company’s business would allow investors to sell their shares at higher prices. Buffett called this strategy the “cigar butt” approach to investing. Walking down the street, an investor eyes a cigar butt lying on the ground and picks it up for one last puff. Although it’s a lousy smoke, its bargain price makes the puff all the more worthwhile. For Graham’s strategy to work consistently, Buffett argued, someone must play the role of liquidator. If not liquidator, then some other investor must be willing to purchase shares of your company, forcing the price of the stock upward.
Buffett explains: If you paid $8 million for a company whose assets are $10 million, you will profit handsomely if the assets are sold on a timely basis. However, if the underlying economics of the business are poor and it takes 10 years to sell the business, your total return is likely to be below average. “Time is the friend of the wonderful business,” Buffett noted, “the enemy of the mediocre.”20 Unless he could facilitate the liquidation of his poorly performing companies and profit from the difference between his purchase price and the market value of the company’s assets, his performance would, over time, replicate the poor economics of the underlying business.
From his earliest investment mistakes, Buffett began moving away from Graham’s teachings. “I evolved,” he once confessed, but “I didn’t go from ape to human or human to ape in a nice even manner.”21 He was beginning to appreciate the qualitative nature of certain companies, compared to the quantitative aspects of others, but he still found himself searching for bargains. “My punishment,” he said, “was an education in the economics of short-line farm implementation manufacturers (Dempster Mill Manufacturing), third-place department stores (Hochschild-Kohn), and New England textile manufacturers (Berkshire Hathaway).”22 Attempting to explain his dilemma, Buffett quoted Keynes: “The difficulty lies not in the new ideas but in escaping from the old ones.” Buffett’s evolution was delayed, he admitted, because what Graham taught him was so valuable.
In 1984, speaking before students at Columbia University to mark the fiftieth anniversary celebration of Security Analysis, Buffett explained that there is a group of successful investors who acknowledge Ben Graham as their common intellectual patriarch.23 Graham provided the theory of margin of safety, but each student has developed different ways to apply his theory to determine a company’s business value. However, the common theme is that they are all searching for some discrepancy between the value of a business and the price of its securities. People who are confused by Buffett’s purchases of Coca-Cola and IBM fail to separate theory from methodology. Buffett clearly embraces Graham’s margin of safety theory, but he has steadfastly moved away from Graham’s methodology. According to Buffett, the last time it was easy to profit from Graham’s methodology was the 1973–1974 bear market bottom.
Remember that, when evaluating stocks, Graham did not think about the specifics of the business or the capabilities of management. He limited his research 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. To increase the probability of success, he purchased as many of these statistical equations as possible.
If Graham’s teaching were limited to these precepts, Buffett would have little regard for him today. But the margin of safety theory was so profound and so important to Buffett that all other current weaknesses of Graham’s methodology can be overlooked. Even today, Buffett continues to embrace Graham’s primary idea, the margin of safety. It has been almost 65 years since he first read Ben Graham. Nonetheless, Buffett never hesitates to remind everyone, “I still think those are the three right words.”24 The key lesson that Buffett took from Graham was: Successful investing involves purchasing stocks when their market price is at a significant discount to their underlying business value.
In addition to the margin of safety, which became the intellectual framework of Buffett’s thinking, Graham helped Buffett appreciate the folly of following stock market fluctuations. Stocks have an investment characteristic and a speculative characteristic, Graham believed, and the speculative characteristics are a consequence of human fear and greed. Those emotions, present in most investors, cause stock prices to gyrate far above and, more important, far below a company’s intrinsic value. Graham taught Buffett that if he could insulate himself from the emotional whirlwinds of the stock market, he had an opportunity to exploit the irrational behavior of other investors, who purchased stocks based on emotion, not logic.
From Graham, Buffett learned how to think independently. If you reach a logical conclusion based on sound judgment, Graham counseled Buffett, do not be dissuaded just because others disagree. “You are neither right or wrong because the crowd disagrees with you,” Graham wrote. “You are right because your data and reasoning are right.”25
Phil Fisher was in many ways the exact opposite of Ben Graham. Fisher believed that, to make sound decisions, investors needed to become fully informed about a business. That meant investigating all aspects of the company. They had to look beyond the numbers and learn about the business itself, for the type of business it was mattered a great deal. They also needed to study the attributes of the company’s management, for management’s abilities could affect the value of the underlying business. They were urged to learn as much as they could about the industry in which the company operated, and about its competitors. Every source of information should be exploited. From Fisher, Buffett learned the value of scuttlebutt. Throughout the years, Buffett developed an extensive network of contacts who have been helpful in assisting him in evaluating different businesses.
Finally, Fisher taught Buffett not to overstress diversification. He believed that it was a mistake to teach investors that putting their eggs in several different baskets reduces risk. The danger in purchasing too many stocks, he felt, is that it becomes impossible to watch all the eggs in all the baskets. Investors run the risk of putting too much in a company they are unfamiliar with. In his view, buying shares in a company without taking time to develop a thorough understanding of the business is far riskier than having a limited diversification.
The differences between Graham and Fisher are apparent. Graham, the quantitative analyst, emphasized those factors that could be measured: fixed assets, current earnings, and dividends. His investigative research was limited to corporate filings and annual reports. He spent no time interviewing customers, competitors, or managers.
Fisher’s approach was the antithesis of Graham’s. Fisher, the qualitative analyst, emphasized factors that he believed increased the value of a company: principally, future prospects and management capability. Whereas Graham was interested in purchasing only cheap stocks, Fisher was interested in purchasing companies that had the potential to increase their intrinsic value over the long term. He would go to great lengths—and even conduct extensive interviews—to uncover bits of information that might improve his selection process.
After Buffett read Phil Fisher’s book Common Stocks and Uncommon Profits, he sought out the writer. “When I met him, I was as impressed by the man as his ideas.” Buffett said. “Much like Ben Graham, Fisher was unassuming, generous in spirit and an extraordinary teacher.” Graham and Fisher’s investment approaches differ, notes Buffett, but they are “parallel in the investment world.”26 Taking the liberty of rephrasing, I would say that instead of paralleling, in Warren Buffett they dovetail: his investment approach is a combination of a qualitative understanding of the business and its management (as taught by Fisher) and a quantitative understanding of price and value (as taught by Graham).
Warren Buffett once said, “I am 15 percent Fisher and 85 percent Benjamin Graham.”27 This remark has been widely quoted, but it is very important to remember that it was made in 1969. In the intervening years, Buffett has made a gradual but definite shift toward Fisher’s philosophy of buying a select few businesses and owning those businesses for several years. My hunch is that if he were to make a similar statement today, the balance would come pretty close to 50/50.
In a very real sense, Charlie is the active embodiment of Fisher’s qualitative theories. From the start, Charlie had a keen appreciation of the value of a better business and the wisdom of paying a reasonable price for it. However, in one important aspect, Charlie is also the present-day echo of Ben Graham. Years earlier, Graham taught Buffett the twofold significance of emotion in investing: the mistakes it triggers for those who make irrational decisions based on it, and the opportunities it thus creates for those who can avoid falling into the same traps. Charlie, through his readings in psychology, has continued to develop that theme. He calls it “the psychology of misjudgment,” a notion we look at more fully in Chapter 6, and through persistent emphasis he keeps it an integral part of Berkshire’s decision making. It is one of Charlie’s most important contributions.
Buffett’s dedication to Ben Graham, Phil Fisher, and Charlie Munger is understandable. Graham gave Buffett the intellectual basis for investing—the margin of safety—and helped him learn to master his emotions in order to take advantage of market fluctuations. Fisher gave Buffett an updated, workable methodology that enabled him to identify good long-term investments and manage a focused portfolio over time. Charlie helped Buffett appreciate the economic returns that come from buying and owning great businesses. To this, Charlie helped educate Buffett on the psychological missteps that often occur when individuals make financial decisions. The frequent confusion surrounding Buffett’s investment actions is easily understood when we acknowledge that Buffett is the synthesis of all three men.
“It is not enough to have good intelligence,” wrote Descartes; “the principal thing is to apply it well.” Application is what separates Buffett from other investment managers. A number of his peers are highly intelligent, disciplined, and dedicated. Buffett stands above them all because of his formidable ability to integrate the strategies of these three wise men into one cohesive approach.
Notes
1. Adam Smith, Supermoney (New York: Random House, 1972), 172.
2. New York Times, December 2, 1934, 13D.
3. Benjamin Graham and David Dodd, Security Analysis, 3rd ed. (New York: McGraw-Hill, 1951), 38.
4. Ibid., 13.
5. “Ben Graham: The Grandfather of Investment Value Is Still Concerned,” Institutional Investor, April 1974, 62.
6. Ibid., 61.
7. John Train, The Money Masters (New York: Penguin Books, 1981), 60.
8. Philip Fisher, Common Stocks and Uncommon Profits (New York: Harper & Brothers, 1958), 11.
9. Ibid., 16.
10. Ibid., 33.
11. Philip Fisher, Developing an Investment Philosophy, Financial Analysts Research Foundation, Monograph Number 10, p. 1.
12. Fisher, Common Stocks, 13.
13. Fisher, Developing an Investment Philosophy, 29.
14. Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett, rev. ed. (Birmingham, AL: AKPE, 2000), 89.
15. Robert Hagstrom, Investing: The Last Liberal Art (New York: Columbia University Press, 2013).
16. Remarks made at the 1997 Berkshire Hathaway annual meeting; quoted in Janet Lowe’s biography of Charlie Munger, Damn Right! (New York: John Wiley & Sons, 2000).
17. Andrew Kilpatrick, Warren Buffett: The Good Guy of Wall Street (New York: Donald I. Fine, 1992), 38.
18. Robert Lenzner, “Warren Buffett’s Idea of Heaven: ‘I Don’t Have to Work with People I Don’t Like,’” Forbes, October 18, 1993, 43.
19. Berkshire Hathaway Annual Report, 1989, 21.
20. Ibid.
21. L. J. Davis, “Buffett Takes Stock,” New York Times Magazine, April 1, 1990, 61.
22. Berkshire Hathaway Annual Report, 1987, 15.
23. Warren Buffett, “The Superinvestors of Graham-and-Doddsville,” Hermes, Fall 1984.
24. Berkshire Hathaway Annual Report, 1990, 17.
25. Benjamin Graham, The Intelligent Investor, 4th ed. (New York: Harper & Row, 1973), 287.
26. Warren Buffett, “What We Can Learn from Philip Fisher,” Forbes, October 19, 1987, 40.
27. “The Money Men—How Omaha Beats Wall Street,” Forbes, November 1, 1969, 82.