I've always been interested in how Berkshire Hathaway (NYSE:BRK.A) Chairman Warren Buffett formed the foundation of his investment philosophy. I would suspect that anyone who shares this interest and has not yet read the writings of Benjamin Graham should do so.
Benjamin Graham was one of Buffett's professors at Columbia University business school, and he is considered the father of the "value investing" investment style practiced by Buffett and others. His books Security Analysis and The Intelligent Investor spell out in great detail the core philosophies and methodologies of investing.
But before Warren Buffett was the "Sage of Omaha," he was a student in Graham's class. An extraordinary one, for sure, but one whose philosophy was still very much a work in progress.
Graham drew a line between speculation and investing, calling the former a futile activity. As he famously wrote in the opening pages of Security Analysis, "[I]n speculation when to buy -- and sell -- is more important than what to buy, and also that almost by mathematical law more speculators must lose than can profit."
No, this time is NOT different
Graham also would have proclaimed to his students that "New Eras" were actually not new, and anytime that these words were used to describe current market conditions, the investor should take heed and find shelter before the coming storm. Understanding that "New Eras" weren't in fact new would have been invaluable to individual investors if they had studied Graham's writings during the Internet bubble. Graham demonstrated that the "common-stock insanity" of the 1920s was much more a function of "the nature of human beings than the nature of common stocks."
It would have been in this classroom setting that Buffett may have heard for the first time what he would later adapt into one of his famous questions: why are we "most optimistic when prices are highest and most despondent when they are at their bottom?"
This grounding would serve Buffett well as investors seem to become infected with "common-stock insanity" from time to time. The knowledge he gained from Mr. Graham helped him take advantage of situations when the stock market as a whole (or individual companies and/or industries) fell out of favor with speculators for no reasons related to fundamental business performance. Think of the large gains he made investing in American Express (NYSE:AXP) or Coca-Cola (NYSE:KO), for example.
Don't buy the stock, buy the business
Graham emphasized the importance of investing in a rational, business-like manner. He also taught that investors should understand that "investment is by [its] nature not an exact science." Graham once said, "It is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price [of a company]."
Mr. Graham always taught that security analysis involves analyzing a stock as a business and not as a piece of paper that can be traded on the stock exchange for whatever the current quote is. How many times have we seen folks convinced that a company would be a value at a few pennies cheaper per share? Quite simply, the information available is insufficient to make so precise a determination.
Any student of Mr. Graham would have come to understand that the importance of the intrinsic value concept comes not from trying to determine the exact worth of the business in question but in trying to determine if "the value is adequate -- e.g., to protect a bond or justify a stock purchase," that the art of security analysis is "more useful when applied to a business of inherently stable character than to one subject to wide variations."
Mr. Graham would certainly have spent at least one class period covering the difference between price and value. This may be the single biggest misconception that investors make to this day, nearly seven decades after Graham so eloquently described the disconnect. "In the field of common stocks ... the danger of paying the wrong price is almost as great as that of buying the wrong issue ... the new era of investing left price out of the reckoning, and that omission was productive of the most disastrous consequences." Graham believed that investors should demand "unvarying insistence upon the reasonableness of the price paid for each purchase."
Make the market your tool
When Mr. Buffett espouses the importance of forming your own conclusion, he might have been influenced by Mr. Graham when he wrote "The analyst must pay respectful attention to the judgment of the market place... but he must retain an independent and critical viewpoint. Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand."
Mr. Graham may also have influenced Mr. Buffett concerning the issue of retaining company earnings or paying dividends to the shareholders. Mr. Graham advocated that that "Withholding and reinvestment of a substantial part of the earnings must be clearly justified to the stockholders on the grounds of concrete benefits therefrom exceeding the value of the cash if paid to stockholders."
Mr. Buffett has maintained that Berkshire Hathaway (NYSE:BRK.A) will pay dividends only if he can find no opportunities to reinvest the earnings at an acceptable rate of return. How many other companies have retained earnings without a clear picture of what to do with the money? How many billions of dollars have been wasted by companies simply due to the fact that they were burning a hole in managements' pockets?
Is depreciation really an expense?
Mr. Graham observed that "Depreciation is not a mere bookkeeping conception, because for the most part it registers an actual diminution of capital values, for which adequate provision must be made if creditors or owners are to avoid deceiving themselves." Mr. Graham effectively debunked the use of EBITDA (earnings before interest, taxes, depreciation, and amortization) as an earnings measurement tool several decades before it came into vogue!
Many companies abuse the EBITDA method when reporting their earnings in order to put a better spin on their financial results. A management team that tries to convince others that depreciation isn't an ongoing cash expense may start to believe their own propaganda.
Safety first
One lecture that Mr. Buffett paid a great deal of attention to was the lecture that covered the margin of safety concept. Simply put, Mr. Graham advised investors to purchase stocks at a price that would provide them an adequate return even if something happened that wasn't anticipated when the investor was trying to judge a company's future cash flows or when a mistake was made on the economics of the business in question.
Here is another way to think of this concept. If you driving a truck with a 14,000-ton load, would you cross a bridge that was rated to handle up to a 14,500-ton load? I'd turn around and look for another crossing point!
Mastering the fundamentals
It is obvious that key areas of Mr. Buffett's investment philosophy lean heavily on the teachings of Mr. Graham. The body of knowledge that Mr. Buffett obtained as a student of Mr. Graham became part of Mr. Buffett's fundamental body of investment knowledge.
Athletes must understand and practice the fundamentals of their particular sport. They often spend many hours mastering these basic processes. They have to do this if they wish to be more than just an average player. Investors are no different. Reading and practicing the ideas contained in Security Analysis and the Intelligent Investor will provide you with the fundamental information you need to master in order to become a successful investor.
Richard Rockwood is a longtime member of The Motley Fool Community and a guest writer. The Fool is investors writing for investors.
