Followers and disciples of Benjamin Graham and
Warren Buffett
have largely evolved respectively into the two major camps of
value investing: (1) Benjamin Graham's cheap and safe; and (2)
Warren Buffett
's quality and cheap. I discuss how I derive the elements of
cheap, safe and quality from the investment styles of Graham and
Buffett
below.
Benjamin Graham - Cheap & Safe
Widely regarded as the father of value investing and the founder
of security analysis, Benjamin Graham was the pioneer of the
cheap and safe approach - cheap stocks with minimal risk of the
permanent impairment of capital. In his books "The Intelligent
Investor" and "Security Analysis," he came out with a list of
criteria for selecting stocks, including but not limited to the
following:
Benjamin Graham's Cheap
- Price ?15 x Average Earnings over the past 3 years
- Price ? 1.5 x Net Tangible Asset Value
- P/B x P/E ? 22
- Price
Benjamin Graham's Safe
- Current Ratio ? 2
- Long Term Debt ? Net Current Assets
Benjamin Graham's Quality (Less Emphasis)
- No losses in each of the past ten years
- Average EPS for 1st 3 years of 10 year period ? 133% x Average
EPS for last 3 years of 10 year
- "Uninterrupted" dividends for at least 20 years
Warren Buffett
- Quality bought cheap
"It's far better to buy a wonderful company at a fair price than
a fair company at a wonderful price" a Warren Buffett quote shows
how much he values the quality of a company. Based on my reading
of Warren Buffett's shareholder letters, Mary Buffett's book "The
New Buffettology" and Robert Hagstrom's book "The Warren Buffett
Way," I have a list of criteria below, including but not limited
to the following:
Warren Buffett's Quality
Qualitative
-Durable Competitive Advantage by virtue of strong brand-name
products/services
- Razor / razor blade-type business model - company that sells
something people use every day but wears out quickly
- Pricing Power - ability to increase prices of products or
services in line with inflation
-'Easy to Understand' Business
- Consistent operating history and favorable long term prospects
- Good Allocator of Retained Earnings - created at least one
dollar's extra market value for every dollar of retained earnings
- Management rational, candid with shareholders and does not
follow the herd blindly
Quantitative
- Consistently High Return on Equity (ROE)
- Upward trend in EPS and book value
- Positive Free Cash Flow, minimal capex
- Value-accretive Share Repurchases
Warren Buffett's Cheap
- Discounted Net Cash Flows ('Owner Earnings')
Warren Buffett's Safe (Less Emphasis)
- Low Multiple of Long Term Debt / Earnings
What Ben Graham and Warren Buffett shared in common:
Cheap-Safe-Quality
Cheap
Both Benjamin Graham and Warren Buffett used valuation methods to
determine the cheapness of a stock. Benjamin Graham used a
combination of asset-based valuation methods and price multiples
like P/E & P/B; Warren Buffett used a variant of discounted
free cash flow (DCF) which he termed "Owner Earnings".
Safe
For both Benjamin Graham and Warren Buffett, excessive debt was
undesirable, and they employed credit ratios as a measure of the
company's credit risk. Benjamin Graham used liquidity ratios like
the Current Ratio to ascertain if sufficient current assets were
available to be liquidated to meet current liquidity needs in
terms of current liabilities; Warren Buffett used coverage ratios
to determine if a company had sufficient earnings to repay the
debt on its books.
Quality
Even though Benjamin Graham's stock picks were perceived as
"cigar butts", he still had a minimum quality threshold for an
investment: no track record of losses and approximately a 3%
annual growth rate in earnings over the long term. Warren
Buffett, who was influenced by both Charlie Munger and Phillip
Fisher, had a mix of both qualitative and quantitative criteria
to assess the quality of a stock.About GuruFocus: GuruFocus.com
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