By Glen Arnold
Many people regard Warren Buffett, the greatest living exponent of the value school of investing, first as an important teacher of investment principles, and only second as a wealthy individual. Of course, the fact that he has made a tremendous amount of money adds credibility to his teaching because he has empirically proved the soundness of his philosophy. But for many, it is the acuity of his ideas and simplicity of his approach which appeal because his methods seem accessible to all.
Buffett was not born with these ideas, nor did they come to him in a flash of light early in his career. He had to keep searching, building and failing, over and over, until he was proficient. The story of his struggle is encouraging because it emphasizes that success in stock investing does not rely on genius, but rather on a continual focus on good principles.
Buffett’ s Early Learning
Buffett began investing when he was 11 years old. He put $ 120 in savings into Cities Services, and from there he slowly built his portfolio. At age 20, after many business ventures and investments, his portfolio only amounted to $ 15,000. In addition to being short on money, he suffered from a poverty of investing ideas.
Buffett’ s real education began in 1949 when, as a 19-year-old, he read Benjamin Graham’ s book, The Intelligent Investor. He later enrolled in Graham’ s Columbia University course and subsequently worked for him as a security analyst, from 1954 – 1956. In addition to learning a great deal from Graham, he also made some spectacular investment deals around this time. They included a 48 % gain in a few months from GEICO shares when he was 21 years old, and the Rockwood chocolate chip bonanza, in which the 24-year-old Buffett more than doubled his investment, making $ 13,000 to add to his growing fund.
The Buffett family at home in Omaha, Nebraska, in 1956. Left to right: Howard( 17 months), Susie( 21/2 years), Warren and Susan.
The Benjamin Graham School of Practical Investing
By the time Buffett met Graham in 1950, Graham was 56 years old and had been through some rough times running small investment funds. Prior to the Great Crash, Graham was a relatively cautious investor, but not cautious enough when the downturn approached. Between 1929 and 1932, 70 % of the $ 2.5 million fund he was running for clients was lost or withdrawn.
Graham had witnessed valuations made on earning projections made in an optimistic mood, and he had seen investors buy in the hope of selling to a greater fool who would pay even more because the price had gone up. He had experienced buying based on charts, tips, no real knowledge of the business and insider information. The result of his soul searching was the foundation of the value school of investing, which so influenced Buffett and is adhered to by thousands today.
Following the Great Crash, many observers concluded that it was pointless to assess share value. After all, if in 1928 a share could be worth $ 100( according to the market price), and 15 months later worth only $ 5, who was to know what the real value was? A far better method, they said, was to focus on assessing the mood of other share buyers. When other buyers think the price will go up, the investor should try to buy before it does. This focus on the market, rather than on the company and its performance in serving its customers, is one distinguishing feature of speculators, as opposed to investors.
Defining Investment
Graham and his co-author David Dodd provided the following contrasting definitions of investing and speculation in their book, Security Analysis, in 1934:
“ An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
There are three essential elements in this definition:
1. Thorough analysis: When people invest in a business, they will own a small portion of it and should, therefore, ask many of the same questions they would ask if they were buying the whole business. For example, what is the turnover and profit history? Does it have a good reputation with customers? This type of analysis requires rationality, independence of mind and a critical examination of the facts. For Graham, this analysis was primarily focused on the proven facts from the quantitative side. He recognized the importance of the qualitative, such as the power of a well-recognized brand or the quality of the managerial team, but his 1929 experience made him cautious about putting too much weight on his assessment of the business prospects and management’ s ability and integrity.
2. Safety of principal: It’ s very important to build in a margin of safety when buying shares, rather like the extra safety built into a road bridge. A bridge is not built to withstand only historically recorded wind speeds and other loads; it is built to standards well beyond that. Similarly, investors should only buy shares when there is a large margin of safety between the purchase price and their calculation of intrinsic value.
3. Satisfactory return: Investors should avoid getting caught up in over-optimism or greed, which will often lead them down a path beyond their capabilities, or stretch the risk limits they can stand. The irony is that great investors act with safety of principal in mind and aim only for a satisfactory rate of return. Yet, in the long run, they outperform those who take the path of higher risk.
Warren Buffett’ s Other Lessons from Graham
Graham learned that returns depend on the investor’ s knowledge, experience and temperament. First, the investor needs to understand the business world and how it works. Some grasp of accounting, finance and corporate strategy is essential, though this can be enhanced and developed over time. Having a curious mind is a prerequisite, but an investor does not have to develop the level of knowledge required purely from his own experience. A lot can
www. MoAF. org | Spring 2018 | FINANCIAL HISTORY 21