In his role as a professor at Columbia University, Benjamin Graham gave out only two A+ grades--and Warren Buffett (Trades, Portfolio) got both. Yet, when Buffett applied for a job at Graham-Newman, Graham turned him down. With his customary self-deprecating wit, Buffett later said, "Ben made his customary calculation of value to price and said no."
According to authors Stephen Horan, Robert R. Johnson and Thomas Robinson, in their book "Strategic Value Investing: Practical Techniques of Leading Value Investors," Graham later reconsidered and hired Buffett in 1954.
Throughout his life, Buffett has championed Graham and his pioneering work in what was to become known as value investing. Still, he has followed his own investing path, departing from Graham's philosophy and practices in several important ways.
One of them was to move away from what are called "cigar-butt companies." Buffett wrote, "Ben was looking for the used cigar butt. That is, he bought crummy companies, but they were so cheap that they had one puff left in them. On the other hand, I buy into very big, well run operations--companies that I would be very happy to leave the country for ten years and come back to."
In other words, Graham had a quantitative approach, while Buffett took a more qualitative approach. Regarding qualitative issues, the guru emphasized two of them:
- Quality of management (although he would also argue that exceptionally good companies do not need good management).
- Economic pricing power, also known as a competitive advantage, or in Buffett's own metaphor, "But all the time, if you've got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it."
When discussing the quality of management, the authors reminded us it's important to remember how Buffett and his co-chairman, Charlie Munger (Trades, Portfolio), manage Berkshire Hathaway (BRK.A)(BRK.B). They have a legendary light hand, giving the managers of their subsidiaries a great deal of independence.
Buffett has written that they have been well rewarded for not micro-managing.
"Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly--or not at all--because of a stifling bureaucracy."
The authors also reported that Buffett is on the record as saying the single most important variable in analyzing a business is pricing power. And, he has taken his own advice about economic moats, buying companies that have pricing power. For example, BNSF Railway became part of the Berkshire Hathaway stable of companies because there is limited competition and new railways aren't being built anymore.
Buffett also invested heavily in companies with exceptionally strong brands: Coca-Cola (NYSE:KO), Gillette, Anheuser-Busch (BUD) and Proctor & Gamble (NYSE:PG). These companies do not have monopolies or limited competition, but they do have bases of very loyal consumers. They have "franchise power," which allows them to attract and retain customers.
Buffett also diverged from Graham on diversification. Graham bought a lot of really cheap companies, in part because he believed that even with a wide margin of safety, a company could still fail the investor. The more diverse the stable of investments, the more likely it was that an investor would succeed.
On the other hand, Buffett thinks diversification takes care of a different problem, saying, "Wide diversification is only required when investors do not understand what they are doing." He has also called diversification protection against ignorance.
The opposite of a diversified portfolio is a concentrated portfolio. According to the authors, Berkshire Hathaway has held a concentrated portfolio; between 1976 and 2006, the top five stocks collectively averaged 73% of portfolio value.
Buffett takes that idea a step further, arguing that concentration can reduce risk by focusing an investor on a limited number of stocks. GuruFocus contributor James Li published an article titled, "Warren Buffett's Top 7 Holdings as of His 89th Birthday" on Aug. 30 and in it, he showed the guru continues to run a concentrated portfolio.
Li reported that Berkshire Hathaway holds 47 stocks. That may seem a relatively high number of stocks for a conviction portfolio, since some gurus operate with fewer than 20 stocks, some with even just a handful. But, of course, Buffett is running a massive portfolio, $208.10 billion at the latest accounting.
Li also wrote that the top three sectors--financial services, technology and consumer staples--accounted for more than 88% of the portfolio's value. As for those top seven companies, they are Apple Inc. (NASDAQ:AAPL), Bank of America Corp. (NYSE:BAC), Coca-Cola Co. (NYSE:KO), Wells Fargo & Co. (NYSE:WFC), American Express Co. (NYSE:AXP), The Kraft Heinz Co. (KHC) and US Bancorp (USB). All obviously have strong brand power.
Returning to Buffett's thoughts on diversification, he recommended that most investors put their money into index funds. He wrote, "By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."
Clearly, Buffett learned much from Graham in his early years, but over time, he has learned much more, as the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" have successfully argued.
And as he learned more, his investing style diverged from that of Graham's in several important ways. For example, he added qualitative factors to his analyses, most importantly that there be good management and an economic moat.
Diversification also emerges among the differences, with Buffett moving away from Graham's practice of buying a lot of cheap companies and hoping a few of them would be winners (something like modern-day venture capitalists). Buffett came to believe that intently watching a small portfolio would be more effective than buying many cigar-butt companies. His record proves that these new investing ideas and practices worked very well.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Strategic Value Investing: Benjamin Graham
- Strategic Value Investing: Relative Valuation
- Strategic Value Investing: Residual Income Models
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