value investing
Benjamin Graham

by Larry Harmych of http://intelligentinvestors.org/

Preface:

Benjamin Graham’s intellectual paradigm has influenced many successful investors.  These investors, each coming from a town called Graham-and-Doddsville (coined by Warren Buffett), did not all use Benjamin Graham’s investment philosophy in the same way.    Though nuanced as these philosophies were they were still basically the same: buying a dollar for less than a dollar with risk decreasing each cent less.

However, in reading Buffett’s famous article from which the town’s name came a lot was left to be desired.  This is classic Buffett style, saying enough to hook you and then hanging you out to dry.  I believe his reasoning on this to be simple: Buffett wants you to do all the heavy lifting yourself.  Giving away investment secrets would be the intellectual equivalent of that of trust fund babies inheriting money they did not earn (note: Buffett is not fond of trust fund babies).

“Science and philosophy do not progress by regarding their past investments as ends in themselves; the object is always to preserve that which is valuable in the old methods while adjoining new methods that refine their meaning and extend their horizons.” –Christopher M. Langan

The Art of Practical Investment Decision Making, by Larry Harmych

Just as legendary investor Warren Buffett sat under the tree planted by Benjamin Graham, Buffett, too, has planted a tree worthy of men sitting under.  Whereas Benjamin Graham emphasized the quantitative (buying a dollar for fifty cents), Warren Buffett emphasizes the qualitative.  These qualitative factors relate not only to the company one wishes to purchase but also to the one making the purchase.  Though Buffett credits Munger with this modified investment style (an amalgamation of Graham’s style and qualitative factors), Munger gives the credit right back insisting that Warren had been doing this all along.  In fact, much of this style has been drawn from Phillip Fisher and then perfected by Buffett, who early on in his career even characterized his investment style as fifteen percent Fisher.

The most important qualitative factor Buffett emphasizes is staying within one’s own circle of competence.  If you are a petroleum engineer should you be looking for investments in financials?  Surely not.  Look first in your area of expertise.  Buffett and Munger have largely avoided technology stocks altogether.  Peter Lynch, a Buffett devotee, discusses the mistake he made in his book One Up On Wall Street by not staying within his circle of competence, namely Dreyfus and Franklin, missing a potential 100 and 138-bagger:

“I’d been coming to work here for nearly two decades.  I know half the officers in the major financial-service companies, I follow the daily ups and downs, and I could notice important trends months before anyone on Wall Street.  You couldn’t be more strategically placed to cash in on the bonanza of the early 1980s.”

“I was right on top of all of them.  I knew the Dreyfus story, the Franklin story, and the Federated story from beginning to end.  Everything was right, earnings were up, the momentum was obvious.  How much did I make from all this? Zippo.”

It would not be wise to ask your mechanic to do your taxes or your accountant to do your car maintenance; likewise, don’t pretend you’ll be better at investing in oil companies than banks if your work is heavily related to banking.  Do not pretend to know more than you do, expand your circle of competence whenever possible, and know the boundaries of your circle well to avoid potential investing pitfalls.

Another important factor Buffett emphasizes is the quality of a company’s management.  This factor is of paramount importance.  Management’s energy is much like the sun’s in that it is powerful and permeates an organization.  Management should stick to an overarching philosophy and business model that generates trust, promotes quality, and empowers employees.  Buffett exemplifies this himself with his own managerial strategy.  He has complete faith in his management and is completely hands-off when it comes to running his subsidiaries.  How could he be more competent than a management in place that has already proven to grow a successful business that interested him in the first place due to its quality?  Buffett’s latest stock purchase of Fiserv, Inc. has as much to do with quantitative factors as it does to do with qualitative factors, and often times these two go hand-in-hand.  Fiserv’s management is top-notch and Fiserv itself is ranked as #1 in several of the industries it serves.   Quality management will tell you the way it is not the way you want it to be.  Take Lonnie Stout, CEO of J. Alexander’s, as an example, in the company’s latest annual report he says, “I will share with you what I think we did well during this two-year downturn. I will also share with you some things I think in retrospect we should not have done.”  He also called the latest business results “troubling.”  Throughout his letter to shareholders there is a peppering of emphasis on responsibility both fiscally and managerially.  He does not shy away from the truth.  While there are many more factors to management quality, these examples should help to point investors in the direction they should be facing.

Another important qualitative factor is quality of thought.  Although Buffet has always been a better-than-average thinker, it was not until the addition of Munger that Buffett’s thinking power was raised exponentially.  Munger is the human equivalent of a supercomputer and routinely lectures about the importance of mental models.  Since the investor is essentially involved in a game where minds come together to trade perceived value, which is but a subset of a worldwide network of perceptions that makes up the totality of what constitutes reality, it is important to know what drives the mind.  Munger’s essential belief is that the mind is largely driven by psychological factors that were created to automate thinking.  While automated thinking once had biological advantages, it is primitive in its origins and it is not advantageous when deployed by an investor.  The investor’s ultimate goal then is the shape his thinking so that he remains as objective and calculating as ever.  By learning several mental models investors can avoid the psychological traps that most investors fall prey to.  Such models include the concepts of: compound interest, permutations and combinatorics, probability, breakpoint (from engineering), critical mass, cost-benefit analysis, and economics of scale, just to name a few.  Aside from the simple reason that they enjoy it this is why Buffett and Munger are such avid readers—to be more knowledgeable, gain insight, and thus be more objective.  The wise investor does not ignore this crucial qualitative factor, for how can you know the value of anything in the market if you don’t know what constitutes society’s value perceptions?

There are many qualitative factors from which Buffet and Munger gain insight.  None of these should be discounted.  However, more important than spelling them out is understanding why and how they are arrived at.  If an investor understands this then he might just do some thinking on his own and perhaps that is

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