The Ultimate Bargain Hunter
Since the financial crisis, Warren Buffett's Berkshire Hathaway has had significant exposure to financial stocks in its portfolio. Q1 2021 hedge fund letters, conferences and more At the end of March this year, Bank of America accounted for nearly 15% of the conglomerate's vast equity portfolio. Until very recently, Wells Fargo was also a prominent Read More
This 700-page book laid out the structure for a logical approach toward investing. It took investing out of the dark ages of astrology, hunches and tips. The authors said that successful investing is based not on chance or guesswork but on analysis of a company’s past record. It provided structure and logic and created an intellectual framework for sound investing.
A few years later, in 1949, Graham wrote The Intelligent Investor, which, unlike Security Analysis, was geared to the layperson. The book found its way into the hands of a teenager in Omaha, Nebraska. Reading the book, he said, would change his life. That teenager was Warren Buffett.
Buffett read the first edition of The Intelligent Investor early in 1950, when he was 19 years old, and he has said, “I thought it was the best book about investing ever written. I still think it is.” In a recent interview when asked how his investing approach has changed since he started investing, Buffett said, “My approach to investing I learned in 1949 or 1950 from a book by Ben Graham, and it’s never changed.”
Over the past 80 years, Graham’s principles have continued to endure, and they are ever sounder and better understood with each passing year.
Graham’s approach toward stock investing comprises three principles:
1. View stocks for what they really are – pieces of a business and not wiggles on a chart.
2. View the stock market as your partner, which he called Mr. Market, that each trading day offers to buy or sell your shares. Keep in mind that he is there to serve you, not to guide you.
3. And buy only when there is a gap between the price of the stock and the underlying worth of the business – or, as Graham called it, “a margin of safety.”
Graham, also known as the father of security analysis, approached the stock market not as a financial engineer using complex mathematical equations, but as a businessperson.
I have found over the years that if investors get the first principle, that stocks are pieces of a business, the other two principles flow from there. But if they have a hard time seeing stocks in that way, they probably will never get it and will end up buying and selling stocks based on everything but the fundamentals of the business.
It never ceases to amaze me how successful businesspeople apply one approach to investing in a private business and another when it comes to stocks. Imagine the owner of a private business making decisions based on the following:
• Deciding to open a new division only when the 50-day moving of his company’s daily sales crosses above the 200-day moving average of its daily bank deposits.
• Upon hearing of the nationalization of a bank in England, he calls a business broker and offers his 100-year-old very profitable family business for sale at 30% below its intrinsic value.
• After a government report is released that shows unemployment rose to 7%, he then calls a competitor and offers to buy that business for 25% above the company’s asking price. The reason for his exuberance is that the unemployment number was 0.20% lower than his forecast.
• While charting his company’s bank deposits, he notices that the chart pattern is tracing out an “inverse head and shoulders” pattern, and he makes a decision to lay off 20 employees.
If these decisions were actually made by a private businessperson, I question how long the person would stay in business. It would be hard to find a businessperson drawing conclusions on such disconnected data and actually implementing them. Yet most investors would not give it a second thought if I told you I was talking about stocks instead of a private business.
Most people who invest in stocks forget that they are actually pieces of a business. Instead they make decisions on buying and selling pieces of that business (shares) based on emotion and with very little regard for the underlying value of the business. In a nutshell, these types of investors are not in the proper mind frame that Graham laid out in his first principle.
Graham said the key to a sound investment is to “consider yourself as a part owner, which is a very sensible approach for sound investment. Ask yourself: If there was no market for these shares, would I be willing to have an investment in this company?”
As a value investor, you know that over the short term stock prices fluctuate based on how popular a stock or industry is. Traders buy stocks simply because they are rising and sell them because they are falling. They even have a name for it, momentum traders. These traders don’t perform any analysis on the company’s financial statement, competitive advantage or stock price in relation to the value of the company.
The stock price fluctuations caused by this type of approach offer the value investor an enormous opportunity. When a stock or industry becomes unloved and unwanted, the stock price drops to levels that have no relationship to the underlying worth of the business.
What seems outright silly when it comes to making decisions in a private business, investors have no problem applying to stocks. Over the long term stock prices move in step with the intrinsic value of the business. It is during times when the stock price soars way above the intrinsic value of the business that we want to be sellers, and buyers when the stock price trades for a fraction of the business’s worth. Warren Buffett said it best: “Be fearful when others are greedy and greedy when others are fearful.”
Viewing stocks as pieces of businesses instead of as symbols that are traded thousands of times during the day gives a value investor a big advantage. Instead of making investment decisions based on the release of the Federal Reserve Bank of Philadelphia’s Fed Index or the U.S. Census Bureau’s Construction Spending report, value investors make investment decisions based on the company’s financial statement and the difference between price and value.
Now, doesn’t that make much more sense?