GRAHAM & BUFFETT
INVESTOR WOULD LIKE TO KNOW THE DIFFERENCE BETWEEN BEN GRAHAM’S TAKE ON VALUE INVESTING AND WARREN BUFFETT’S. FPANSWERS EXPLAINS,
Q: I’ve been reading a lot about value investing this summer, but I’m still confused about the difference between Ben Graham’s approach to value investing and Warren Buffett’s. Can you explain the difference? — John, a confused 20-year-old
FP Answers: John, Ben Graham is considered to be the father of value investing, but Warren Buffett has popularized it and made it known to the wider public. As Buffett says, “value investing is simple but not easy.” Yet, there is still a lot of confusion in the public sphere about the strategy.
As far as I can tell, there are at least two misconceptions about value investing in general.
The first is the belief that all value investors do is sort stocks by price-to-earnings (P/E) or price-to-book (P/B) ratios and buy the stocks with the lowest multiples, with a preference for small-cap stocks. This is only partly true. Value investors do like small-cap stocks with low multiples, because they consider them potentially undervalued, making the stock worth examining a bit closer, but not yet worth buying.
To determine whether such stocks are worth buying, value investors proceed to gauge their intrinsic value and then invest in them only if these stocks meet a margin-of-safety requirement, which usually means the price is at least a third below the intrinsic value. These are the truly undervalued stocks and the stocks worth investing in.
But a strategy that focuses on low-multiple, small-cap stocks seems to fly in the face of what Buffett and other well-known value investors do these days, which is to prefer larger-cap stocks without necessarily low multiples. This creates more public confusion about value investing.
Who really are the true value investors? Is it Warren Buffett and like-minded investors, or those who emphasize low PE and P/B smallcap stocks? Turns out, both groups are value investors.
Value investing has evolved over time, not because anything has changed or that the rules of the game have changed, but mostly because the demographics and the size of assets under management at some of the key players have changed.
People who talk about value stocks in general refer to low P/E or low P/B smallcap stocks. These are the obscure and undesirable stocks that tend to be associated with a high likelihood of being undervalued. This is what Ben Graham taught about at Columbia University in the 1930s and ‘40s.
Buffett was a student of Ben Graham and learned to invest in these stocks — also known as cigar-butt stocks — early on in his career. These are catalyst-driven investments that tend to be shorter term in nature. Value investors who follow this approach are more opportunistic, as Buffett was early on in his career.
But his methodology in more recent years has changed. He can no longer afford to be opportunistic. Berkshire Hathaway Inc. has become too big to be able to easily invest in smaller and less-liquid stocks.
Buffett acknowledges this in a letter to shareholders where he stated that “cigarbutt strategies worked very well when I was managing small sums.” He went on to say that “... in 1951 when I bought Geico most of my gains came from investments in mediocre companies that traded at bargain prices. Ben had taught me that technique very well and it worked.”
Buffett has evolved not because the rules changed, but because his assets under management skyrocketed. He now buys larger companies with higher-than-typical P/E and P/B multiples. But these stocks are still value stocks, because they possess significant competitive advantages that are sustainable in the long run.
As a result, while the early Buffett would opportunistically buy and sell stocks, he now likes to hold his stocks for the long run. His holding period, as he has frequently said, is “forever!” Why? Because if the stocks he buys have a significant degree of sustainable competitive advantage, chances are that their intrinsic value will be ahead of the stock price. If this is the case, then the recommendation will be to not sell, or, by extension, never sell.
Value investing comes in different colours and so do those who are practising the craft. The cigar-butt approach by Buffett early on offers many more profitable opportunities than the high quality-competitive-advantage-driven investing approach that he currently follows. That is why his returns have declined when compared with those early on in his career.
We know from Berkshire Hathaway’s performance over the years that its highest returns were earned when Buffett was following the Ben Graham approach, and that the company’s more recent performance, which took place after he changed his approach to that of a quality investor, while satisfactory, lags its earlier performance.
If we split Berkshire Hathaway’s 1965-to-2018 period into two equal sub-periods, it had an average rate of return of 24 per cent in the first period, whereas it averaged a little less than 15 per cent in the second period. This confirms the company’s returns have slowed since Buffett started to emphasize high-quality stocks.
How about examining the performance of the two different investing styles in a more quantitative, generic and objective fashion? I and a colleague examined this question using United States data for the period 1982 to 2015.
We find that value beats growth in the total sample (by 4.3 per cent), but the value premium is actually driven by companies with the poorest earnings quality. The average value premium for companies with the best earnings quality (the top quartile, the Buffett-like stocks) is 0.6 per cent, whereas the corresponding value premium for those with the poorest earnings quality (the bottom quartile, the Ben Graham-type stocks) is 9.6 per cent.
As a result, an investment strategy that emphasizes lower-quality value stocks will improve the long-term performance of a value portfolio. True, such an approach will have higher short-term volatility, but, as value investors, we do not consider volatility as a measure of risk.
George Athanassakos is a professor of finance and the Ben Graham Chair in Value Investing at Ivey Business School, which he joined in July 2004. His new book, Value Investing; From Theory to Practice, is scheduled to be released at the end of this year. A short book synopsis is available.