The success of Buffett in his investing career can largely be attributed to his discovery of the works of Benjamin Graham in The Intelligent Investor and Security Analysis. Under the tutelage of Graham, both at Columbia and at his firm Graham-Newman, Buffett flourished in an age where market inefficiencies were rampant, and one in which the average investor could literally find dollar bills trading for fifty cents by thumbing through Moody's manuals. Such companies selling below their theoretical liquidation value no longer exist in the quantities they once did to make them sufficiently profitable.
By examining the writings of Benjamin Graham, it is clear that he had little trust in forecasts. He believed that too much time and effort had been placed into the technique with very little to show for it. The truth is that forecasting the future is immensely difficult, with incalculable variables affecting the eventual outcome. Such a view tempered Graham's view, and as a direct consequence, he laid his focus on investing in net-nets - companies selling below their estimated liquidation value. Such an investing methodology placed great emphasis on what already was, as opposed to what could be, and therefore greatly reduced the margin of error.
It is arguable that such an approach still required an element of forward-looking. This is undeniable. Graham's rebuttal was as follows:
Firstly, the possible range of outcomes was far greater than the possibility of the business going into terminal decline. The options that were open to management were to liquidate the business, sell off unprofitable divisions or engage in turnabouts. Secondly, these businesses were already priced as such depressed valuations that this provided for a huge margin of error, and even if the business did go into eventual liquidation, Graham would be protected. Finally, Graham emphasized that such an operation should not be taken singularly, and that while he could not be sure of the success of an individual company, collectively as a whole, such an operation would be adequate for investors.
With such opportunities disappearing in the 1970s, Graham adopted his methodology to focus on companies which fit the criteria set out below:
1. An earnings-to-price yield at least twice the AAA bond rate.
2. A P/E ratio less than 40% of the highest P/E ratio the stock had had over the past 5 years.
3. A dividend yield of at least ⅔ of the AAA bond yield.
4. A stock price below ⅔ of tangible book value per share.
5. A stock price below ⅔ of Net Current Asset Value.
6. A total debt less than book value.
7. A current ratio greater than 2.
8. A total debt less than 2 times Net Current Asset Value
9. An earnings growth of prior 10 years at a minimum 7% annual compound rate
10. Stability in growth of earnings with no more than 2 declines of 5% or more in year end earnings in the ten years prior are permissible.
The first five are essentially valuation criteria, and the following five are criteria that ensure the financial health of the business.
What will strike you most is that all of these criteria are historical and not forward-looking. No mention is made of forward price/earnings ratios, future growth rates or opportunities. They are all historical valuations, which are obtained with information that is available definitively as opposed to data which is predicted.
It is clear that Benjamin Graham espoused a methodology that played very little credence on what the industry focuses largely on today - the future growth prospects on the company.
Interestingly enough, Buffett, Graham's most illustrious pupil, while keeping to the fundamental principles of Graham, took an entirely different approach from his teacher. Influenced by Philip Fisher and Charlie Munger, he departed from Graham's approach, focusing on the future growth prospects of the business itself, something which we will explore extensively in the following article.