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
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
-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
- 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
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".
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.
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 tracks the stocks picks and portfolio holdings of the world's best investors. This value investing site offers stock screeners and valuation tools. And publishes daily articles tracking the latest moves of the world's best investors. GuruFocus also provides promising stock ideas in 3 monthly newsletters sent to Premium Members .
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