Warren Buffett Learned Everything He Knows from This One Book

Value investing is the name of a particular investment philosophy that stresses a long-term approach to investing. Rather than follow short-term trends in the market, value investing relies on thorough research to discover companies that are undervalued and selling below their measurable value.

The original concept of value investing was created by Benjamin Graham and David Dodd with the publication in 1934 of their classic Security Analysis.

In the book, Graham and Dodd established several principles that would form the basis for their value investing philosophy: Discipline, a long-term investing horizon, ascertaining a stock’s “intrinsic value,” and the inherent limitations of using earnings trends as a basis for determining value.

Long-term investment horizon

Graham and Dodd believed that the ability to achieve stable and consistent returns rested on individuals adopting a long-term investment horizon.

Long-term investing frees the investor from the consternation attendant on short-term swings in the market and the all too frequent panic and sell offs that ensue.

In practice however, for many, this is a difficult strategy to implement. During significant market downturns, panic and fear can override rational thinking.

Graham and Dodd emphasized that the stock market is in a state of constant flux and trying to time these downturns is difficult, if not impossible. As such, investors must have the necessary resolve to hold on to stocks they have purchased at fair prices, even if they temporarily decline in value.

Maintaining a long-term outlook can be extremely trying during periods of significant market downturns. Graham and Dodd stressed that the value investor must have the fortitude to remain firm when everyone else is exiting the market

Intrinsic value

The authors of Security Analysis made an important distinction between investment and speculation. Investors have a long-term outlook and patiently research and seek companies that may not be favored by Wall Street.

Many of these businesses present genuine investment opportunities because their financials present a picture of health and stability but these facts are not reflected in the price of the stock.

Speculators, by comparison, do not take the time to research a business on its own merits. Rather, they chase the earnings trend to the exclusion of all other factors, including some which may indicate troubling signs for the future health of the company.

Central to the entire value investing philosophy is the concept of “intrinsic value.” Graham and Dodd were the first to emphasize that determining as stock’s value is not a function of its price alone, but rather, how much a person would be willing to pay for that stock were he to purchase it as a private business.

This methodology of ascertaining value focuses on a particular company’s assets, its debt, the interest coverage on liabilities, the average of the past three years of earnings, its book value and the stability of prior year’s earnings as well as the company’s position within its particular industry.

This technique separated the prevailing price of a stock from the fundamentals of its underlying business. For example, a stock selling below its book value would be a strong indication that was undervalued and hence selling below its intrinsic value.

Difficulty of predicting earnings

The authors of Security Analysis repeatedly stressed the importance of humility when trying to predict the future earnings of a company, regardless of the valuation methodology employed or the trend of its earnings — a measure that far too many analysts today obsess over, particularly with regards to the high valuation the FAANG group of tech stocks.

While acknowledging the “vital significance” of determining future growth, Graham and Dodd nonetheless explicitly state in Security Analysis that the book does not discuss in any detail the determination of the future prospects of a company “because little of definite value can be said on the subject.”

This is an important concept for value investing and underlies the distinction Graham and Dodd make between investment and speculation. The authors reinforce this crucial point, one upon which value investing rests, when they critiqued the “trend of earnings” approach investing,

“It may be objected that as far as the future is concerned it is just as logical to expect a past trend to be maintained as to expect a past average to be repeated. This is probably true, but it does not follow that the trend is more useful to analysis that the individual or average figures of the past,” they wrote.

“For Security Analysis does not assume that a past average will be repeated, but only that it supplies a rough index to what may be expected of the future. A trend, however, cannot be used as a rough index; it represents a definite prediction of with better or poorer results, and it must be either right or wrong.”

Track record

Graham and Dodd’s most prominent disciple is Warren Buffett. Indeed, Buffett said that Security Analysis is one of the four books in his library that he particularly treasures, and he says that the book changed his life. The teachings of the principles enumerated in Security Analysis “became the bedrock upon which all of my investment and business decisions have been built.”

No one can dispute the phenomenal success of the “Oracle of Omaha.” His track record speaks highly of the success of value investing and the rewards for those with the appropriate discipline who abide by its unwavering principles.

Critics of Graham and Dodd

Many analysts and fund managers are critical of value investing and view Graham and Dodd’s theories as a Depression-era, industrial-heavy fixed-asset anachronism in today’s world of computer chips, the Internet and social media.

Many contend that “growth” investing over the past decade has far surpassed and outperformed “value” investing.

A roaring, historically unprecedented 10-year bull market that has heavily favored the tech stock sector would seem to validate such a proposition. However, there is nothing in the lessons to be gleaned from Graham and Dodd that contain any suggestion of an inherent bias towards one sector versus another.

A close reading of Security Analysis would confirm that there is nothing in the teachings of Graham and Dodd that would suggest that Facebook, Amazon or Google would be off limits to value investors. What is paramount for successful investing is the relationship between price and value.

The principles described in Security Analysis are timeless and transcend any particular market environment. Investors would be wise to incorporate the lessons offered by Graham and Dodd within their own investment strategies.

Small-cap winners galore

The big stock market winners share one common attribute: Near the beginning of the ascent of their shares, the companies offer revolutionary products or services, are market leaders in their respective industries, or both. Some big stock market winners that possessed the attributes outlined above are Netflix (NFLX), which we recommended to investors in October 2002; Intuitive Surgical (ISRG), which we bought and recommended in July 2004; Baidu.com (BIDU), which we bought and recommended in August 2006; and MercadoLibre (MELI), which we recommended to investors in October 2010. Get up-to-date small-cap stock picks from David Frazier, editor of Small-Cap Profit Confidential.
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