I started investing by following Ben Graham’s Approach, which focuses more on quantitative analysis and less on qualitative.
This approach is also known as Cigar-butt approach. In which you look for very cheap bargains and try to take the last ‘puff’ before they are thrown away.
So, basically it means that you buy ‘very cheap’ valued businesses and sell it when they become ‘cheap’ or ‘fairly’ valued.
Problems With The Approach
Firstly, I realized that your upside, i.e. profit, was limited because you cannot expect a gruesome business to perform like a great business.
Secondly, this approach requires diversification as chances of these businesses going bankrupt is generally high but you still buy them because they are available at a huge discount i.e. less than their Net Current Asset Value.
Thirdly, it didn’t matter whether you understood the business or not.
This approach actually did work for me and helped me in making small profit on my investments. But I did not feel as if I was investing in the businesses, rather it felt like playing with the stock market.
Buying something just because it is cheap and not giving importance to the business lying behind it, did not feel right.
Soon I realized that long back Warren Buffett had switched from this approach and no longer followed it!
I felt like an idiot, as I invested my money believing that Warren Buffett follows Cigar-Butt approach.
But I guess investing is not that easy. If it would have been that easy to just put some numbers on the screen and buy a basket of those stocks then everyone would have done it.
Here is a video explaining why Warren Buffett left Cigar Butt approach.
So, what does he follow now?
This is what he wrote in 1976 Berkshire Hathaway shareholder’s letter:
- Favorable long-term economic characteristics
- Competent and honest management
- Purchase price attractive when measured against the yardstick of value to a private owner and
- An industry with which we are familiar and whose long-term business characteristics we feel competent to judge.
Yes, it’s that simple! But let me tell you it might be simple but it’s not easy.
This approach makes you think more like you are making an investment rather than just playing with the prices in the stock market.
I think the fourth point is what the majority of people ignore.
They try to get into the market and try to find bargain anywhere and everywhere possible and this leads them to finding bargains in companies they don’t even understand.
So, what happens then?
In one of my previous articles I have talked about this a little, ‘circle of competence’. But Vishal Khandewal of SafalNiveshak explains very well that when does a company fall under your circle of competence.
A business will be ‘within’ your circle of competence if you fully understand the underlying economics of it:
- How it works?
- What drives its growth?
- What makes it profitable?
- How does it stand against its competitors?
- How does it manage its raw material costs?
If you fail to answer such type of questions about a company then it does not fall under your circle and if a company does not fall under your circle of competence then you are just speculating.
After reading about the circle of competence I realized that before this I was only trying to make quick money. Even this had less chances of succeeding as following the cigar-butt approach I didn’t even know the economics of that business.
Now, I look for quality businesses which I can understand with good management available at a ‘reasonable’ price.
(Thanks to Mojohandykraftz for reading drafts of this.)