Buffett started out investing using the principles he learned from Graham. Graham made millions of dollars but Buffett made billions.
Now why is that? Did Buffet mixed a secret sauce to Graham’s principles?
Well sort of.
Buffett’s partner, Charlie Munger told him not just pay attention to value, but to pay more attention to business fundamentals. And that’s what Buffet did.
He started to find companies which he calls has a “durable competitive advantage“. These are excellent businesses with a consumer monopoly that has a powerful earnings potential that has expanding value in the long run. And when he finds out businesses like these, he buys them and let the magic of compounding do the work.
The problem with Graham principle
The problem with Graham’s principles is that it focuses too much on value. He doesn’t care about the company’s fundamentals.
You see, Graham buys companies when they are undervalued. He knows it if the stock is priced significantly below its intrinsic value. He buys stocks and puts in what he calls a ‘Margin of Safety’. This is a safety net that puts him in a less risky position. This safety net also tells him how much money he can earn on that stock.
What Graham does is that he basically bought anything that’s cheap without looking at a company’s growth in the long-term. He even buys ‘basura’ stocks (‘basura’ in this context is referred to stocks that are prone to value traps). You know what happens to basura stocks right? The problem with cheap companies is that they really never reach those intrinsic values and some even lose value overtime.
Tweaking Graham’s style
So why did Buffett made billions while his mentor made only millions?
If you had read the book Buffettology, (oh by the way, it’s a great book!) the author explains that Buffet doesn’t calculate intrinsic value.
Now that’s something to think about isn’t it?
He basically look for companies that has consistently high Return on Equity because he believes that these cash flow generating businesses expand their value overtime so it doesn’t make sense to compute for its intrinsic value. Buffet even buys companies with high valuations as long as the computed rate of return is realistically very high!
How does Warren Buffett invest?
What Buffett does is this;
- look for companies which he calls has durable competitive advantages,
- calculates the expected annual rate of return,
- studies and compares the data gathered and compares them to similar investments,
- buys the one with he thinks will give him the highest rate of return.
Buffett’s mindset is this; If company ABC has a stock with an intrinsic value of 95 pesos and currently trading at 100 pesos growing at an annual compounded rate of return of 15%, Buffett would prefer buying this stock compared to company XYZ that has a 120 pesos intrinsic value trading at 100 pesos with a growth rate of 5%. This is because of the higher returns he would gain in company ABC in a 10-yr. period.
Buffett applied this strategy consistently and that’s what made him his fortune today.
This mindset has been imprinted on the back of my head when I started investing. Every time I see my investments go down, up and sideways, I always think of Buffett and everything becomes fine.
Happy investing!