The word’s best-known and most successful general investor, Warren Buffett, had a eureka moment early in his career when he discovered the teachings of Benjamin Graham. And Graham’s investment philosophy still underpins Buffett’s investment strategy today.
It’s true that Buffett has evolved his strategy over the years. But it’s clear Graham’s ideas still form the bedrock of Buffett’s approach to evaluating stocks and businesses. And, by studying Graham, we can figure out how Buffett decides whether a share is cheap or not.
The share-picking philosophy of Warren Buffett’s teacher
One of Graham’s books, The Intelligent Investor, has three central ideas. The first is Intrinsic Value. Shares represent partial ownership of a real underlying business. So, the underlying business has a real value. Or, to put it another way, the business has an intrinsic value.
The second of his ideas is the concept of Mr Market. Although businesses have an intrinsic value and grow or decline at their own pace, their shares don’t. Share prices in general (Graham’s Mr Market) move up and down at times regardless of what the underlying business is doing. Sometimes a share price is too optimistic about the prospects of the underlying business. And sometimes a share price is too pessimistic.
Graham’s third idea is the concept of a Margin of Safety. Graham advocated buying shares when Mr Market is being too pessimistic about the prospects of an underlying business. In other words, Graham bought shares when they provided a discount to the intrinsic value of a business. By doing that, he gained a margin of safety for his investments.
Finding intrinsic value
In essence, I reckon that’s how Warren Buffett decides what qualifies as a cheap share. But there are a few things to consider with the approach. And perhaps the biggest problem to overcome is to decide how we define the intrinsic value of a business.
For example, in the current environment, many share prices plunged because of the pandemic. However, a fallen share price doesn’t in itself guarantee a share is cheap. Indeed, lots of businesses suffered a collapse in earnings along with their falling share prices. And on the surface, lower earnings suggests fallen stock prices are less of a bargain.
But problems in business can be temporary. And the pandemic will deliver mixed outcomes to different businesses in that regard. Some sectors and businesses may be damaged permanently, but others may suffer only a fleeting hit to their earnings. So, a close focus on earnings alone may not be the best method for determining whether a share is a bargain or not.
And I reckon Warren Buffett gets around the problem by examining quality indicators. For example, he puts a lot of weight on the return-on-capital and return-on-equity performance of a business over time. And he’s known for saying he looks for wonderful businesses selling at fair prices. In the end, the lowest share prices may not represent the greatest bargains.
