One of the least discussed secrets of great practitioners of the value investing strategy is the use of cash, cash equivalents, and bonds to augment returns. From Benjamin Graham and Warren Buffett to Wallace Weitz and Marty Whitman, intelligent use of excess funds has as much to do with growing your capital over the long run as does selecting individual common stocks. We’re going to look at some of the techniques that have been used by value investors to manage their reserves, and the role played in the overall portfolio.
The focus value investing strategy is different from traditional, Benjamin Graham value investing strategy because it is based upon the idea of putting money into more of an investor’s “best ideas”, as Warren Buffett put it. Some value investors despise focused investing, while others swear by it. I’m always very hesitant to talk about this particular strategy on Investing for Beginners where I publish my investing articles for total newbies, mostly because some lazy person may not study far enough and realize that focused value investing is only possible when someone has diversified income sources. Done wrong, it can be financially devastating.
In his classic treatise, The Intelligent Investor, Benjamin Graham, the father of value investing, created an allegory to help new investors understand how to think about stock prices and value investing in general. By using it, you can help protect yourself from overpaying for a stock, panicking when the market crashes, or doing foolish things resulting from emotional reactions to the nightly news. Along with the margin of safety concept, Mr. Market is a cornerstone of the value investing strategy.
The single most important concept in all of investing, according to Benjamin Graham and later confirmed by his star student, Warren Buffett, comes down to three simple words: Margin of Safety. What is the margin of safety? How do you calculate it? How important is it to developing a successful value investing strategy? As you’ll see in a moment, the theory behind value investing is that the ultimate return you earn on your investments will be closely related to the size and quality of the margin of safety you build in to your purchasing decisions, whether you are buying shares of Coca-Cola or building a hotel.
Originally serving as stock broker to the father of value investing, Benjamin Graham, Tweedy, Browne & Company converted to a money management company and eventually launched several highly successful mutual funds that operated with the same value investing style for which they had become renowned. After beating the market by several percentage points for nearly forty years, the firm’s place in the halls of investing greats has been securely established.
There are several common characteristics that often present themselves in stocks that are thought to be attractive to those who follow a value investing strategy. From high dividend yields to low price-to-book values, here’s a list if you are new to the concept of value investing.
In 1950, William Ruane, or Bill Ruane as he was known, took a course on value investing taught by Benjamin Graham and David Dodd at Columbia University despite having graduated from Harvard Business School. One of his classmates was Warren Buffett, with whom he formed a friendship. Years later, when Buffett dissolved his investment partnership, he recommended that any partners still interested in value investing put their money with Ruane, who had launched his own firm, Ruane, Cunniff. The flagship value investing vehicle of the new firm was the Sequoia Fund, an open-ended mutual fund. Over the next 38 years, the Sequoia fund outperformed the S&P 500 by compounding at 15% per annum versus 13% for the broader index.
In addition to penning several of the most important value investing books in history, Benjamin Graham, the father of value investing, was one of the two partners in the Graham Newman Corporation, the investment fund through which he put money to work. It was at this firm that Warren Buffett worked early in his career, learning from the master. As he amassed an astounding investing record, Graham divided his portfolio into several categories, or “operations”. These served value investing students well for more than seventy years and some still have value today.