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HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT This page intentionally left blank. HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT Lawrence A. Cunningham McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto McGraw-Hill abc Copyright © 2001 by the McGraw-Hill Companies,Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-138104-X The material in this eBook also appears in the print version of this title: 0-07-136992-9. All trademarks are trademarks of their respective owners. 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DOI: 10.1036/007138104X CONTENTS Acknowledgements ix Introduction: The Q Culture xi PART I: A TALE OF T WO MARKETS 1 Chapter 1. Mr. Market’s Bipolar Disorder 3 Swings, Bubbles, and Crashes / 5 Be an Anomaly / 11 Barrel of Monkeys? / 12 Chapter 2. Prozac Market 17 Obscurity / 17 Simplicity / 18 The Perfect Dream / 22 Tidying Up the Tale / 28 Chapter 3. Chaotic Market 33 New Wave / 33 Next Wave / 36 Complexity / 46 Behavioral Finance / 47 Chapter 4. Amplified Volatility 51 Information Volatility / 51 Transaction Volatility / 59 Trader Volatility / 63 Prognosis / 66 Chapter 5. Take the Fifth 69 Who’s in Charge? / 70 Sticking to Your Knitting / 71 Alchemy / 81 The Long Run / 86 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use v vi Contents PART II: SHOW ME THE MONEY 89 Chapter 6. Apple Trees and Experience 91 Fools and Wisdom / 91 Horse Sense / 100 Chapter 7. Your Circle of Competence 105 The Initial Circle / 106 The Nurtured Circle / 109 A Full Circle / 114 Decision Making / 116 Chapter 8. Recognizing Success 119 Business Fuel / 120 Managers under the Microscope / 124 Bang for the Buck / 128 The Full Tool Chest / 131 Chapter 9. You Make the Call 133 Assets / 134 Earnings / 138 Silver Bullets and the Margin of Safety / 142 Cash / 144 Market Circularity / 146 Chapter 10. Making (Up) Numbers 153 Perennials / 153 Satire / 157 Charades / 162 Coda / 167 PART III: IN MANAGERS WE TRUST 169 Chapter 11. Going Global 171 The Two-World Story / 172 Illusions of Duty / 176 One World to Come / 180 Contents vii Chapter 12. Rules and Trust 193 The Family Manager / 193 Local Governance / 195 General Governance / 200 Your Voice at the Table / 202 Chapter 13. Directors at Work 205 Hail to the Chief / 206 Pay / 207 Deals / 212 Capital / 215 Checking Up / 217 Chapter 14. The Fireside CEO 221 Master Servants / 221 Action / 222 Lights / 230 Trust / 235 Conclusion: The V Culture 243 Notes 245 Index 257 This page intentionally left blank. ACKNOWLEDGMENTS T he main ideas in this book trace their intellectual lineage to Benjamin Graham, whom I never knew but must thank post - humously, and Warren Buffett, whom I have the great fortune to know and from whose writings, talks, and conversations I have gained knowledge and insight. Neither of these men, of course, has any responsibility for this book’s content and no doubt would disa - gree with some of what it says, though it is written as a narrative interpretation of principles they developed, to which it tries to be faithful. Mr. Buffett deserves my continuing thanks for permitting me to prepare a collection of his letters to the shareholders of Berkshire Hathaway, The Essays of Warren Buffett: Lessons for Corporate Amer - ica, and for participating along with Berkshire Vice-Chairman Charles Munger in a symposium I organized to analyze it. Thanks also to the readers of that collection of wonderful writings for en - couraging me to write the present book, especially the courageous college and business school professors who use that book in their courses and their many students who tell me how valuable it is. Other fans of that book who encouraged me to write this one include my friends at Morgan Stanley Dean Witter, led by David Darst and John Snyder; Chris Davis and KimMarie Zamot at Davis Selected Advisers; the team at Edward D. Jones; and supporters too numerous to mention at other firms who appreciate the business analysis way of investing. By training and professional habit I am a corporate lawyer, and as my students know, effectiveness as a corporate lawyer requires mastering not only (or mostly) law but also business, including fi - nance, accounting, and governance. For tutelage in that philosophy, I thank my friends and former colleagues at Cravath, Swaine & Moore as well as that firm’s clients. Not all law faculties recognize the intersection of law and busi- ness. My colleagues at Cardozo Law School do and support my re- Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use ix x Acknowledgments search and writing in the fields of finance, accounting, and gover- nance that seem to others a step beyond law as such. Among these colleagues, special thanks to Monroe Price for introducing me to Warren Buffett through their mutual friend Bob Denham. For grant - ing me a sabbatical to devote time to work on this book, I especially thank Dean Paul Verkuil and Dean Michael Herz. My personal and institutional ability to span these and other subjects has been greatly aided by Samuel and Ronnie Heyman, both nonpracticing lawyers and astoundingly talented businesspeople, in - vestors, and philanthropists. They generously endowed the Samuel and Ronnie Heyman Center on Corporate Governance at Cardozo, a multifaceted program I direct that explores this range of disciplines in teaching, research, and policy review. My own teachers also deserve my thanks, particularly Elliott Weiss, now professor at the University of Arizona College of Law, who long ago drew my attention to Graham and Buffett’s ideas and who generously shares his wealth of knowledge. For allowing me to use in modified form some materials from a textbook we worked on together. I also thank Professor Jeffrey D. Bauman of Georgetown University Law Center, and West Group, that book’s publisher. Thanks also to West Group for allowing me to use in modified form some materials from another textbook I wrote, Introductory Account - ing and Finance for Lawyers, which is not for lawyers only. Many thanks to the whole team at McGraw-Hill for their con- fidence, enthusiasm, and guidance, particularly Kelli Christiansen, Jeffrey Krames and Scott Amerman. Most of all, thanks to my wife, JoAnna Cunningham, who pains- takingly edited the entire manuscript with precision and grace and encouraged me every step of the way. [...]... the ability and fortitude to understand what is hard for others to understand and to gauge better than others how a business and its industry are evolving have a decided advantage But it remains important for each investor to come to grips with what is and what is not within his circle of competence to make the informed judgments that intelligent investing requires * Kara Scannell, Anatomy of a Bull... right set of tools and good judgment Equipped with these tools and working within your circle of competence, you can determine how much and what sort of evidence is required to be comfortable with a valuation estimate Yet there is no single reliable tool to pinpoint the value of a business, so intelligent investors must observe Benjamin Graham and Warren Buffett s cardinal rule of prudent investing:... areas of thinking about markets and prices, and businesses and managers It builds a latticework of common sense to fill the vast value void in today’s markets The book first shows you why it is a mistake to operate as a market analyst or to look to the market to reveal value when all it can do is reveal prices It then presents the tools to think about performance and value but also cautions about how financial... where to look The core idea is your circle of competence, created by the twentieth century’s most successful investor and business educator, Warren Buffett It is defined by your ability to understand a company’s products and operating context Circles of competence are as varied as the investors who must define them All investors must grapple with the challenge of using current and past information to gauge... or less attention to the underlying nature of businesses With temerity and great humility, this book offers an account of Graham s ideas and Buffett s extension and application of them that reflect the example and tradition It is † Warren Buffett, The Superinvestors of Graham and Doddsville, Hermes (Columbia Business School), Fall 1984 xviii Introduction: The Q Culture a broadened and extended narrative... affected their investing habits All readers will also discover that the history of EMT is fascinating It is a story about research designed to enlarge knowledge, to explain and understand the world, research whose results are intermittently neglected and then overblown The story tells us that EMT is not the last word on how stock markets work, even though the power it has had over investors and teachers... deal available compared to all the others And opportunity does knock One way to test opportunity is to take Loeb’s approach: always ask whether you would be comfortable committing a large portion of your resources to a single stock you are considering Buffett and other outstanding investors, including Peter Lynch, know that an intelligent appraisal depends on your ability to understand a business This... Average stock prices swing by 50% every year, while underlying business value is far more stable Share turnover is enormous The number of shares traded compared to the total shares outstanding spiked from 42% to 78% on the New York Stock Exchange between 1982 and 1999 and from 88% to 221% on the Nasdaq between 1990 and 1999.3 Prices on particular stocks rise sharply and fall furiously within days and weeks... on value first, and then compares value to price to see if an investment holds the promise of a good return That kind of focus requires the investor to operate as a business analyst, not as a market analyst or securities analyst and certainly not as a Q trader This book develops a mind-set for business analysis as the antidote to the Q culture It discusses the tools of stock picking and highlights critical... effect (stocks rated highly by the Value Line Investment Survey tend to outperform the market in terms of price) • The analyst effect (stocks of companies followed by fewer analysts tend to become pricier compared to those followed by more analysts) • The month effect (stock prices tend to rise at the end and the beginning of months) • The weekend effect (stock prices tend to be lower on Mondays and higher . HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT This page intentionally left blank. HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT Lawrence. intelligent investors avoid businesses that are hard to understand or subject to rapid change. On the contrary, those investors equipped with the ability and fortitude to understand what is. for others to under - stand and to gauge better than others how a business and its industry are evolving have a decided advantage. But it remains important for each investor to come to grips