Is your investing style closer to Ben Graham or Warren Buffett?

Some of the mistakes I made in investing can be traced back to taking a Ben Graham approach to a Warren Buffett type of business. Ben Graham approach is primarily based on mean reversion in business, not just in stock prices, but in the fortunes of the businesses. Warren Buffett on the other hand, specialized in identifying the tiny sliver of businesses that defy mean reversion.

Knowing if an investment falls closer to the Graham approach or the Buffett approach would go a long way in determining a number of key portfolio considerations like position sizing, holding period, selling price and required margin of safety. Satisfactory results can be obtained with either approach, but what does not work is applying a Buffett approach to a Graham type business and vice versa.

Graham writes in Security Analysis that “the most striking characteristic of large American businesses is their repeated pendulum swings from better to poorer results and back” and that “a remarkably small percentage of these enterprises actually go out of business through voluntary liquidation or sheriff’s auction“. These two points are really the foundation on which a vast majority of Graham’s investment strategies are based on. He confesses this “to be of greatest importance in the determination of a sophisticated investment policy“.

Graham basically wants to take advantage of the phenomenon of mean reversion in businesses. So all he needs is some way to make sure that he is buying businesses below their mean value and wait for the businesses to recover. Graham never really tried to estimate the intrinsic value of a business but instead he just wants to make sure that he is paying a price far below what can be readily justified. His famous “Net Nets” strategy is the most dramatic illustration of this approach.

Graham felt that it would be difficult for investors to determine either the quality of management or the future growth rate of earnings. To him management quality should already be reflected in current earnings and to give credit separately to management would be double counting. Graham scarred from The Great Depression, thought it was not prudent to rely on earnings growth to justify the value of a business.

Buffett, having successfully applied many of Graham’s strategies, however pushed the value investing frontier to include high quality businesses rather than just broken down nags that are Graham’s bread and butter.

Buffett believed that there exists a very small subset of businesses, which due to strong competitive advantages are likely to earn high rates of return on capital and grow their earnings at an attractive rate for very long periods of time. Management quality, which to Buffett essentially means good capital allocation skills, can be accessed from past behavior.

Graham’s approach is primarily quantitative. He does not have a strong opinion on the intrinsic value of the business, management, returns on capital or growth. He spreads his bets on a large number of holdings to reduce the risk of any one individual business failure. As he relied on mean reversion, he was actively selling shares when they rose closer to intrinsic value or if he found something that is a better value.

Buffett’s approach on the other hand combines both quantitative and qualitative factors. As he is trying to find the rare business that has strong competitive advantages that are unlikely to deteriorate for decades, his search would generate only a handful of ideas over a lifetime. This approach calls for an intimate understanding of the business along with a firm conviction on the intrinsic value which allows for taking concentrated positions. As the businesses grow intrinsic value at an attractive rate, these can be held even if their price reaches or even slightly exceeds intrinsic value and thus turnover is very little.

Most investors who have studied them are well aware of these differences between the two. However, as Buffett evolved from primarily being a Graham type investor into his own style, his writings and actions have evolved as well in line with this change. To followers of Buffett, who are seeking to learn from him, his writings and his investments have to be viewed in context of the investment approach that he was following.

My mistake in this area is buying a high quality company that passed all of Buffett’s criteria and selling it at around 90% of my estimate of its intrinsic value. My thinking was dominated by Graham’s mean reversion warnings and suggestion to sell at close to intrinsic value. It was an expensive mistake.

Table: Summary of Ben Graham’s and Warren Buffett’s approach to investing

Ben Graham

Warren Buffett

Search Strategy Periodic screening on quantitative criteria Keep a target list of businesses
Number of Holdings Diversified (30+) Concentrated (5 to 6)
Holding Period 1 to 3 years or close to intrinsic value Very long term (20+ years) & Do not sell even if it reaches intrinsic value
Confidence in Intrinsic Value Estimate Low Firm conviction (even though it is a range of values)
Buying Price Two thirds of intrinsic value or less Slight discount to intrinsic value or  buy close to intrinsic value if there are additional kickers like untapped pricing power or buybacks
Source of Margin of Safety Discount to intrinsic value based on past earnings or current asset value Growth in intrinsic value based on quality of business and competitive advantages
Importance of Management Ignored Look at passion for business & capital allocation skill

Most investments do not come neatly packaged under Graham or Buffett categories, but knowing where in the spectrum they fall under, provides a useful set of portfolio tactics that can be applied for that situation.

 

| February 19th, 2015 | Posted in Investment Approach |

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