Why did Buffett move away from Ben Graham's investing philosophy?

Benjamin Graham , popularly known as the 'father of value investing', was among the first few investors who emphasised fundamental analysis in the stock market. He was also instrumental in shaping Warren Buffett's investing strategy, as Buffett admits most of the time.

Given his public admiration for Graham, one might assume Buffett followed in his footsteps in his investing career. Yet, most of Buffett's investments diverge from Graham's investing style. Let's understand why.

The drawbacks of quantitative investing

One of Graham's fundamental investment principles that Buffett was not a fan of was pure quantitative investing. Graham focused on companies that traded below their intrinsic value and bet on their mispricing. Further, he underlined the importance of portfolio diversification to boost the probability of gains.

However, there were certain limitations to this strategy. Given that it mainly focused on factors that could be quantified (assets, dividends, earnings), there was little to no emphasis on a company's management or the quality of the business in general.

Moreover, the strategy would only work if there was a trigger for value unlocking or if the market realised a stock's actual value within a short time span. Let's take an example to understand better. Suppose a company with assets worth Rs 10,000 crore trades at a market value of Rs 8,000 crore. If the markets take a long time to realise the company's intrinsic value, say 10 years, it would be useless to investors.

To see if it is true, we conducted a study to analyse whether the pure quantitative approach works in Indian markets. We chose companies with a market capitalisation of greater than Rs 1,000 crore, P/B (price-to-book) ratio of less than one and cash plus current investments that are more than 50 per cent of the market cap. Then, we took five-year rolling periods from FY15 to FY23 and compared the Sensex returns with the value basket we created.

The table shows that the value portfolio underperformed the Sensex in three of the five periods. Based on this strategy, if you had invested Rs 10 lakh in FY15 and held it till FY23, you would have underperformed the Sensex by nearly Rs 1.18 lakh. This shows that even if you had kept invested as per Graham's tenets over the long term, your portfolio would have delivered lower returns than the Sensex.

Quality over quantity

Due to limitations with Graham's strategy, Buffett gradually tilted towards Philip Fisher's investing style. Unlike Graham, Fisher stressed the importance of assessing a company more on qualitative aspects such as the quality of management and business prospects, which cannot be measured easily.

In Buffett's words, "With the "cigar approach" [Ben Graham's approach], you can find a nasty cigar on the ground, with one puff left, can pick it up, light it, and you get a free puff. You can keep doing this and get many free puffs. That's one approach, that's what I did. I looked for very cheap stocks quantitatively. After exposure to [Philip] Fisher and Charlie [Munger], I started looking for better companies. Previously, I was doing both. Now we are looking for good companies, not just cheap companies."

Did Buffett altogether abandon Graham's methodology?

Not really.

On the contrary, Buffett has acknowledged two critical learnings from Graham that he applies to his investing style: margin of safety and importance of emotions in the stock market. What's more, Buffett describes his investing strategy as a blend of Graham and Fisher's philosophy.

Also read: How to pick stocks the Benjamin Graham way

This article was originally published on January 05, 2024.