Wednesday, October 29, 2008

The Warren Buffett Way: Chp 2 Part 1: The Two Wise Men

Both Benjamin Graham and Philip Fisher had a profound influence on Warren Buffet's investment philosophy. In fact, Warren Buffett once said that he is 85% Graham and 15% Fisher.

Benjamin Graham
Benjamin Graham was born May 9th, 1894. Later in life, he favored studying mathematics and philosophy. At the age of 25, in 1919, he was already earning a salary of $600,000 at a Wall Street partnership. In 1926, he started the Graham-Newman partnership with Jerome Newman. It was this partnership that hired Warren Buffet in 1954.

Graham wrote two classic texts on investing, Security Analysis and The Intelligent Investor. Graham wrote Security Analysis shortly after the crash of 1929 with co-author David Dodd, both of whom were professors at Columbia. The crash of 1929 destroyed much of the wealth that Graham had built to that time and had a profound impact on his approach to investing. He came to believe that downside protection is of paramount importance and led to the idea of investing with a margin of safety. According to Graham, sound investing is investing with a margin of safety.

Security Analysis introduced several novel ideas. One novel idea was introduced when Graham wrote that securities are only investments if they have a degree of safety of principal and a satisfactory rate of return (he was referring to both stocks and bonds).

Graham introduced his definition of the intrinsic value of a security as "that value which is determined by the facts". Graham believed that the intrinsic value is not a precisely determinable figure, but rather is represented by a range of values.

Not losing money and being aware of the downside risks in a security was very important to Graham. He stressed the importance of understanding where the "solid ground" was with investments. For Graham, solid ground was established by calculating the liquidation value of a company's net assets. Graham placed most valuation emphasis on facts, rather than qualitative factors.

However, Graham also recognized that the earnings power of a company was a very important factor in the valuation process. Graham's second approach to investing was focusing on low P/E stocks.

Graham's approach to investing was based on the belief that securities were frequently mispriced in the market and was often caused by the human emotions of fear and greed. After the 1973-1974 bear market, Graham was invited to a money manager conference. Based on what he heard at the conference Graham wrote "I could not comprehend how the management of money by institutions had degenerated from sound investment to this rat race of trying to get the highest possible return in the shortest period" (from the Institutional Investor, April 1974).

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