Benjamin Graham, often regarded as the father of value investing, devised a defensive investment strategy aimed at  protecting investors from significant losses while providing  moderate returns. His investment philosophy centered on  selecting financially sound, undervalued companies with a “margin of safety.”

In his seminal work, Security Analysis, Graham provided a  comprehensive framework for evaluating defensive investment  strategies, emphasizing thorough analysis and sound judgment.  He outlined two key approaches for defensive investors:

• First, he advocated for investing in a diversified portfolio of  high-quality, stable companies to mirror the overall market. This  method, often referred to as passive investing, allowed investors  to reduce the risks associated with selecting individual stocks.
• Second, Graham suggested constructing a portfolio of individual  securities based on both qualitative and quantitative criteria.  Defensive investors were advised to prioritize well-established  companies with strong financials, low debt, and a history of  stable earnings.
• This strategy involved balancing stocks and  high-quality bonds to provide diversification and reduce  exposure to market volatility.While most of Graham’s teaching remain relevant today, Warren  Buffett, his most  favoured and renowned student, has adapted  these principles to fit the modern context.
• For those who follow Graham’s teachings religiously, these adaptations by Buffett  offer an interesting perspective on evolving investment  strategies.

 

1. SIZE OF THE COMPANY

One of the core elements of Graham’s strategy was to invest in  adequately sized companies. By targeting large, established  firms with substantial resources, Graham sought to minimize the  risk of significant volatility or failure. These companies, often  holding a dominant market position and strong financial  fundamentals, were better equipped to withstand economic  downturns and market disruptions.

• The rationale was  straightforward: larger companies tend to be more stable, as  they are more diversified in their operations, and have greater  access to capital, which  reduces the likelihood of bankruptcy.
• However, Warren Buffett, one  of Graham’s most famous  students, modified this strategy to align with his own  investment philosophy.
• While  Graham focused on large  companies, Buffett took this  approach further by emphasizing on high-quality  businesses with robust  competitive advantages or “economic moats.”

 

2. This shift reflected Buffett's

understanding that not all large companies were created equal - some had more durable business models, stronger brands, or technological advantages that set them apart from their peers.

Buffett’s focus on companies with strong competitive advantages is exemplified by his investments in firms like Apple, Coca-Cola, and American Express.

These companies not only have a large market presence but also possess unique competitive advantages that allow them to generate consistent cash flows and maintain market leadership.

 

3. THE FINANCIAL SOUNDNESS CHECKLIST

Graham’s focus on liquidity and financial health was another critical aspect of his defensive strategy. He recommended investing in companies with a strong current ratio, ideally at least 2:1, meaning the company’s current assets were twice its current liabilities.This ratio indicated that the companycould easily cover its short-term obligations, reducing the risk of financial distress. Warren Buffett shares Graham’s cautious approach toward financial stability but places more emphasis on long-term debt.

• He focuses on how effectively a company can manage its debt over time, assessing how long it would take to repay all debts using current earnings.
• Buffett believes that excessive long-term debt can pose a major risk, particularly during periods of economic downturns, when earnings might decline.
• Companies with manageable levels of debt are better positioned to weather tough times, ensuring their long-term survival.This focus on long-term financial stability is central to Buffett’s strategy.
• He avoids companies with high levels of leverage or those that depend heavily on borrowing to fund operations. Instead, he prefers businesses that generate enough cash flow to comfortably service their debt, which allows them to maintain financial flexibility and avoid excessive risk.

 

4. EARNINGS STABILITY: GRAHAM VS. BUFFETT

Another key aspect of Graham’s strategy was his emphasis on earnings stability. He believed that investors should only consider companies with a history of positive earnings over the past ten years. This criterion ensured that the company demonstrated resilience and consistency over a significant period, making it less likely to encounter sudden financial distress.

For instance,

under Graham’s criteria, if a company like Infosys Ltd had shown stable earnings for the past decade, it would be considered a solid investment.This focus on long-term earnings stability reduced the risk of investing in companies with volatile or unpredictable profits, ensuring a more reliable investment over time.Buffett, while valuing earnings stability, is more flexible in his approach. He emphasizes consistent earnings growth over time rather than requiring a strict ten-year history of positive earnings.

• For Buffett, it is more important that a company has the potential for long-term growth, even if it experiences occasional setbacks.
• He is willing to overlook a year or two of negative earnings if he believes the company is fundamentally sound and has stronggrowth prospects.
• A more flexible approach like this allows Buffett to take advantage of opportunities in companies that may be temporarily undervalued due to shorttermissues.
• Rather than adhering strictly to past earnings, Buffett looks for companies that are positioned to grow in the future, even if they have encountered recent challenges.

 

5. DIVIDEND PAYMENTS: GRAHAM VS. BUFFETT

Dividends were a cornerstone of Graham’s defensive investment strategy. He believed that companies with a long history of consistent dividend payments demonstrated financial stability and a commitment to returning value to shareholders.Graham recommended that investorsprioritize companies with at least a 20-year record of uninterrupted dividend payments.Buffett, on the other hand, has a different perspective on dividends.

• Under his leadership, Berkshire Hathaway has never paid dividends. Instead, Buffett prefers to reinvest profits into the company to fuel long-term growth.
• He believes that retaining earnings within the business can generate higher returns for shareholders over time, especially when those profits are used to expand operations, make acquisitions, or invest in new growth opportunities.
• Additionally, Buffett points out the tax disadvantages of dividends, as they are taxed at ordinary income rates, while capital gains from selling shares are taxed at lower rates.
• This makes capital appreciation more attractive to long-term investors than dividend income.Buffett’s stance on dividends reflects his broader investment philosophy of focusing on long-term value creation rather than short-term returns.
• He prefers companies that reinvest profits to grow their businesses, which can lead to greater capital appreciationover time.

 

6. VALUING STOCKS: GRAHAM'S PRICE-TO-BOOK RATIO VS. BUFFETT’S FOCUS ON INTANGIBLES

Benjamin Graham’s strategy for valuing stocks involved assessing their price-to-book value (P/BV) ratio. He believed that a company’s stock should not trade at more than 1.5 times its book value. This conservative approach ensured that investors were buying stocks that were trading at or below their intrinsic value, providing a margin of safety.

In contrast, Warren Buffett places less emphasis on the P/BV ratio and more on the intangible qualities of a company. Buffett recognizes that many successful companies derive a significant portion of their value from intangible assets such as brand strength, intellectual property, or customer loyalty.

These intangible assets may not be fully reflected in a company’s book value, but they can be critical drivers of long-term profitability and competitive advantage.

For example,

• companies like HDFC Bank Ltd, which has a P/BV ratio of 3, would not meet Graham’s criteria. However, Buffett would focus on the bank’s intangible assets, such as its brand, technology, and customer base, and consider its competitive position in the market.
• In Buffett’s view, these intangible assets justify a higher P/BV ratio because they contribute to the company’s long-term success and profitability.

 

7. EARNINGS GROWTH: GRAHAM’S ONE-THIRD INCREASE VS. BUFFETT’S FOCUS ON TRAJECTORY OF GROWTH

Graham’s approach to earnings growth was relatively straightforward. He required companies to demonstrate at least a one-third (33.3%) increase in earnings per share over the past ten years. This criterion ensured that companies were growing at a pace that outpaced inflation, making them attractive long-term investments.Buffett’s approach to earnings growth is more nuanced.

While he prefers companies with strong growth potential, he is not as rigid in his expectations. Buffett acknowledges that some companies, especially those in cyclical industries, may experience periods of slow growth or temporary setbacks.

For example,

• Wells Fargo, a long-time investment of Berkshire Hathaway, had an average earnings growth rate of only 2.2% over the past decade.
• Despite this, Buffett continues to invest in the company, reflecting his belief in its long-term potential.Buffett’s focus on earnings growth is more about the overall trajectory of the company rather than meeting specific short-term benchmarks.
• He is willing to overlook temporary earnings declines if he believes the company has the potential to achieve long-term success.

 

8. GRAHAM’S MARGIN OF SAFETY VS. BUFFETT’S ADAPTATION

The concept of “margin of safety” is one of the most well-known principles of value investing, introduced by Benjamin Graham. It involves buying securities at a significant discount to their intrinsic value to protect against potential losses. By paying less than what the company is worth, investors create a cushion against unforeseen declines in stock prices or mistakes in judgment.Warren Buffett has adapted this concept to suit modern market conditions.

• While he still values the margin of safety, Buffett focuses more onthe quality of the business and its long-term prospects.
• For Buffett, the margin of safety is not just about buying cheap stocks or a number to guide - it’s about investing in high-quality businesses at reasonable prices.
• Buffett’s adaptation of the margin of safety concept reflects his broader investment philosophy. He is willing to pay a premium for companies with strong competitive advantages, believing that their long-term growth potential provides a margin of safety in itself.

 

9. GRAHAM’S DIVERSIFICATION VS. BUFFETT’S CONCENTRATION

Graham was a strong advocate of diversification as arisk-reduction strategy. He believed that by spreading investments across a wide range of industries and asset  classes, investors could reduce the risk of any single stock’s underperformance.

Buffett, however, takes a different approach to diversification. He prefers to concentrate his investments in a smaller number of high-quality companies that he understands deeply.

Buffett believes that diversification comes from understanding the businesses in which one invests.

Rather than owning a large number of stocks, Buffett argues that it’s better to own a handful of companies that are well-positioned for long-term growth.

Buffett’s strategy of focusing on a smaller number of high-quality investments is exemplified by Berkshire Hathaway’s portfolio, which often contains large, concentrated bets on a few select companies.

For Buffett, the key to reducing risk is not diversification but deep knowledge of the businesses in which he invests.

 

 ______________________________________________________________

 

Read the Summaries of world's 300 most-celebrated and Must Read Books 

In an attempt to learn constantly, we peruse the world's must-read books. Our team reads and notes key concepts and ideas from these most-celebrated books. We cull key learnings from these 300 best Invesment books, covering wealth, business and self-help to philosophy and others. We penetrate the core of these books and the messages or learnings the authors offer. We have created 300 summaries for our own consumption. You could also download them to learn, gain and retain the wisdom these books offer.

Download Now

100Bagger: Eagle Post

Aimed at compounding knowledge and wealth, we bring to you best stories and resources every month handpicked by our 100 Bagger team.

• Bonus: You'll also receive a FREE COPY of our latest ebook, "MARKET CYCLES: HOW THEY WORK AND HOW TO PROFIT FROM THEM"
• E-copy of Highlighted 45 Page Detailed Naval Ravikant Interview
• Book Summary "The 4-Hour Work Week"