Most readers on this forum should be pretty familiar with the Ben Graham approach versus the Warren Buffett (Trades, Portfolio) approach –Â quantitative versus qualitative. Both are valid approaches in value investing but each one requires a different set of skills. Some of us may possess the skills for both approaches but most of us are better suited for only one approach. There are many similarities and differences between these two approaches. For the sake of simplicity, I will only discuss the differences related to temperament and skill set.
The Graham approach, in my opinion, requires a substantial understanding of financial accounting and especially the balance sheet accounts because your intrinsic value calculation is heavily dependent upon the net assets value of the business. Therefore, you need to know that timbers are carried on the balance sheet at historical costs as opposed to the real value if you are investing in a timber land company. In other words, you need to be able to tell whether the assets or liabilities on the balance sheets are understated or overstated. You also need to be aware of the potential assets impairment if you invest in a teen retail business because if teenagera’ tastes change next year, your inventory may be only worth half of what it is on the balance sheet. You also need to be able to detect off-balance sheet assets and obligations. If the company you invest in is a credit guarantor of an unconsolidated entity, or the counterparty of a massive derivative contract, you need to be able to figure that out. You can’t just take stated net current asset value as the intrinsic value, although you are very tempted to do so. You also need a basket of cheap stocks for this approach to work. Concentration rarely works if you use the Graham approach.
The Buffett approach, on the other hand, depends less on balance sheet analysis. This doesn’t mean you don’t have to understand financial accounting. You still need to understand the basic accounting rules so you can figure out the real earnings power of a business. The difficult part of the Buffett approach is that it involves a great deal of judgment and the intrinsic value is nothing more than an educated guess – unlike a hard number from the Ben Graham approach. It takes a lot more time to analyze the qualitative factors of the business than the quantitative side of the business. But even after you have done the scuttlebutt work, you still have to make the judgment call on the quality of the business and management team and if you are wrong, you don’t have a number to lean on. However, if you are right, your reward can be much more substantial than the reward you would have reaped with the Graham approach. And unlike the Graham approach, you should concentrate on your best ideas if you want to significantly outperform.
A while ago, I wrote an article on personality types and investing, which you can find here. I think the same logic can be applied in deciding which approach suits your personality the best. If you have an accounting or finance background and you are extremely opposed to uncertainty and uncomfortable with making judgment and guesses, maybe you are more suited for the Ben Graham approach. However, if you have no problem with dealing with uncertainties and making judgment calls based on things you know and things you don’t know, you could be better off with the Buffett approach.
Again, I am not saying that you should pick an approach just because your personality type and skill set fit the approach. You can have the right skill set for one approach, but the other approach makes more sense to you. If this is the case, you have to understand the limitations in your temperament and skill set if you decided to go with your preferred approach.
