The Snowball_ Warren Buffett and the Business of Life - Alice Schroeder [83]
Graham said that a company is no different than a person, who might think that her net worth was $7,000, comprising her house, worth $50,000, less her mortgage of $45,000, plus her other savings of $2,000. Just like people, companies have assets that they own, such as the products they make and sell, and debts—or liabilities—that they owe. If you sold all the assets to pay off the debts, what would be left was the company’s equity, or net worth. If someone could buy the stock at a price that valued the company cheaper than its net worth, Graham said, eventually—a tricky word, “eventually”—the stock’s price would rise to reflect this intrinsic value.15
It sounded simple, but the art of security analysis lay in the details—playing detective, probing for what assets were really worth, excavating hidden assets and liabilities, considering what the company could earn—or not earn—and stripping apart the fine print to lay bare the rights of shareholders. Graham’s students learned that stocks were not abstract pieces of paper, and their value could be analyzed by figuring what the whole pie of a business was worth, then dividing it into slices.
Complicating matters, however, was that issue of “eventually.” Stocks often traded at odds with their intrinsic value for long periods of time. An analyst could figure everything right and still appear wrong in the eyes of the market for the investing equivalent of a lifetime. That was why, as well as being a detective, you had to build in what Graham and Dodd called a MARGIN OF SAFETY—that is, plenty of room for error.
Graham’s method struck people who studied it in one of two ways. Some grasped it immediately as a fascinating, all-consuming treasure hunt and others recoiled from it as a dreary homework assignment. Warren’s reaction was that of a man emerging from the cave in which he had been living all his life, blinking in the sunlight as he perceived reality for the first time.16 His former concept of a “stock” was derived from the patterns formed by the prices at which pieces of paper traded. Now he saw that those pieces of paper were simply symbols of an underlying truth. He instantly grasped that the patterns formed by trading these pieces of paper did not signify a “stock” any more than those childhood piles of bottle caps had signified the effervescent, sweet-sour-spicy taste of soda pop that made people crave it. His old notions dissolved in an instant, conquered by Graham’s ideas and illuminated by the way he taught.
Graham used all kinds of nifty, effective tricks in his class. He would ask paired questions, one at a time. His students thought they knew the answer to the first, but when the second came along, it made them realize that maybe they didn’t. He would put up descriptions of two companies, one in terrible shape, practically bankrupt, another in fine form. After asking the class to analyze them, he would reveal that they were the same company at different times. Everyone was surprised. These were memorable lessons on thinking independently, typical of how his mind worked.
Along with his Company A and Company B teaching method, Graham used to talk about Class 1 and Class 2 truths. Class 1 truths were absolutes. Class 2 truths became truths by conviction. If enough people thought a company’s stock was worth X, it became worth X until enough people thought otherwise. Yet that did not affect the stock’s intrinsic value—which was a Class 1 truth. Thus, Graham’s investing method was not simply about buying stocks cheap. As much as anything it was rooted in an understanding of psychology, enabling its followers to keep their