What You Can Learn From Buffett's Mentor

Warren Buffett is generally viewed as the top of the heap of the world's elite investors, a master of the market who has trounced index after index for decades. Yet as great as Buffett is, even he had a mentor who taught him the ins and outs of investment success.

Buffett's mentor was none other than Benjamin Graham, the man generally credited with introducing the world to the concept of value investing. Far more than just a dictate to buy cheap stocks, Graham's value strategy is one that advocates knowing exactly what you get for your money and protecting yourself from failures. With that in mind, three factors matter more than anything else to value investors: dividends, valuation, and diversification.

Own a company, not a stock
Key to Graham's strategy is a clear understanding that as a shareholder, you own part of a company and deserve to be rewarded as the company succeeds. Indeed, Graham was so adamant about that point that in his famous book The Intelligent Investor, he dedicated a chapter to dividends. In it, he stated that payout ratios around two-thirds of earnings made sense, unless a company was consistently able to reinvest that money for strong, profitable growth.

Not only do dividends provide investors with a tangible reward for their ownership, they help keep a company's management focused on delivering real value. After all, companies need to part with cold, hard cash to make those payments, and if the money doesn't materialize, shareholders notice.

Few companies pay two-thirds of their earnings as dividends these days, as most managers fancy themselves sophisticated capital allocators. That said, companies that pay out at least one-third of their earnings as dividends still reward their shareholders and benefit from the discipline that paying dividends forces on management.

What you get for your money
Of course, what Graham is most famous for is his focus on buying companies for less than their intrinsic value (what they're really worth). While there are many ways of estimating that value, Graham's formula was IV = EPS*(8.5+2G)*(4.4/AAA). Or, in plain English, a company's intrinsic value is made up of the following factors:

• EPS: This is the company's normalized earnings per share. In essence, the Graham equation tries to figure out a company's worth in terms of a multiple to what it's really earning, after backing out special items.
• (8.5+2G): In essence, a company is worth 8.5 times earnings just for standing still, plus twice the company's expected growth rate to account for future earnings growth.
• (4.4/AAA): 4.4 was Graham's minimum benchmark return rate to justify investing at all, and "AAA" is the yield on AAA-rated corporate bonds. This is Graham's attempt to ensure that your return compensates you for the additional risk you take on by investing in stocks rather than bonds.

The lower the price at which you can buy a company, when compared to its intrinsic value, the stronger your margin of safety. That gives you both more room to run if the company succeeds and better protection should your analysis turn out to be wrong.

Speaking of being wrong ...
Perhaps most important of all, Graham was a firm believer in the concept of diversification -- of not putting all your cash in one company or even industry. Because no matter how good your analysis may be, either you could get it wrong or something could happen to the company or industry to cause you to lose your investment.

Graham likened diversification in investing to a casino running a roulette wheel. Once in a while, the casino has to pay out -- big -- when a gambler's number comes up. But over time, the house has a built-in edge that assures it will make money. Diversification is your protection against losing it all in that rare event.

Put it all together
When you find companies that pay solid dividends, trade below their intrinsic values, and are spread out across industries, you've got the basics of a portfolio that would make Graham proud. Take a look at these stocks, for instance:

Data from Capital IQ, a division of Standard & Poor's.

As they operate in different lines of business, investors who own all of these stocks would be largely protected from a failure that knocks down not only a company but an entire industry. As they all pay a decent cut of their earnings as dividends, their shareholders get directly rewarded as the businesses succeed. And since they're all trading below what Graham's equation would call fairly valued, there's good reason to believe they're trading at bargain prices.

That's not a bad modern-day version of Graham's timeless lessons.

At Motley Fool Inside Value, we know that Graham's methods are as solid today as they were when he taught them to Buffett. That's why we still follow his teachings as we search for the next generation of market-trouncing value investments for our members. If you'd like to see our favorite bargain stocks based on an investing strategy that has beaten the test of time, you can try Inside Value free for the next 30 days. Simply click here -- there's no obligation.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. Home Depot is an Inside Value pick. PepsiCo is a Motley Fool Income Investor recommendation. The Fool owns shares of and has written puts on Medtronic. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool has a disclosure policy.