3 Books That Shaped My Investment Philosophy

by: Financial Canadian

Summary

I'm an avid reader and believe one of the best ways to learn about investing is to study the greats.

Accordingly, three books that I read when I started my financial journey have had a major effect on my investment philosophy.

These books are Security Analysis, The Warren Buffett Way, and Pioneering Portfolio Management.

This posts outlines the effect these three books have had on me.

Almost all of the investments I have made are based on a thesis stemming from these books:

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Similarly, my decisions on these investments have been greatly influenced by the three authors, people who are considered authorities in the world of finance. I know this is a corny thing to say, but I really do stand on the shoulders of giants. This post will explain a little bit about my approach to investing and give a quick review of the three books that have influenced me the most.

My Investments are Based on Value

Almost all the techniques I use come from the "value" school of investing - a movement started by the genius Benjamin Graham and carried down by other legendary investors.

The whole premise of value investing lies in purchasing investments at a substantial discount to their intrinsic value. If a company is worth $20/share and it is trading at $10/share, value investing tells us that eventually the stock price will reflect the company's intrinsic value and increase to $20/share, allowing investors to profit. This difference between the company's intrinsic value and its share price is called the "margin of safety".

Why do I prefer value investing? The appeal lies in its inverted risk-reward curve. Let me explain.

For most investments, if you want a higher return, you need be able to accept a higher level of risk. Typically, high upside means high downside. Because of this, investors often divide opportunities into categories based on both their risk and their return, with lower-yield investments like money market or bonds considered "low-risk" and higher-yield investments like common stocks deemed "high-yield". It is uncommon to find investments that are both low-risk and high-yield, or else all investors would flock to them.

Value investing is unique because it often allows investors to make low-risk, high-yield security selections. The secret lies in the margin of safety, a term I briefly mentioned earlier. As the margin of safety increases, the risk goes down and the yield increases. This uniquely inverted risk-reward curve is the biggest reason why I am a value investor - where else can you consistently find opportunities to invest your money safely, for a great return? Let me know in the comments!

That being said, talking about margins of safety for a couple hundred words is only the tip of the iceberg when it comes to value investing. I plan on writing a full article on it later, but for now, let me show you where I learned it. I'll start by telling you about a book hailed as the "textbook on value investing," which is first on my reading list for the beginning investor. After that, I'll share a book chronicling the journey of the world's most successful investor, who also preaches value investing. To round up, I'll show you the first book I ever read about finance - a book I think about almost every day.

Security Analysis , By Benjamin Graham and David Dodd

Ever hear the phrase "an oldie but a goodie?" That saying describes this book perfectly. Originally published in 1934, the original text was strongly influenced by the Great Depression, so its continuing relevance today proves this is a timeless read. People call it the textbook on value investing, and it's hard to disagree.

The authors are two people whose lives I find very fascinating. Benjamin Graham is often called the father of the school of value investing, and many would consider him the primary author of this book (if such a thing exists). He's had such an influence on the school of value investing that you'd be hard-pressed to find someone in finance who hasn't heard his name. Graham was a devoted teacher at the Columbia Business School, loved by his students, and his disciples have grown into some of the most successful investors in the world. Namely, Graham has influenced people like Warren Buffett, CEO of Berkshire Hathaway, and Peter Lynch, the retired manager of the tremendously successful Fidelity Magellan Fund.

Because Graham is such a well-known figure in the investment world, people seem to forget that the book has two authors. David Dodd was originally a student of Graham's at Columbia University, and it is said that the first draft of Security Analysis came from Dodd's notes from that class. Eventually, Dodd joined the faculty at Columbia alongside Graham, and the rest is history.

Enough background. Now let me tell you why this book is a "must read." The first thing that struck me, as someone with a math degree, is the analytic approach of the authors. They manage to be both extremely thorough and very readable - something I struggle with as an author. You can tell that the authors are numbers guys. The book is full of charts, tables, and other quant stuff, which really helps them drill home the techniques they are teaching you. Sometimes it's hard to understand concepts without examples - but don't worry, Security Analysis is full of them.

Speaking of concepts, the book is full of fundamental truths about value investing that are explained in detail with examples. One of the most striking points was the difference between an investor and a speculator. The authors differentiate the two groups beautifully with the following passage:

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Today, we might more accurately call speculators "traders." These are people who purchase stocks with no concern for how the underlying company is performing as a business; instead, they are interested in predicting whether the stock price will go up or down on a short-term basis. Instead of viewing common stock as a part ownership of a business, speculators view them as simple commodities to be traded for quick profits.

The authors state that one of the key differences between an investment and a speculation is time. If we imagine a spectrum in our head of holding periods, with the left side of the spectrum being minutes, hours, or days and the right side of the spectrum having months, years or decades, Graham and Dodd asserted that purchases on the left side of the spectrum are far more likely to be speculations. In short, the intention to hold for the long-term generally means you have enough faith in the underlying business for the purchase to be an investment.

This book has literally changed my life. It laid out a road map to smarter, more effective investing, and has allowed me to simultaneously reduce risk and increase my returns. Remarkably, the practices laid out in this book have been successfully used by a ton of other normal people like myself. If you are interested in reading other Security Analysis success story, check out the essay "The Superinvestors of Graham-and-Doddsville," which details various value investors and how they have managed to crush the market over time.

With a proven track record that has stood the test of time, Security Analysis is the first book I would recommend to someone looking to learn about investing. If you're interested in purchasing this book, you can click here to start your road to smarter investing.

The Warren Buffett Way , By Robert G. Hagstrom

Warren Buffett's net worth is north of $60 billion. As the chairman and CEO of the international conglomerate Berkshire Hathaway (BRK.A, BRK.B), he has grown the business from a dying manufacturing company into a ubiquitous company that owns household names like Dairy Queen, Fruit of the Loom, and GEICO Insurance. Buffett is also a value investor. To me, that is not a coincidence!

Remember Ben Graham, the author of Security Analysis? Warren Buffett is his greatest student. And by student, I mean that literally - he studied under Graham at Columbia Business School, and Buffett has openly admitted that Graham is the second most influential man in his life (behind his own father).

Buffett had a very interesting childhood, described in detail in Hagstrom's book. He demonstrated from an early age that he had a knack for making money. His early business ventures included running the newspaper delivery route, selling Coca-Cola door-to-door, running a small pinball machine business, and purchasing his first stock (Cities Service Preferred, now operating as Citgo Petroleum Corporation) at the age of 11. He also filed his first income tax return at 14 (something I haven't even done yet - thank God for accountants!).

Buffett's greatness didn't stop there (or why would I be writing about him?!). After graduating from Columbia Business School, he begged Ben Graham to let them work together, even offering to work for free. Graham refused initially, but eventually he did employ Buffett in Graham-Newman Corp. as a securities analyst (sound familiar?). From there, Buffett made a killing by running investment partnerships with various individuals and taking fees based on his investment returns. He grew his partnership large enough to purchase the outstanding shares of Berkshire Hathaway, which was a lagging textile manufacturer at the time. After making some management changes and switching the company's main operations to insurance, Buffett had himself a promising company.

After spending the first chunk of the book outlining his remarkable upbringing and early career, Hagstrom does a wonderful job describing the strategies Buffett uses to make his investments. The Warren Buffett Way divides the analysis into four important categories (with subcategories!) as follows:

Business Tenets

Hagstrom spends probably the most time describing the business criteria behind each of Buffett's stock purchases. Buffett has some very strict requirements, saying he has more cash than he can invest effectively. It's hard to doubt him when you look at the tremendous success he's had.

You will notice that estimating a company's earnings are key to Buffett's methods of common stock valuations. Keep that in mind as you continue reading - I know that personally this book has made me always key-in to a company's earnings when deciding whether or not to invest.

Buffett's three business tenets are as follows:

1. Is the Business Simple and Understandable?

For Buffett, having an understanding of how a business operates is key to being able to estimate its intrinsic value. For instance, he was ridiculed for avoiding technology companies during the incredible dot-com bull market of 1995-2001. Tech companies were reaching record valuations and smart investor were taking their profits, but not Buffett. His reason? His lack of understanding. Later on, when the dot-com bubble burst and many investors saw their retirement portfolios cut in half, Buffett emerged relatively unharmed.

Without understanding a company's business model, especially how it makes its money, investors will have no clue what types of risk come with their investments. People hungry for big returns suffered when the dot-com bubble burst in 2000. Similarly, overleveraged real estate tycoons got crushed in the 2008 housing market disaster. By picking simple and understandable businesses, Buffett avoids this risk.

2. Consistent Operating History

According to Buffett, companies that have unreliable earnings histories are more likely to have unreliable futures. With metrics that are extremely variable between years, how are we able to accurately predict how the company will perform in the future?

Consider Coca-Cola (NYSE:KO), one of Buffett's larger stock holdings. His stake was purchased in 1988, after the 1987 market crash offered him an attractive price. Coca-Cola's earnings were remarkably stable over the years, and the company's global presence and international brand reassured him that its consistency would continue into the future.

3. Favorable Long-Term Prospects

What exactly does it mean to have "favourable long-term prospects?" According to Hagstrom, Buffett firmly believes a company must demonstrate reliable growth in terms of both earnings and net income year over year.

One of the techniques he uses that is a little bit different from Benjamin Graham's is the concept of an economic "moat." In layman's terms, this is a business' competitive advantage that will allow it to certainly remain profitable in the foreseeable future. Having a great economic moat, according to Buffett, is a sound predictor of long-term success.

Management Tenets

Traditionally, Berkshire Hathaway has preferred to purchase wholly-owned subsidiaries where possible, rather than taking a non-controlling share via common stocks. This gives the company the ability to make management changes where desired. Interestingly, in most cases it hasn't exercised this power, claiming that the management they purchase along with the company is often as valuable as anything else. By examining the three management tenets that Hagstrom has identified in Buffett's investment, we will see why this is the case.

4. Is the Management Rational?

Buffett believes the most important role of executives is the allocation of capital, believing the rational choice is the one that has the highest risk-adjusted return. He loves managers who excel at trimming unnecessary costs, so that they have more working capital to reinvest in their business. By repeatedly choosing capital allocations that demonstrate this rationality, managers can prove they are worthy of a Buffett investment.

5. Is the Management Candid with the Shareholders?

Another important role of business management is to not only help shareholders realize a return on their investments, but to also communicate effectively the progress of the business. You can see Buffett's emphasis on effective communication by the way he managers Berkshire Hathaway - not only are his annual meetings tremendously popular and entertaining for shareholders, but reading his annual reports shows he strongly believes in communicating with his investors.

6. Does the Management Resist the Institutional Imperative?

When Hagstrom mentions the "institutional imperative," he is referring to the tendency of companies to make foolish decisions based on the actions of their peers. Buffett avoids this, and every other investor should too.

Financial Tenets

People who knew Buffett from the time he was younger have often remarked that he had a gift for mathematics. Clearly, this has boiled through to the way he runs his company - if the financials aren't there, he won't invest.

7. Return on Equity

We can calculate return on equity as net income divided by shareholders' equity. Further, shareholders' equity is simply the company's assets minus its liabilities. Obviously, the higher this number, the better.

8. Owner Earnings

Earnings analysis could be a blog post all on its own, and to be honest, Hagstrom doesn't cover this in much depth. What he does talk about, though, is the concept of owner earnings - the money that business owners are entitled to from the operations of their business. Calculating owner earnings is complicated and usually a little bit different for every line of business.

Typically, any other way of reporting earnings is frowned upon by Buffett. He notably despises the use of EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization), saying, "We'll never buy a company when the managers talk about EBITDA."

9. Profit Margins

Profit margins are how much income a company retains for every dollar of sales (or revenue). For example, if a grocery store has a 20% profit margin, this means it retains $0.20 for every $1.00 of groceries it sells. Just like every other financial metric we've talked about so far, Buffett looks to maximize this number when making investments.

10. The One-Dollar Principle

So far, every financial tenet that Buffett practices is pretty standard. Other successful investors follow the same practices. This next one, however, is something that I've never heard outside of the realm of Warren Buffett.

The one-dollar principle is used to determine whether companies should retain their earnings or pay them out in dividends. Essentially, the principle states that for every one dollar of retained earnings, the intrinsic value of the company should also increased by at least one dollar. If the company is unable to invest its dollars at market value (or ideally, for a ratio greater than one-to-one), those dollars would be better spent by paying out dividends. In this way, the shareholders themselves can determine where to invest this money.

Value Tenets

11. What is the Value of the Business?

Valuing businesses is a problem that employs millions of financial analysts worldwide. The problem is so large that it is undoubtedly outside the scope of Hagstrom's book, but he does provides an effective non-rigorous introduction to Buffett's techniques of company valuation.

12. Buy At Attractive Prices

It seems crazy logical now, but before reading this book, I didn't have an understanding that any company can be a bad investment for the wrong price. Similarly, most companies can be good investments if purchased at enough of a discount.

When I first began investing in the stock market, I blindly bought my employer's stock without considering its current price compared to the historical average. Since the company was trading near record highs, when it leveled off a bit I promptly lost money. That was a bad first venture into the stock market.

Case Studies

My favorite part of this book is definitely Chapter Four, which thoroughly describes nine of Buffett's successful common stock investments and how he has applied his investment philosophies to these purchases. The purchases that Hagstrom outlines are:

  1. The Washington Post Company
  2. GEICO Corporation
  3. Capital Cities/ABC
  4. The Coca-Cola Company
  5. General Dynamics (NYSE:GD)
  6. Wells Fargo & Company (NYSE:WFC)
  7. American Express Company (NYSE:AXP)
  8. International Business Machines (NYSE:IBM)
  9. H.J. Heinz Company (NASDAQ:KHC)

One of Buffett's more interesting stories is his purchase of Amex. In the 1960s, a relatively small salad oil company in New Jersey was qualifying for loans based on the inventory of salad oil that it held in its warehouses. Knowing that the oil would float on water, the management ordered that water be poured into the oil containers. This artificially inflated the company's inventories, allowing it to qualify for larger loans. When the company eventually started to default on its outrageously large loans, Amex's stock price was crushed, and Buffett picked up a massive amount of shares cheap. It remains one of his core holdings.

Buffett's business success is unmatched. But that's not why I find him intriguing as a person. My favorite trait about Warren Buffett is his continuing frugality in the face of tremendous wealth. He still lives in the same home he purchased in the 1950s, even though he could conceivably pay cash for any house on the planet if he sold some investments. He also pays himself a (relatively) small salary of $100,000, considering he is the CEO of the fifth largest publicly traded company in the world. Even his wedding was rumoured to be extraordinarily frugal. I love it!

This book has really had an impact on me and my investments, and I highly recommend it. If you want to pick up a copy for yourself, you can click here to buy it at a bargain from Amazon.

Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment , By David Swensen

This was the first full book I ever read about finance, back when I was a young spry chick at the age of 18. I was in my first year of my undergrad, and when reading about my school on Wikipedia I noticed the term "endowment." I had no idea what this meant, but a few hours later, I had completed my first little introduction to institutional investment, thanks to the Internet.

But why did I pick this book? Certainly, there are a ton of other resources on endowment funds. Well, this guy is a pioneer. You can't Google search "institutional investment" without eventually finding David Swensen's name. After working at big Wall Street names like Lehman Brothers and Salomon Brothers, he joined the Yale Endowment team in 1985 and has averaged tremendous returns ever since. When he joined Yale, their endowment was valued at approximately $1 billion. Currently, Swensen manages about $24 billion for the Yale endowment fund, and his strategies are being used worldwide by other institutions, with varying degrees of success.

Interestingly, many of the other institutions that have attempted to copy Swensen's techniques have dramatically underperformed. Most people chalk this up to the skill of the Yale team - they are the best at what they do, and people on the outside don't have quite a grasp on everything that Yale does to make itself successful.

Swensen has also written another book called Unconventional Success: A Fundamental Approach to Personal Investment. This book is aimed at the individual investor rather than the institution, and has been tremendously popular with the general public. I read this book much later than Pioneering Portfolio Management; however, it has taught me just as much (if not more).

In his books, Swensen recommends the following three strategies to help the individual investor succeed:

  1. The investor should hold a portfolio of no more than six core asset classes, namely domestic equities, emerging market equities, international equities, government fixed income, corporate bonds, and real estate.
  2. The investor should rebalance the portfolio regularly.
  3. Without confidence in a market-beating strategy, the investor should investor in a portfolio of low-fee index funds.

His asset allocation recommendations are as follows (he has since confirmed to the media that these recommendations are dated, but these are the figures from the book):

  • 30% domestic equity funds
  • 20% real estate investment trusts (REITs)
  • 15% Treasury bonds
  • 15% inflation-protected securities
  • 15% international equity funds
  • 5% emerging market funds

Personally, I haven't followed this template very much myself, for a few different reasons. First off, I haven't had much of a chance to do my research on inflation-protected securities, so I just don't feel comfortable putting my money into them. As far as bonds go, I tend to avoid them because I currently have a very long-term (retirement) investment horizon. I've also avoided international investments because I don't have the time to keep up on my research on them. Currently, I would say my ratio is probably around 10% bonds, 40% REITs, and 50% domestic equity.

My favorite part of Pioneering Portfolio Management is Swenson's criticism of mutual funds. He absolutely tears them apart over their excessive fee structures, claiming they thrive on high turnover investment strategies that do little to benefit investors in the funds. An interesting point of view, certainly, but for many mom-and-pop investors who don't have time to thoroughly manage their own finances, mutual funds do the trick.

Swenson also makes a very good point by saying that beginner individual investors often make the mistake of reverse rebalancing. Instead of properly rebalancing their portfolio after a certain period of time, amateur investors often sell losers and buy more winners. When equity prices revert back to the mean, they get burned because huge portions of their portfolios drop and they've sold off the portion that would bounce back.

If you're interested in picking up a copy of either one of Swensen's books for cheap off of Amazon, you can get Pioneering Portfolio Management by clicking here or Unconventional Success by clicking here .

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.