Financial History Issue 125 (Spring 2018) | Page 23

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 Between 1929 and 1932 , 70 % of the $ 2.5 million fund he was running for clients was lost or withdrawn .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

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