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The Fundamental Difference Between Benjamin Graham & Warren Buffett Part 2

February 15, 2013 | About:

During the early days of his career, Buffett invested in the same was as Graham did, focusing on a variety of "cigar butts" - businesses that were for the most part unattractive except for their price, complimented with investments in special situations. However, with influence from Philip Fisher, author of "Common Stocks & Uncommon Profits," and his partner, Charlie Munger, Buffett switched his focus to what he is now more famous for: businesses that possess competitive moats selling for reasonable prices.

Where the philosophies of Graham & Fisher merged and where Buffett first had his "eureka" moment were, in my view, during the Salad Oil Scandal of 1963. American Express fell victim to fraud and suffered substantial losses as a result. Here Buffett sensed an opportunity: was the underlying business that American Express (AXP) engaged in damaged? His "scuttlebutt research" revealed that it was not. While the scandal cost American Express greatly, the impact that it had on its name and level of prestige, along with its ability to generate future profits from that credibility, were left unharmed and intact.Graham's focus on hard assets would have steered him away from American Express.

Fisher's influence though was far greater here, as he believed the qualitative aspects of the business were far more important, and Buffett effectively integrated the two underlying views: buying a business with an endurable economic moat at a bargain price. The crux of the investment decision came down to the underlying question of whether the impact on the business was permanent. History has shown that Buffett was right on all counts.

Buffett has often remarked that the value of a business is essentially the value of all its future cash flows added up and discounted to the present, i.e. a discounted cash flow model. This means that one has to take a rough guess regarding the estimated growth rate in order to arrive at such a figure. It is essential to bear in mind that such figures are not plucked from thin air, that they are the results of a careful examination of existing financial results and a careful analysis of the business itself and any managerial decisions.Making such a projection into the future is inherently a risky bet. Many variables are at play: The entrance of future competitors and the emergence of new trends are just some of the potential problems.

For this very reason, you saw Buffett gravitating towards businesses which had an inherent "inevitability" to them, businesses akin to Coca Cola (KO), P&G (PG) and Wells Fargo (WFC), for example. Although their future is not certain, there is a higher probability that particular habits will not change that much, such as the way us humans eat and drink, in comparison to what new gadget we will own tomorrow. It is therefore easy to understand why Buffett chose not to invest in technology companies regardless of the valuations; any projection into the future will be inherently flawed from the outset and rendered meaningless.

While Buffett's approach certainly aided him well, there are pitfalls for the average investor who seeks to adopt such an approach to investing. There are shortcomings to Graham's approach of finding statistical bargains, although its attractiveness is that it requires very little judgment in predicting the future. It is very much a simplified "quant-based" strategy founded on the fundamental principles of value investing.Buffett's approach requires much greater skill. It requires much more intensive research into not only the underlying company, but its competitors, the industry and much more. All these factors are required to make a future projection of cash flow. Furthermore, it is easy to err in the process of making an estimation of future growth rates and it is hard to ascertain whether one is right in the predictions for the years ahead.

Either strategy, providing that it is applied effectively, will yield satisfactory results for investors. However, those who attempt to mimic Buffet must bear in mind the intricacies of his investment process and put in the requisite work required of such a method.

About the author:

Juno Tay
Founder of The Asia Report, a Leading Financial Publication on Investing In Asia.

Visit Juno Tay's Website


Rating: 4.1/5 (14 votes)

Comments

Discoveror
Discoveror - 1 year ago
NICELY put and, more valuably, summarized.

I wish that reading `700 pages of 'Security Analysis' said as much ... and as succinctly.

THANK YOU ... for that.
LwC
LwC - 1 year ago
IMHO the attempts by commentators to interpret Buffett's investing practice as divergent from Graham's is overblown. Buffett himself has contradicted those opinions many times.

Here's one example: "[Graham and Dodd] laid out a roadmap for investing that I have now been following for 57 years. There's been no reason to look for another." - Warren Buffett (2009)

Juno Tay
Juno Tay premium member - 1 year ago
Discoveror: Thank you for your kind words.

LwC: I think Buffett has deviated from Graham quite clearly in his investment methodology - i.e. how he values business, the price he is willing to pay etc. However, the principles, such as margin of safety, ignoring Mr. Market are still well and true.

Problem with financial journalism its all in "sound bites". I really recommend reading his shareholder letters and both his biographies to gain a better understanding of what he does.
LwC
LwC - 1 year ago
Yes, you are correct of course. How foolish of me to pay attention to Buffett's opinion. Sorry about that!

jonkevinlai
Jonkevinlai premium member - 1 year ago


Juno, good article.

LwC, I too pay attention to Buffett's opinions and it is certainly more than just that one liner in isolation. It is also Buffetts opinion that besides Graham and Dodd, he has been deeply influenced by Fisher and also his partner Munger. He has said so himself many times in interviews and shareholder letters.
LwC
LwC - 1 year ago
@jonkevinlai,

Well at least I referred to an actual quote expressed by Buffett in support my opinion. The author of this article did not even once quote Buffett even though he/she purports to provide insight into Buffett's thinking. I'm satisfied to rely on even just one short quote by Buffett for insight into his thinking over someone else's potentially misguided opinions. You are in turn free to choose which sources you will rely on to guide your thinking about the subject.

I've provided in another thread a link to a study that IMO gives a more nuanced, and more cogent view of the subject:

http://www.gurufocus.com/forum/read.php?1,208849,208849#msg-208849

Please note that the author of this study provides information and quotes that are referenced to his sources. This a marked contrast to Juno Tay's article, which does not provide even one source for the material he/she incorporated into his/her article. Of course you can decide for yourself which author presents the better case in support of their conclusions.

Good luck.

Juno Tay
Juno Tay premium member - 1 year ago


LWC:

As Benjamin Graham once said, you are neither right nor wrong because the crowd agrees or disagree with you, but because of your research and reasoning.

My own conclusion was based on my own research and work into Buffett's career. If you are looking for quotes on Buffett, I can only say to look to his biographies, or the multiple books available to reach your own conclusion.

Regards,

LwC
LwC - 1 year ago
"If you are looking for quotes on Buffett, I can only say to look to his biographies, or the multiple books available to reach your own conclusion. "

Well gee whizz Juno Tay, maybe I have done a fair amount of reading of Graham, Buffett, Fisher, and others, over the years and have already reached my own conclusion based on the reading and my own investment experience. So I will ignore your rather snarky response and focus again on the credibility of your thesis.

Yes I have reached my own conclusion, and in fact, that is what I stated in my first response to you: that IMHO Buffett has not "fundamentally" diverged from Graham's investment methodology. IMO it's just the opposite: that though Buffett has "evolved" his investment practice over the years, he still adheres to Graham's fundamental investment practice as he learned it directly from Graham. In part, I believe that because Buffett says so himself.

In addition to Buffett's apparently unambiguous quotes on the subject, I even provided above a link to another study on the subject that IMO fairly contradicts your assertion. Did you read it? Not only does he tackle the attempts by commentators such as yourself to assert that there is a "fundamental difference" between Graham and Buffett, but IMO he does a good job of it. And unlike you, he provides references to his quotes and sources in the form of footnotes and a bibliography.

And I point out again, while you assert that you have done your "own research and work into Buffett's career", you have not provided any references for your sources. You have not even quoted Buffett on the subject. You didn't even provide a Buffett quote about Fisher. How do reconcile your thesis to Buffett's own words? You didn't even bother to try.

In short, between you and Buffett, IMO Buffett is the more credible source.

Good luck.

AlbertaSunwapta
AlbertaSunwapta - 1 year ago
A simple difference between the two might be recognition of the impact of trading and capital gains taxes on final returns.
Juno Tay
Juno Tay premium member - 1 year ago
LwC:

I am afraid you have misunderstood the point of my article.

I never once stated that Buffett had deviated from the practices of value investing. In fact, I do believe that he has remained true to the principles of it. What this article was about however, was the difference way that Buffett applied value investing as compared to Graham - hence the title - the fundamental difference between Graham & Buffett. I am not sure how you came to that conclusion.

And yes, I do agree that Buffett has evolved which what I was driving at. In the earlier stages of his career, especially during his partnership years, you see buffett investing in a lot of "cigar-butts". He later when on to buying good businesses at good prices (American Express, Disney), to buying good businesses at "okay" prices (Heinz).

Regards,
AlbertaSunwapta
AlbertaSunwapta - 1 year ago
I think too much emphasis has been placed on the idea that Buffett made his early money on cigar butts. I recall his early letters talking about buying the 'generals', as in generally undervalued shares, and these generally moved with the market, so these generals were unlikely to be cigar butts. Moreover I believe he credited the generals with providing most of his outperformance.

This is worth reading for further insight...

http://www.gurufocus.com/news/169950/how-warren-buffett-made-his-first-100000

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