"Interesting possibilities abound on the financial scene, and the intelligent and enterprising investor should be able to find both enjoyment and profit in this three-ring circus. Excitement is guaranteed." -Ben Graham, from the postscript of The Intelligent Investor.
I was listening to the tribute video that came out a few days ago on Ben Graham. It's a great video put together by Columbia Business School, and I highly recommend taking a listen to it. In it, the producers interview Warren Buffett, among other great investors, and Buffett said something that I've been thinking about on and off for a few days.
In the video, Buffett gives his usual (and much deserved) praise for Graham as a mentor, teacher, and investor. But he also subtly mentioned some huge differences between Graham's investment philosophy and Buffett's own investment ideas. Buffett made a comment in the video about how Graham's philosophy was more geared toward "passive" investing (through diversification) while Buffett chose to be much more active and concentrated. The comment he made that was very interesting was this (paraphrasing):
"The irony is that while Graham was a quantitative investor, he made more money by investing in Geico (a growth stock), than all the other investments his firm ever made-combined."
Buffett also mentioned that Graham was not primarily concerned with achieving the best performance. (I'm not sure that's true, as I think Graham likely believed his strategy provided him with the best chance at superior performance while also focusing on keeping risk as low as possible. Graham probably knew he wasn't going to have the best results, but he probably felt his strategy gave him the best chance at superior results, given his emphasis on risk control.) But regardless of what Graham thought about his strategy, his actual results were remarkable (20% for 20 years while he ran his fund), and he rarely lost money. Buffett's results are of course better. That fact, along with the fact that Graham made a fortune investing in one growth stock begs the question:
"Is it better to follow the investment philosophy of Buffett or Graham?"
It's of course possible to incorporate aspects of both philosophies, but I personally believe Graham is much easier to "clone" than Buffett, for reasons I'll explain another time, but mainly because Graham used purely publicly available numbers and Buffett used qualitative analysis that is difficult to copy.Buffett & Graham on Diversification
Buffett credits Graham with providing the foundation that Buffett was able to build on for the rest of his career. The foundation was the book, The Intelligent Investor, that Buffett first read as a 19 year old college student in 1949. Buffett specifically sites chapter 8 and chapter 20 (market fluctuations and margin of safety) as the main concepts an investor needs to understand.
But Buffett soon began differentiating his own style from Graham's. In fact, Buffett often became frustrated with Graham's insistence on focusing on "just the numbers" and disregarding management evaluation or other qualitative analysis.Another key subject that the two investment stars disagreed on was the topic of diversification.
Graham was a staunch advocate of diversification. He believed the best way to assemble a portfolio was to think like an insurance actuary: allocate a relatively equal amount of capital to a large group of stocks with characteristics (such as low prices to book value and earnings) that over time tend to lead to superior investments results. Some stocks might "die", but in aggregate, the insurance bet pays off. Most stocks live (continue or return to profitability) and continue to pay premiums (earnings and dividends).
Graham of course also used to look for "net-net" stocks, or stocks selling below their liquidation value. But the point of his philosophy was that he knew if you could assemble a basket of these undervalued and unloved stocks, the basket would outperform the market with very little risk of permanent capital loss. There would be individual securities that would lose money, or even go bankrupt, but the benefit of diversification ensured that the portfolio in aggregate would provide superior results. Just like the casino owner wants as many people to play the slots as possible, Graham wanted to invest in as many "net-net" situations he could find. He was exploiting an edge, and by using the multiplicity of transactions principles (i.e. the more transactions, the more predictable the results), he could invest in a low risk strategy that also had above average returns.
So it was just a numbers game for Graham. Find as many undervalued stocks as possible. (Graham also used other strategies such as merger arbitrage and other special situations, but even these other strategies were quantitative in nature).
Buffett, on the other hand, quickly became interested in analyzing stocks qualitatively. He felt he could gain an edge by doing more in depth research. He visited companies, he talked to management, and he considered the actual prospects of the business. He did this alongside of Graham's techniques of analyzing the balance sheet. He basically believed that using both quantitative and qualitative analysis was better than just using one or the other. Graham thought qualitative analysis was useless and even counterproductive.
It's a fascinating topic to think about, especially for mere mortals (like most of us), who don't possess the genius that Buffett has in analyzing business. Walter Schloss (a fellow Graham disciple who was great friends with Buffett-and who also produced incredible investment results) said it best about Buffett:
So this isn't to say we can't all learn tremendously from Buffett (we can, and have, learned more from him than anyone else). It also isn't to say we can't emulate aspects of his philosophy and investment ideas. But Schloss is basically just warning the aspiring investor to realize that the skills Buffett has are innate and difficult to copy. Graham's had innate talent as well, but given simple math skills, his investment philosophy is much easier to copy. Schloss basically did just that and made 21% per year for nearly 50 years (wow…).Graham, Buffett, and the fortune they made in GEICO
So it certainly is ironic that Graham made more money in one investment with Geico than he did with all of his other countless investments over 20 plus years. But my take on it is this: that fact doesn't mean that one should abandon the workmanlike, quantitative investment style that he espoused for so many years.
Graham put it best in the postscript of The Intelligent Investor… he is referring to he and his partner in this passage, written in third person. I used certain passages (paraphrasing in spots to keep it relatively brief) from the first couple pages. Check out the book for the full postscript:
"We know very well two partners who spent a good part of their lives handling their own and other people's funds… Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced… Their portfolio was always well diversified, with over 100 issues represented… In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum…
"(Then) an opportunity was offered to purchase a half interest in a growing enterprise… The pair was impressed by the company's possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting to 20% of their fund's capital… (The investment) did so well that it advanced two hundred times or more the price paid for the half interest…
"Ironically enough, the aggregate profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide ranging operations in the partners' specialized fields, involving much investigation, endless pondering, and countless individual decisions.
"Are there morals to the story?… (One moral) is that one lucky break, or one supremely shrewd decision… may count for more than a lifetime of journeyman efforts. But behind this luck, there must usually exist a background of preparation and disciplined capacity. One needs to be sufficiently established….To Sum it Up- Both Ideas Work, but Which Gives You the Best Chance at Success?
So Graham believed that although he made more money on Geico than all his other investments combined, he still believes the most prudent path to follow is the one he followed throughout his career: steady, careful analysis with an emphasis on balance sheet and income statement public data. Graham liked to hit base hit after base hit, and just chip away day after day, while always being ready for the potential fat pitch that he could hit out of the ball park.
Buffett used that philosophy as the foundation and then became a home run hitter. Graham remained a consistent investor looking to get on base as often as possible.
Both philosophies can work… the key is understanding them, and more importantly, deciding what individual strengths and weaknesses you have as an investor. For me personally, I know that I have a better chance of success if I focus mostly on Graham's quantitative techniques. Over time, I intend to continually improve my analytical skills, but my emphasis is on making "base-hit" investments over and over using timeless value techniques using mostly numbers from income and balance sheets. It worked in Graham's day, worked for Buffett in his early days, it works today, and will always work over time.
Graham's philosophy has a structural edge in the market. Understanding it and developing a simple process to systematically execute it will give you a practical edge and provide you the opportunity for superior investment results.