Warren Buffett was a student and employee of Benjamin Graham, the man who is credited with developing the central philosophies of value investment. Buffett was hugely impressed by Graham's work, spurring him to become a student, and later an employee, of the financial thought leader. Throughout his career as a famous value investor, Buffett has adhered to Graham's general philosophy, and in particular his three pillars, which are that stocks should be regarded as businesses, investors should operate with a margin of safety and the market should be considered a facilitator rather than an indicator.
While Buffett ascribed to Graham's overall theory and intrinsic valuation techniques, the two men differed in the practical application of that theory. Buffett maintained a more qualitative approach, with slightly more emphasis on future performance, and this approach was enabled by a voracious appetite for in-depth business analysis.
The late Benjamin Graham's greatest contribution to finance was the development and refinement of intrinsic valuation techniques. Graham showed that rational investors should calculate a business's value based on financial fundamentals, and this technique allowed him to identify opportunities in the market when particular stocks were materially overvalued or undervalued. This approach was largely quantitative and relied heavily on identifying stocks that were mispriced relative to current accounting measures. When panic, news or momentum created a disconnect between fundamentals and valuation, intrinsic valuation would identify opportunities.
Buffett adopted Graham's underlying philosophy, but he changed the application of these theories to accommodate a qualitative element. The qualitative component was heavily influenced by the work of Philip Fisher. Buffett's strategy focused on identifying wide competitive moats and companies with enduring viability. Graham's quantitative techniques can be difficult to employ without relying on significant speculation in highly efficient markets. Value investors often use a variant of discounted cash flow to calculate intrinsic value, but this method can become unreliable for volatile or high-growth enterprises.
Buffett found that Graham's techniques could be applied more reliably to stable, durable companies with strong competitive advantages, viable margins and quality management. These considerations are absent from a strict qualitative methodology based on accounting items. As a result, Buffett took Graham's philosophy and added a layer of research to its application, which can drastically complicate the investment process. Buffett has claimed that investors who are not prepared to log extensive fact-gathering time should instead remain in diversified vehicles over long time periods.
Buffett is also more reliant on forward-looking metrics than Graham. Graham's intellectual underpinning caused him to distrust the validity of forecasts, which seek to predict data that is by definition unknowable. Using speculative numbers as calculation inputs leads to fewer reliable outputs and wide margins of error. Graham preferred opportunities that afforded him a wide margin of safety, while minimizing the probability of error, which allowed him to overcome the limitations inherent in forecasting.
As Buffett's career progressed, innovations in investment theory and technology reduced the incidence and extent of market inefficiencies. This necessitated a more nuanced approach from investors. Buffett's qualitative methods have helped him limit the impacts of an uncertain future, thus extending the applicability of Graham's strategies to a wider range of equities. Buffett's methods still do not focus on highly speculative growth stocks, but he is able to incorporate more factors into the process.
Personal Interest in Business
The application of Graham's theory diverged between the teacher and pupil due in part to timing, but it was also attributable to differences in their personalities. Graham was an academic as well as an investor, and his approach to understanding markets and valuation were shaped by this outlook. His contemporaries recall that he had numerous interests, so his pursuit of market mastery was incomplete relative to other famous investors. His concern on the topic was primarily to develop a replicable process that could be applied to any going concern.
Buffett claims to have been more interested in actual businesses than Graham, which allowed him to become more knowledgeable on the topic. This passion and curiosity for the field has equipped Buffett with the patience and motivation to marry qualitative considerations with strong quantitative methodology, thereby augmenting Graham's powerful theory.