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It is better to buy a wonderful company at a fair price than a fair company at a wonderful price – Warren Buffett, 1989 Letter to Shareholders

The advent of value investing occurred with the publication of Ben Graham and David Dodd’s Security Analysis in 1934. This was the first blueprint for analyzing a security’s underlying business and determining its intrinsic value. Graham published a more popularized version of his ideas with The Intelligent Investor in 1949.

Graham emphasized buying cheap stocks from a quantitative perspective. Stocks with a low Price to Earnings or Price to Book ratios are descendants of Graham’s basic idea. Warren Buffett read The Intelligent Investor as a young man and became a Graham disciple, studying with him at Colombia University and later going to work for his investment firm in New York City. Graham’s ideas are the starting point of value investing or Value Investing 1.0.

Buffett applied Graham’s ideas in his first investment partnership in the 1950s and 1960s with extraordinary results: “Most of my gains in those early years came from investments in mediocre companies that traded at bargain prices. Ben Graham taught me that technique, and it worked” (Buffett, 2014 Letter to Shareholders).

However, Buffett eventually discovered two flaws in his cigar butt strategy. First, it wasn’t scalable. It worked well with small sums of money but wouldn’t as assets under management increased. Second, cigar butt investing was necessarily short term. Time is the enemy of the bad business and so these bargain stocks had to be sold on the first bounce – the last puff of the cigar – before the economic fundamentals caught up with them (Buffett 2014 Letter to Shareholders).

The turning point for Buffett was his relationship with Charlie Munger. The two were introduced in 1959 when Buffett was 28 and Munger 35. Munger told Buffett to forget about investing in cheap stocks and focus on quality stocks that could compound earnings over the long term. My suspicion is that Munger got this idea from Phil Fisher’s Common Stocks and Uncommon Profits (1958). If so, Fisher is the forgotten man of value investing and deserves far more credit than he receives for his contribution to the discipline.

Buffett’s investment alongside Munger in See’s Candy in 1972 was a turning point for him. The family controlling See’s wanted $30 million for the business – and Charlie said it was worth that much – but Buffett didn’t want to pay more than $25 million. Fortunately for him they accepted his offer and the future of value investing was forever improved: “Through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments” (Buffett 2014 Letter To Shareholders).

Through his investment in See’s, Buffett verified Munger’s premise that high quality companies that could compound earnings over long periods of time were superior to cheap stocks that had to be flipped quickly once their value was realized by the market. The culmination of this type of investing in Buffett’s career is his investment in Apple (AAPL) over the last decade. This has come to be known as Value Investing 2.0.

While Value Investing 2.0 continues to be the gold standard, some value investors have pushed the frontier of the discipline by finding value where traditional practitioners have not been able to see it. Bill Miller and Nick Sleep’s (with Oais Zakaria) early investment in Amazon (AMZN) is the prototype. When I was first learning value investing in the early 2000s, I invested in Mason Hawkin’s Longleaf Partners Fund. At the same time, Miller was investing in Amazon. Hawkins and other more traditional value investors couldn’t see how Amazon could possibly be characterized as a value stock as Miller claimed. It was quite expensive on traditional metrics like Price to Earnings, Price to Book, etc… But history has vindicated Miller and Sleep.

William Green tells the story of Sleep and Zakaria’s Nomad Investment Partnership and their transformative investment in Amazon in Chapter 6 of his book Richer, Wiser, Happier (2021). Sleep and Zakaria started out investing in cheap stocks a la Ben Graham – just like Buffett. But a 2002 investment in a debt ridden British bus operator called Stagecoach – in which they left a lot of money on the table – opened their eyes to a new approach. Stagecoach stock had crashed from 2 pounds and 85 pence to just 14 pence and Sleep and Zakaria figured it was worth 60 pence. They were correct and cashed out around 90 pence – 6x their original investment. But Stagecoach kept rallying and and hit 3 pounds 68 pence in late 2007. “We felt like a bit of a horse’s arse,” said Sleep. “We had framed it in our minds as only ever being a cigar butt.”

But their insight into why they had left money on the table led them to Costco and then Amazon. When they first invested in Costco in 2002, the stock had tumbled from $55 to $30 due to concerns about its low profit margins. But Sleep and Zakaria saw the long term logic of Costco’s strategy. By continually lowering prices whenever they could, Costco created enormous loyalty – even fanaticism – in its customer base. Because they always got the best value at Costco, they saw no reason to shop anywhere else. Over the long term, this resulted in far more sales and profit than if the company had tried to maximize both in the short term.

When Amazon launched Amazon Prime in 2005, which offered free two-day shipping for $79/year, Sleep and Zakaria immediately recognized what Bezos was up to. “Oh my God, I know exactly what game they’re playing here,” thought Sleep. “Amazon suddenly became Costco on speed.” Nomad started buying Amazon aggressively. At one point, it grew to 40% of the fund’s assets. From 2009 through 2013, Nomad returned 404% led by its oversized Amazon position.

In a recent podcast with William Green, the iconoclastic value investor Chris Begg, who now teaches the legendary Security Analysis course at Colombia University that Warren Buffett took with Ben Graham in the early 1950s, Begg talked about Value Investing 3.0 and used Sleep’s investment in Amazon as the paradigm case. Begg went on to suggest that Tesla may be the next iteration of this next frontier of value investing.

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