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Grahamites
Grahamites
Articles (403) 

Graham Approach or Buffett Approach, Which One to Choose?

November 25, 2014

Most readers on this forum should be pretty familiar with the Ben Graham approach versus the Warren Buffett (Trades, Portfolio) approach – 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.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.6/5 (12 votes)

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Comments

zaim
Zaim - 6 years ago    Report SPAM

Very well said.

batbeer2
Batbeer2 premium member - 6 years ago

Thanks for an article worth reading.

You say:

>> Some of us may possess the skills for both approaches but most of us are better suited for only one approach.

There's skill and there's talent.

Benjamin Graham was a gifted writer, philosopher and teacher. Given these credentials, it is perhaps surprising that he is best remembered for his work on the quantitative side of investing.

Anyone who has studied "Security Analysis" will find that the book is not one outburst of genius. Rather it is the result of much hard work and the experience Graham had gained after two decades on the job. That is not to detract from the monumental value of his work but rather to point out that his work deserves even more respect becasue the man was more gifted in other areas.

With Buffett it may be the other way around. Some say he's a human calculator; he can look at a sheet of numbers and pick out an error within seconds where others couldn't figure it out in a week. But Buffett has spent a career honing the skills that are needed to master the qualitative side of investing.

In other words, these men were born with unusual talents and subsequently spent spent a lifetime developping what they were not born with. That may be why they achieved so much.

It reminds me of a nice article about Abraham Lincoln who accomplished so much becasue he consistently took the more difficult path.

Just some thoughts.

jtdaniel
Jtdaniel premium member - 6 years ago

Excellent article, Grahamites. The choice probably does come down to personality types or traits. The net-net guys seem like hoarders to me. I don't want a portfolio full of junk any more than I want a house full of junk. Obviously, Graham-style investing has proven successful; it is just not a good fit for me. A large number of high-maintenance holdings does not interest me. Neither does turning over a large portfolio every two or three years. Much less stressful, in my view to hold shares in a few great businesses that are almost sure bets to increase their instrinsic value over a long holding period.

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