What Warren Buffett learned from the father of value investing

I recently re-read Benjamin Graham’s seminal book, The Intelligent Investor. Ben Graham taught Warren Buffett, who valued Graham’s instruction so highly that he went to work for him for free.

So, what can we learn from the seminal text of value investing?

Paying for future earnings is a fool’s gambit

Paying for money in the future that the company may or may not earn is madness, according to Graham. Paying too much for earnings simply condemns you to mediocre returns until profits catch up with the market price of securities. Even though it’s a great company, CSL Limited (ASX: CSL) valued at 30 times earnings is a long way from Graham’s ideal kind of investment.

In fact, if CSL keeps growing profits at 8% per annum, it will take 6 years of growth just to bring it down to a Price to Earnings (P/E) ratio of 18, approximately the market average. That’s not to say you shouldn’t buy CSL, but today’s prices demand that it starts to grow faster.

Don’t pay more than a 30% premium to ‘book’ value

Graham recommends buying at a discount to book value to ensure you’re getting a bargain, although he suggests a premium of up to 1.3 times book value may be acceptable. This is particularly important for businesses like Commonwealth Bank of Australia (ASX: CBA), where the value of CBA’s assets and the return it earns on those assets directly correlates with the amount of profit it makes for shareholders.

An exception to the rule?

Graham, and editor Jason Zweig, wrote in a time before most online businesses were experiencing much success. Although an investor should do quite well following Graham’s formula, his strictures would see investors miss a number of today’s asset-light technology businesses that are generating huge sales.

Accounting software company XERO FPO NZX (ASX: XRO) is a typical example. Even if we include ‘intangible’ assets as part of its book value, Xero is trading at 9 times its net assets of ~$242 million at the most recent half year. Yet it was able to sell $132 million worth of software subscriptions during this time, and should comfortably earn more than $1 in sales this year for every dollar it has in assets.

The internet means that corporations can achieve big sales with a relatively light asset model and thus, higher P/B ratios – although it is still important not to overpay. The trend towards sale-and-leaseback of assets is also lightening corporate balance sheets without overly hurting their cash generation.

Are you an ‘enterprising’ or a ‘defensive’ investor?

If you’re a defensive investor, you’re short on time, experience, or perhaps not that interested in investing. In this case, you should outsource your investments to a professional, with fees not more than ~1% of your assets per annum. Most relevant is Graham’s assertion that if you are a defensive investor, but don’t put in the time to research and improve your investing skills, you will lose money.

The enterprising investor is able to look at a wider range of smaller companies and opportunities, with an eye towards using his skills to benefit from ‘Mr Market’s’ manic-depressive swings in price. He/she must invariably put in the time to develop her investing skills, and will probably end up doing a lot of trial-and-error in the process.

What Would Jesus Do?

One of the few moments of levity in an unusually dry book is when Graham suggests that Jesus was a better investor than the average American stockholder circa 1972. He implies that if the Gospel says investors can fire their ‘steward’ (corporate manager) for incompetence, modern shareholders should be far more active in expressing their displeasure and questioning management. After all, management works for you.

A timely reminder, as shareholders today don’t appear to be all that different from their 1972 counterparts.

Foolish takeaway

What’s remarkable is that The Intelligent Investor was first published in 1949 and, even though it has gone through several revisions since then, its lessons still ring true 75 years later. Jason Zweig’s commentary add a lot of value and perspective for the modern reader, and The Intelligent Investor should be on every investor’s reading list.

How 1 Man Turned $10K Into Over $8 Million

Discover how one man turned a modest $10,600 investment into an $8,016,867 fortune. Learn more about this man and how you can start down the path toward financial independence. Simply click here to learn more.

Motley Fool contributor Sean O'Neill owns shares of Xero. The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.