Lesson 2 of 7
What changed between Graham and Buffett
Graham bought statistical bargains; Buffett, crediting Munger, paid fair prices for better businesses. The difference is arithmetic about the holding period.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A discount pays once, but a high return on reinvested capital pays every year and overtakes a discount quickly.
- Buffett named the shift himself, in the 1989 letter: a wonderful company at a fair price beats a fair company at a wonderful price, and he credits Munger with seeing it first.
- A version of owner earnings built from the cash flow statement adds back every non-cash charge, stock pay included, and so treats a real transfer to employees as free.
The shift from buying statistical bargains to paying more for businesses that earn high returns on capital is usually told as a change of taste. It is arithmetic about the holding period, and short enough to print.
The cigar butt against the wonderful company at a fair price
The cigar butt
- Buys a statistical bargain below what the assets are worth.
- Profits once, when the gap between price and value closes.
- A business going nowhere is spending the discount while you wait.
A wonderful company at a fair price
- Pays a fair price for a business earning a high return on capital.
- Profits every year the return is reinvested, not once.
- Needs the return to persist and the company to find somewhere to put new capital.
A discount pays once. A high return pays every year it is reinvested.
Why compounding overtakes a discount
A Graham investor sells once the gap closes and looks for the next one. That works only while new bargains keep appearing, and each switch costs tax and friction.
Two conditions hold the second and third rows up. The high return has to persist, which is a question about competition, not arithmetic. And the company has to be able to put new capital to work at that rate; a high return with nowhere to reinvest compounds at whatever the cash does instead, which may be far less.
Owner earnings is an estimate
Buffett's owner earnings, from the appendix to the 1986 letter, is reported earnings plus depreciation, amortisation and certain other non-cash charges, minus the capital spending (and any extra working capital) needed to maintain the business.
GAAP does not require companies to split spending into a maintaining part and a growing part, and most do not, so Buffett called the maintenance figure a guess. Substituting reported capital expenditure for the maintenance share is reproducible but understates a growing company's owner earnings; estimating the maintenance share describes the business but is a judgement nobody can audit. ValueScreener takes the first road and says so wherever the figure appears.
Stock pay is not free
ASC 718 makes stock-based compensation an expense; the indirect cash flow statement (ASC 230) adds it back as non-cash.
Operating cash flow adds back stock-based compensation along with every other non-cash item. A shortcut that starts there treats a transfer of ownership to employees as though it cost nothing. Buffett's own wording said certain charges, and his 1992 letter argues that options are compensation and compensation is an expense. It is non-cash. It is not free.
Check yourself
Over a single year, which produces the larger return in the worked example: the 30 percent discount alone, or the 20 percent compounder bought at full value?
- They are equal
- The discount alone, 42.9 percent against 20.0 percent
- The compounder, by a wide margin
Show the answer
Answer: B.
Over one year closing a 30 percent gap outpaces a single year of 20 percent growth. The compounder only overtakes it once the holding period stretches out.In the 1989 letter, whom does Buffett credit with seeing the shift to a wonderful company at a fair price first?
- Graham
- Munger
- Nobody; Buffett takes credit himself
Show the answer
Answer: B.
In the 1989 letter, Buffett credits Munger with grasping this before he did.Why can no filing state owner earnings exactly?
- Companies are not required to report capital expenditure
- Accounting rules do not require capital spending to be split into maintenance and growth, so the split is usually an estimate
- Depreciation is not disclosed anywhere in a 10-K
Show the answer
Answer: B.
Total capital expenditure is one filed line. The split between maintaining the business and expanding it is not a required disclosure, so it is a judgement, not a filed fact.Sources
- Berkshire Hathaway shareholder letter, 1989: the cigar-butt approach, and a wonderful company at a fair price, credited to Munger.
- Berkshire Hathaway shareholder letter, 1986, appendix: owner earnings.
- Berkshire Hathaway shareholder letter, 1992: stock options as compensation, and compensation as an expense.
- ASC 718, Compensation, Stock Compensation. ASC 230, Statement of Cash Flows.
What this leaves out
- The compounding rows assume the return on newly invested capital equals the return already in place, the assumption that fails most often; the incremental return is the figure that answers it.
- The table uses invented round inputs, models no company, ignores taxes and transaction costs, and ignores any dividends.
- Whether a return on capital persists for ten years is a judgement, not an arithmetic test, unlike Graham's balance-sheet rules. Nothing here says either approach produces better results.
- Nothing here is advice about any security.