Sunday, September 25, 2005

The Dean of Wall Street

Warren Buffett once remarked that he is a synthesis of "85% Graham and 15% Fisher". Fisher refers to Philip Fisher, the Californian money manager who advocated the importance of doing groundwork and speaking to people on the turf. He coined the term "scuttle-butt" to refer to his technique of relentless recee in his attempt to uncover investment gems.

Who is Graham then? Benjamin Graham is still fondly referred to and revered as the Dean of Wall Street. In the 1930s, he provided the investment community with the framework for security analysis when speculators were abound. Graham lectured Buffett at the University of Columbia and mentored Buffett in his early stages of his career when Buffett worked at his Graham-Newman investment partnership.

What is most interesting to me is that Buffett's superior return today was not the result of applying Graham's valuation techniques. Graham championed the "net-net" technique which calls for purchasing a company when its current assets exceed its total liabilities. Later in his career or life as both are intertwined for investing is a lifetime obsession, Graham also examined the merits of low P/E investing. However, a peek into the financials of Buffett's purchases over the years reveal otherwise. He is not into low P/E investing nor the "net-net" approach. This begets the question – where is Graham’s influence over Buffett?

The difference between investing and speculation
Graham made it clear that investing and speculation are different. He remarked that "almost by mathematical law, more speculators must lose than can profit." Speculators are playing the greater fool game - buying and selling the stock off to the greater fool - before the music stops. And history - whether it was the 1970s with the Nifty Fifties or 2000 with the dotcoms - has shown that the music will always stop. On the other hand, investing requires a through analysis of the company underlying the stock, understanding its strengths and weakness and its competitive environment.

The importance of the Independent Thought Process
While the investor must be respectful of the current market price or direction, Graham stressed that one must develop and retain his own independent thought and evaluation process. This means that the investor, through his own through research, should be able to form his own opinion on the attractiveness of the company and industry regardless of market sentiment. In the herd, one may feel the warmth but in investing, it is important to discern if the direction which the herd is headed is correct. The investor does not need affirmation from the crowd as to whether he is correct. In fact, it is usually costly if there is affirmation from the crowd. The investor is correct only because he has his facts and analysis right.

Mastering Market Psychology
"Mr Market" was a term coined by Graham to refer to the manic depressant which turned up every day (except on weekends) to provide a price quotation for a fractional share of the company ownership. Depending on his exuberance, "Mr Market" can offer sky high or depressed prices for a share. "Mr Market" is so ubiquitous today. He silently runs his quotes at the bottom of your television screen, provides updates on your favourite webpages and can even push prices to your handphones/pagers, almost begging you to transact with him.

Despite his pervasiveness, the choice to buy or not from "Mr Market" remains in the investor's hands. And the decision to buy comes only when the price quoted is more attractive relative to the investor's valuation of the company. This entails divorcing the market price from the true worth of the company. And true worth is established after the investor has completed his due diligence of the company and has done an appraisal of its prospects and established his valuation.

The Margin of Safety
The "margin of safety" is said to be the three most invaluable words in Graham's investment thesis. It means that the investor should only buy securities when the price quoted is substantially lower than what the investor thinks it is worth. The key lies in the word “substantial”. This concept is not unique to the field of investment. For example, in engineering, the electrical engineer would design a circuit that have the ability to carry, say 10 amperes of current, when it is envisaged that only a current of 5 amperes will flow through it. It would be foolhardy for the engineer to provide only for 5 amperes of current.

Hence, by insisting on a margin of safety, the investor provides himself with a cushion should his assumptions turn out to be overly optimistic or should unforeseen circumstances occur. This is especially essential because in investment, unlike engineering where the last decimal place may be pinned down, a lot of factors are qualitative projections and subjective assessments of the company, its industry and its management. This highlights the significance of performing a scenario analysis before a security purchase.

It is evident that the richness of Graham's works extends beyond his mathematical equations but to such intangibles which shaped the mindset of Buffett. I have not done justice to Graham's teachings and ideas by distilling them into this short note. Only direct reading of his pieces is adequate.

I was introduced to Graham at Borders bookstore when Regina informed me that Graham was the one who had largely shaped Buffett. I have offered myself to be shaped too as Graham's approach to investing is so compelling it provides a compass to navigate one through the vicissitudes that characterize irrational markets.



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