How Warren Buffett Differs From Ben Graham

by: Tom Au, CFA

My sister fears that Wall Street investment is a game of "exploitation."

Buffett's "toll bridge" model appears to fit that mold.

Graham had a much more "democratic" approach to investing.

My younger sister, who works in a "social" profession (college professor) asked me recently if Wall Street trading wasn't a game of exploitation. I replied that ideally, Wall Street traders acted as financial "traffic cops" that directed the flow of money to its most productive uses. She conceded that some traders, yours truly perhaps, might perform this function, but railed against investors in "toll bridges" that were meant to "stop traffic" and take tolls from people. I, in turn, had to concede that this was Warren Buffett's model, but not Ben Graham's.

I was born during the presidency of Dwight David Eisenhower, that is, during a period when Graham's Lost Generation contemporaries held sway, and Buffett was just "coming up." In that world, the key to success was to avoid the bottom 20% of stocks, the ones that were headed for bankruptcy. Considered almost as dangerous to one's financial health were "high and mighty" stocks that may have represented objectively good companies, but sold at "fancy" prices.

Buffett basically wants stocks in the top 20% (maybe the top 2%) of growth prospects, with percentage growth rates in the teens. Graham's influence is felt in the fact that he often buys them when they are out of favor, that is selling for prices in the "mid-60%" range. Washington Post was clearly such an investment; GEICO (now fully owned by Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A), Freddie Mac (OTCQB:FMCC), Wells Fargo (NYSE:WFC), and American Express (NYSE:AXP) were turnaround situations; Coke (NYSE:KO) was barely above a market multiple when Buffett purchased it. The main early exception was Capital Cities (which Buffett helped to acquire ABC, and which in turn was acquired by Disney (NYSE:DIS)). In Buffett's words, "Ben Graham isn't applauding me on this one."

The reason why Buffett wanted the top 20% stocks was because many of them had "toll bridges" that would allow them to "charge what the market could bear." Media stocks (up to about 1990) fit this mold. In his 1991 annual report, Buffett described the thinking behind this. Small wonder that detractors believe that investing can be a game of exploitation.

"A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, ... which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million... But gone are the days of bullet-proof franchises and cornucopian economics."

Outside of media, Buffett looked for the so-called "Inevitables" such as Coca-Cola. He appeared to have regretted, if not this posture, at least the resulting decisions. In his 2004 annual report, he wrote of his four largest positions, American Express, Coca-Cola, Gillette, and Wells Fargo:

"Since our original purchases, valuation gains have somewhat exceeded earnings growth because price/earnings ratios have increased. On a year-to-year basis, however, the business and market performances have often diverged, sometimes to an extraordinary degree. During The Great Bubble, market-value gains far outstripped the performance of the businesses. In the aftermath of the Bubble, the reverse was true.

Clearly, Berkshire's results would have been far better if I had caught this swing of the pendulum....I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked."

To take just one example, Coke peaked at $89 a share in 1999, and is still selling at about half that price almost two decades later. Buffett had made the mistake (sometimes made by yours truly), of thinking that the "normal" rules didn't apply to his favorite stocks. And waiting around for one of 50-100 "elite" stocks to fall to acceptable price levels often forces Buffett to hold a lot of cash.

Graham, who was "agnostic" about the merits of individual stocks, would not have made that mistake; for him, price was the main determinant of value, and the main reason for buying or selling. For Graham, the imperative was not to buy stocks that would beat the (stock) "market" but to buy stocks at prices reflecting dividend yields that would enable them beat bonds and money market instruments, the latter two yielding an average of 4-5% a year over the 20th century.

The key difference between stocks and bonds was that stocks carried their own inflation fighter; that is, most companies would typically grow at least "one third in 10 years" or an average of 3% a year, in line with inflation. Even a strategy of limiting one's investing universe to "bond-like" telephone, electric gas and water utilities, REITS, energy MLPs and stocks, and other income-producing slow growers in say the food or pharmaceutical industries, might have produced a return not much below the 10% averaged on Dow industrials for most of the 20th century.

This would be composed of 3-4% inflation-fighting capital gains, and 4-5% dividend yields. Graham felt more secure in expecting 8-9% a year with bond-like risk from the above types of stocks than slightly higher but more volatile returns from more "conventional" industrial stocks, including popular high fliers.

Nowadays, dividend yields typically exceed the yields on the bonds of the same companies; between 1958 and 2002, it was true that dividend yields would fall short of bond yields, but by less than the 3% inflation factor. In either case, Graham and later value purists such as John Neff valued dividends for their "bird in hand" qualities over an equivalent but more speculative amount of capital gains.

Graham's (articulated) philosophy might have been paraphrased as "average stocks for average people." Put another way, while Buffett's stock selection is more like Microsoft's (NASDAQ:MSFT) "best and brightest" employment model, Graham chose stocks the way IBM (NYSE:IBM) chose employees. (IBM hired employees that were slightly above the average of the overall population, but were "average" within the reduced population set after eliminating the bottom 20% of "ne'er do wells." And IBM got exceptional performance out of these employees through "management.")

Graham's choices did not prevent him from turning in an above-average performance using such "average" stocks, managed under a technique available to average people. "If you are shopping for common stocks, choose them the way you would groceries, not the way you would perfume," Graham advised the (mostly) female readers of the Ladies' Home Journal.

That is, buy stocks when they are "on sale," relative to their historical norms. Arguably the best training for Graham and Dodd investing is buying pork butt and beef tenderloin at the grocery store when their selling price is $1-2 a pound less than usual, and (mostly) refraining from buying them at other times. Or buying holiday egg nog ice cream as a "manager's special," clearance sale item in the middle of summer for $1 a quart instead of $3 a quart.

Graham's process was described at the end of this article. It's comforting that one can do well in the marketplace by buying average stocks at great prices, which occur occasionally, rather than great stocks at good prices (a rarer event). If I were ever to start my own firm, I would grill recruits on their grocery shopping abilities, and not their quantitative finance courses. Because Ben Graham thought of stock investing in the former, not the latter, terms.

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.

Additional disclosure: I added a definition in the second line of the third paragraph for "percentiles."

I added the link using the "globe" and hope I did so correctly.