Investors unanimously consider that you must know what you want to buy before looking for prices.
Warren Buffett also advocates this consideration. After following Graham's philosophy for many years, he decided to change to Fisher and Munger’s strategy based on businesses that have superior economics. Graham's thought has made him make mediocre deals. But why are Graham's ideas insufficient for investing?
As I have explained in previous articles, Graham has always invested in businesses with low intrinsic value. He has permanently said that a good deal involved buying when businesses sold well below average price. This philosophy was well reflected in his portfolio, which comprised hundreds of investments.
And, how is intrinsic value determined? Graham said it was more “a range of value” than a single price. But his statement seemed blurry. Intrinsic value is extremely dependent on investors' discretion. He always said that if a man was fat you didn't have to know his exact weight. Knowing he was fat would do. But not everyone uses the same assessment.
And this happens in business too. What appears to be fat to me may not appear as such to you.
Graham thus developed two theories to clarify the issue. One involved buying a group of stocks at less than their current working — capital value, without considering plant and other fixed assets and then deducting liabilities; and the other method was to buy stocks at less than seven times reported earnings for the past year.
Why would Graham consider this profitable? The idea was that the investor bought the stock below the intrinsic value expecting it to increase with the passing of time. However, that was not always the case and sometimes the share price would not realize.
Let's show how out-of-focus his theory is with an example. Suppose you found a company with a share worth $62.50 but at the moment selling at $50. Following Graham's thoughts, it could be perfectly said that the stock was undervalued by $12.50. If you invested in the company at $50 a share and price rose to $62.50 a share the first year, then you would have made a 25% return on your money. But what's wrong about this? Let's suppose the company is not able to realize such value in the first year; then the return on your investment drops dramatically. Even if the company reaches full intrinsic value, $62.50, in the second year, your return drops to 11.8% compounded annually. And what is worst, if the company doesn't realize the value until the third year, your return drops to 7.7% compounded annually and so on. If the company continues to sell at $50 a share, your return is a big zero.
The non-realization of assets shows a drastic drop in the rate of return.
Anyway, he brought a solution to this intrinsic value problem: the margin of safety. He thought it was better to invest in businesses with an important percentage of return that would give him such margin.
The unsound strategy made him develop a standard. This standard required the company to have stable earnings to become profitable for investors and enable them determine intrinsic value. However, stable earnings may provide the intrinsic value but will rarely show the economic nature of the business.
Definitely Graham, unlike Buffett, was not a long-term player. Focusing in the intrinsic value of each year involves short-term planning and Warren's way is completely different.
Warren has always determined that a wise investor is the one who can forecast what will happen with a company in the long term.
This explanation clearly shows why he left his mentor and followed other ideas.
Warren Buffett also advocates this consideration. After following Graham's philosophy for many years, he decided to change to Fisher and Munger’s strategy based on businesses that have superior economics. Graham's thought has made him make mediocre deals. But why are Graham's ideas insufficient for investing?
As I have explained in previous articles, Graham has always invested in businesses with low intrinsic value. He has permanently said that a good deal involved buying when businesses sold well below average price. This philosophy was well reflected in his portfolio, which comprised hundreds of investments.
And, how is intrinsic value determined? Graham said it was more “a range of value” than a single price. But his statement seemed blurry. Intrinsic value is extremely dependent on investors' discretion. He always said that if a man was fat you didn't have to know his exact weight. Knowing he was fat would do. But not everyone uses the same assessment.
And this happens in business too. What appears to be fat to me may not appear as such to you.
Graham thus developed two theories to clarify the issue. One involved buying a group of stocks at less than their current working — capital value, without considering plant and other fixed assets and then deducting liabilities; and the other method was to buy stocks at less than seven times reported earnings for the past year.
Why would Graham consider this profitable? The idea was that the investor bought the stock below the intrinsic value expecting it to increase with the passing of time. However, that was not always the case and sometimes the share price would not realize.
Let's show how out-of-focus his theory is with an example. Suppose you found a company with a share worth $62.50 but at the moment selling at $50. Following Graham's thoughts, it could be perfectly said that the stock was undervalued by $12.50. If you invested in the company at $50 a share and price rose to $62.50 a share the first year, then you would have made a 25% return on your money. But what's wrong about this? Let's suppose the company is not able to realize such value in the first year; then the return on your investment drops dramatically. Even if the company reaches full intrinsic value, $62.50, in the second year, your return drops to 11.8% compounded annually. And what is worst, if the company doesn't realize the value until the third year, your return drops to 7.7% compounded annually and so on. If the company continues to sell at $50 a share, your return is a big zero.
The non-realization of assets shows a drastic drop in the rate of return.
Anyway, he brought a solution to this intrinsic value problem: the margin of safety. He thought it was better to invest in businesses with an important percentage of return that would give him such margin.
The unsound strategy made him develop a standard. This standard required the company to have stable earnings to become profitable for investors and enable them determine intrinsic value. However, stable earnings may provide the intrinsic value but will rarely show the economic nature of the business.
Definitely Graham, unlike Buffett, was not a long-term player. Focusing in the intrinsic value of each year involves short-term planning and Warren's way is completely different.
Warren has always determined that a wise investor is the one who can forecast what will happen with a company in the long term.
This explanation clearly shows why he left his mentor and followed other ideas.
