Tuesday, October 4, 2016

Value Investing: The Line from Graham to Buffett

This article was first published by the Global Association for Risk Professionals on September 30, 2016;

The Oracle of Omaha has not strayed from basic principles but adjusts to changing conditions

The stock of Berkshire Hathaway has historically outperformed S&P500 benchmark. As pointed out in the, Wall Street Journal (http://blogs.wsj.com/moneybeat/2016/05/02/warren-buffetts-epic-rant-against-wall-street/), “From 1965 through the end of last year [2015], Berkshire shares have risen 1,598,284%, compared to the 11,355% return on the S&P 500.”

Warren Buffett, the chairman of Berkshire Hathaway, was a student of Benjamin Graham, the foremost guru of value investing, at Columbia Business School. Buffett is Graham’s most famous disciple and has attracted many to adopt value investing.

“Intrinsic value” and “margin of safety” are the two keys to value investing.

When shares are bought at a price cheaper than what the market values them at, and sold at a higher price later, value is extracted through this transaction.

Sanjay Bakshi, managing partner of Value Quest Capital, a value investor, professor, and ardent fan of Warren Buffett and Charlie Munger, said in an interview, “There are times when the markets are extremely inefficient, and at that time you should take advantage of the market. If ‘Mr. Market’ is buying you out at crazy valuation, give him your shares, and if he is willing to offer his stake very cheap, take it. This fundamental principle of value investing has never been compromised by Buffett or any successful value investor.”

Margin of Safety

Graham’s margin of safety is one principle that has had a profound influence on Buffett. It is the difference between a stock’s market price and its intrinsic value. For example, if the market price is much below intrinsic value, the margin of safety is large enough to protect the investor against future uncertainty and market downturns.

“If you were to distill the secret of sound investment into three words”, Graham wrote in his book The Intelligent Investor, “we venture the motto, margin of safety.”

Firms which trade at a high margin of safety dramatically reduce the risk of a permanent loss of capital.

Sanjay Bakshi offers an explanation: “You need a gap between value and price because value might drop, or your valuation might be wrong. Great businesses get destroyed because of many reasons including technological obsolescence, change in regulations, natural calamity or management hubris. Value investors don’t buy dollars for 95 cents because that leaves little margin of safety. They buy at 50 or 60 cents or even lower. This principle too has not been compromised by any successful value investor.”

‘Great Companies’ and Book Value

While Graham advocated buying stocks that are underpriced relative to their intrinsic value and can earn more than what the market expects – that is, stocks with very high margin of safety or those trading at large discounts – Buffett does not shy away from buying at reasonable prices what he deems a “great company.”

Graham advocated that a defensive investor should look for companies with current ratio of at least 2, long-term debt not more than net working capital, positive earnings for each of the past 10 years, uninterrupted dividends for the past 20 years, 33% increase in earnings per share for the last 10 years using a three-year moving average, price not more than 15 times past three-year-average earnings, etc. Some of these were based on the then prevailing market conditions in the U.S. and can be easily modified to suit the changed conditions, different risk appetites and different countries.

Graham also suggested that conservative investors buy stocks at prices close to their book value per share, and no more than one-third above that figure. However, this criterion alone may not indicate a sound investment, and investors must verify that the company has a sufficiently strong financial position and its stock is selling at a suitable ratio of earnings to price.

Due to the emphasis on book value, which excludes intangibles, the criteria will tend to exclude firms that have considerable assets in the form of goodwill, patents, software, franchises, etc. While Buffett did invest largely in traditional stocks like General Motors and Coca-Cola in the initial days, his portfolio has changed over the years to include the likes of Verisk Analytics and IBM, which have considerable intangibles.

Financial Sector

A common refrain among Graham watchers and followers is to stay away from financial services. These stocks have a very different model, especially when it comes to deposit-taking institutions where the assets are essentially leveraged products and the liabilities can never be truly paid-off, as that would lead to a collapse.

However, according to The Intelligent Investor, “We have no very helpful remarks to offer in this broad area of investment other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments.”

The financial services sector as a whole is very diverse, with numerous banking, brokering and asset financing services coming under the umbrella. Buffett has over the years invested in such companies as American Express, Bank of New York Mellon, Goldman Sachs and Wells Fargo.

Although Buffett has himself said in the past that he is “85% Graham,” it is safe to say that his investment style has evolved over the years and adapted to changing business scenarios. As Bakshi puts it, “Buffett did not change any basic principle of Graham. He just applied them in a different manner.”
Post a Comment