Soon after joining Newburger, Henderson & Loeb in 1914, Ben Graham grew restless. He had started his new job as a clerk, but in short order he was moved into the bond department and trained to be a salesman. But what he really wanted to do was write, not sell bonds. Despite lacking any formal training in economics or accounting, Graham began researching railroad companies, specifically railroad bonds, on his own and writing research reports.¹

One of his reports, on the Missouri Pacific Railroad, caught the eye of a partner at J.S. Bache and Company, a respectable NYSE firm. He was quickly offered a job as a statistician with a 50 percent increase in salary. Graham let Newburger know that although he felt a sense of loyalty to the firm, he was not motivated to be a salesman. Newburger countered with its own pay raise. It was not quite 50 percent but it included a sweetener: the opportunity for Graham to start his own statistical department. He decided to stay and pursue his writing at the same time.

At that time, serious investment capital was limited to buying bonds. Common stock investing was thought to be a speculative game played not on the basis of financial data but insider information. Nonetheless, Graham began writing articles for The Magazine of Wall Street, a newsletter with investment tips for stocks as well as bonds. He soon developed a following. He next published a pamphlet titled “Lessons for Investors.” In it he argued “If the market value of a stock is substantially less than its intrinsic value, it should also have excellent prospects for an advance in price.” It was the first time the words intrinsic value appeared.²

Graham left Newburger in 1923 to start his own investment firm. Two years later he hired Jerome Newman and formed the Graham‐Newman Corporation, which lasted until 1956. Graham's early investment results were promising. Much of his portfolio was hedged or in arbitrage situations, which dampened the steep losses of the 1929 stock market crash. But in 1930, Graham tiptoed back into the stock market—this time unhedged—believing stocks had bottomed. When the market dropped again, Graham, for the second time in his life, was near financial ruin.

But all was not lost. In 1927, before the crash, Graham had begun teaching a night class on investing at his alma mater. The Columbia University catalog promised that a Wall Street investment professional would be teaching Advanced Security Analysis on Monday evenings in Room 305 of Schermerhorn Hall. The class description read “Investment Theories subjected to practical market tests. Origin and detection of discrepancies between price and value.” It was in this class that Graham coined the term security analysis and replaced the Wall Street job title of statistician with a new name—security analyst.³

Graham had but one stipulation in agreeing to teach the class: someone had to be assigned to take detailed notes. David Dodd, a young finance professor with recent degrees from the University of Pennsylvania (BS) and Columbia University (MS), volunteered. Dodd's notes formed the substance for their seminal book, Security Analysis. When it appeared in 1934, Louis Rich of The New York Times wrote, “It is a full‐bodied, mature, meticulous and wholly meritorious outgrowth of scholarly probing and practical sagacity. If this influence should ever exert itself, it will come about by causing the mind of the investor to dwell upon securities rather than upon the market.”⁴

Although Ben Graham and David Dodd will be forever connected to each other through Security Analysis, they never taught a class together. In Columbia's fall semester, David Dodd taught Investment Management and Strategy for first‐year graduate students based on Security Analysis. In the spring, Graham taught a smaller, more intimate investment seminar for only 20 students. For his seminar, Graham also took the lessons from Security Analysis but with the added benefit of connecting them to stocks currently being traded. When Warren Buffett enrolled at Columbia University in 1951, he first took Dodd's class, then the next semester he sat for Graham's seminar.

Stage One: Classic Value Investing

What did Warren learn about value investing from Security Analysis and from David Dodd's and Ben Graham's classes? To begin at the beginning, the first line of the book is “Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and logic.”⁵ Graham and Dodd believed securities analysis was a scientific method in much the same way as law and medicine. But just like law and medicine, securities analysis is not an exact science. No analysis is perfectly predictable, said Graham, but if the analyst follows established, quantifiable facts and methods, the probabilities of success are greatly enhanced.

The facts Graham looked for in both stocks and bonds were those that were easily measurable and current. The methodology outlined in Security Analysis placed greater emphasis on the here and now while discounting the uncertainty of what can happen tomorrow. That which cannot be easily measured, in Graham's mind, can be badly measured and whatever is badly measured brings with it increased risk and the propensity for loss. Graham became anxious when too much emphasis was placed on the future; “speculation,” he wrote, “in its etymology, meant looking forward.” He was much more comfortable with the traditional definition of investment “allied to vested interests, to property rights and values taking root in the past.”⁶

In Security Analysis, Graham included a table to help distinguish between the forces of speculation and investment. He described the “market factors including technical, manipulative, and psychological” as speculative. At the opposite end, he aligned investment with intrinsic value factors including earnings, dividends, assets, and capital structure. Stuck in the middle, straddling both investment and speculation, Graham identified future value factors: management reputation, competitive conditions and prospects for the company, including changes to sales, prices, and costs.⁷

Clearly, we cannot totally separate intrinsic value factors from future value factors. Even so, Graham's preference for calculating value emphasized intrinsic value factors over future factors. Indeed, analysts that worked at Graham‐Newman were dissuaded from visiting and questioning management about the future prospects of their business for fear these insights would tilt too much in favor of the future factors over the intrinsic value factors. Graham even refused to look at a picture of a CEO, worrying that might prejudice his analysis if he didn't like the photo.⁸

The essence of Graham and Dodd's value investing methodology is to pay low prices in relation to current earnings, current dividends, and current assets. To the degree you purchase only companies with low prices relative to these factors, you have built a margin of safety into your purchase. Interestingly, the term margin of safety did not originate with Graham. He found it in Moody's Manual of Investments prior to 1930. “Authorities used the expression ‘margin of safety’ to mean the ratio of the balance after interest to the earnings available for interest.”⁹ Indeed, when Graham called for a margin of safety in the analysis of stocks, he applied the same methodology he used in analyzing bonds. There is a “close similarity between the techniques of investing in common stocks and that of investing in bonds,” he wrote, “The common‐stock investor also [wants] a stable business and one showing an adequate margin of earnings over dividend requirement.”¹⁰

Graham reasoned the larger the margin of safety, the less downside risk the investor would face in the event of a market sell‐off or deteriorating future prospects. He believed the greatest danger for investors was paying too high a price for earnings, dividends, and assets. He cautioned investors to look beyond the obvious. The danger of overpaying can be found not only with good companies but also with low‐quality companies that were priced high because business conditions were currently favorable but not permanent.

At the heart of value investing stand two golden rules. Rule number one is Don't lose. Rule number two is Don't forget rule number one. Graham's rule: A large margin of safety—the difference between a company's current prospects and its stock price—is critical to avoiding the financial damage he himself experienced in the stock market.

In Security Analysis, Graham drew a difference between market analysis and security analysis. “Security analysis has several advantages over market analysis, which are likely to make the former a more successful field of activity for those with training and intelligence.” Graham believed market analysis was “essentially a battle of wits” played against other like‐minded investors all trying to guess what the stock market is going to do over the short term. In this game, there is no hedge. “In market analysis, there is no margin of safety; you are either right or wrong, and if you are wrong you lose money.”¹¹

The margin of safety concept is unquestionably a smart strategy. It is almost the perfect hedge to investing. Buying a common stock at a large discount to your calculation of intrinsic value can give you a handsome return if all works out well but also limits your losses if the future turns out unexpectedly. But that's not all. In addition to providing positive returns, the margin of safety is also an intellectual psychological investment, an investment in temperament that makes achieving profitable returns possible.

The additional benefit of using the margin of safety is that it strengthens an investor's resolve to hold steadfast against the market's inherent short‐term volatility. In Chapter 2 we pointed out how important it is for investors to remain indifferent to the market's emotional whirlwinds. Knowing the value of your investment, knowing you have the cushion of a large margin of safety, strengthens your fortitude. Operating with a margin of safety emboldens investors to act with the Stoic attitude they need to protect themselves while riding the emotional roller‐coaster that is the stock market.

A few paragraphs ago I described the margin of safety as almost the perfect hedge. That means it is not always the perfect hedge. Graham believed if glamorous projections for future growth went unfulfilled it was far better to focus on current assets, even if they were not generating much of an economic return, because someone, somewhere, somehow would squeeze out a decent return even from a poorly operating business. As a last resort, the assets could be liquidated. Of course, this presupposed that someone would always stand ready to buy the book value of bad companies.

A few years later, Warren Buffett learned firsthand why Graham's approach was not foolproof. He discovered that the price he received for selling the book value of poor economic companies that Berkshire owned was often less than desirable.

Using Graham's investment method of buying the common shares of companies, Warren accumulated several businesses for the newly reconstructed Berkshire Hathaway. Although buying cheap stocks of bad businesses during the partnership years worked out well, largely because Warren could quickly sell them and move on, he came to learn that buying and holding cheap assets of bad businesses for Berkshire was a failed strategy. “My punishment,” he said, “was an education in the economics of short‐line farm implement manufacturers, third‐place department stores, and New England textile manufacturers.”¹²

The farm implementation company was Dempster Mill Manufacturing, the department store was Hochschild Kohn, and the textile manufacturer was Berkshire Hathaway. Although Warren had the benefit of owning these companies outright, thereby in charge of capital allocation, the economic returns of these subpar businesses were, in a word, miserable. It was only when Warren, with Charlie's urging, bought See's Candies did he begin to appreciate the economics of a better business. “Charlie and I have found that making silk purses out of silk is the best we can do; with sow's ears, we fail. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.”¹³

In the early 1970s, Berkshire Hathaway owned a company called Diversified Retailing, which in turn owned a company called Blue Chip Stamps. Charlie via his investment partnership also owned Blue Chip Stamps. The company provided supermarkets and gasoline stations with trading stamps to give to their customers, who collected them in books that were later exchanged for merchandise. Like an insurance company, the unredeemed stamps were a form of float, which allowed Blue Chip Stamps to purchase other businesses, including a savings and loan, a newspaper, and a partial interest in a candy company—See's Candies, a West Coast manufacturer and retailer of fine boxed chocolates.

In 1972, Blue Chip Stamps was in a position to purchase the entire business of See's Candies from the founding family. The asking price was $40 million, which included $10 million on the balance sheet. See's had only $8 million in tangible assets, earning $4 million pretax annually. Charlie thought the deal was reasonable but Warren was not so sure. He noted the asking price was three times tangible assets, a price Ben Graham would have surely disapproved. Warren offered $25 million, still thinking he might have overpaid.

Looking back, we can now see that Warren did not overpay for See's Candies. Indeed, See's will go down in Berkshire history as one of the businesses with the highest economic returns. According to Will Thorndike, founding partner of Housatonic Partners and author of the popular book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, between 1972 and 1999 (the last year Berkshire segmented See's Candies earnings) See's generated a 32 percent internal rate of return (IRR). “Remarkably, the IRR was both unlevered and without a terminal value,” Will noted. “If you doubled the purchase price and held everything else constant including cash flow and time period, the IRR was 21 percent. Incredible.”¹⁴

In the 2014 Berkshire Hathaway Annual Report, Warren updated shareholders on the See's investment. Over the 42 years, See's Candies returned to Berkshire $1.9 billion in pretax earnings, requiring only $40 million in additional capital investment. And the See's earnings were redeployed over the subsequent years, allowing Berkshire to buy other companies that, in turn, produced even more profits. It was like watching “rabbits breeding,” said Warren.¹⁵

The lessons Warren learned from the See's acquisition were threefold. First, based on Graham's method of purchasing stocks, See's Candies was not overvalued but significantly undervalued. Second, from the experience of purchasing See's, Warren gained the insight that paying a high multiple for even a slow‐growing company is a smart investment if the capital is rationally allocated. Lastly, he said, “I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments.”¹⁶

When Warren purchased See's Candies, he stepped away from Graham's stringent rule of buying only stocks with prices low in relation to earnings, dividends, and current assets. It is now understood as a significant turning point. The See's experience is in large part what motivated Warren to purchase other consumer products companies with strong brand value. Like The Coca‐Cola Company.

When Berkshire purchased Coca‐Cola in 1988, the stock was trading at 15 times earnings and 12 times cash flow, a 30 percent and 50 percent premium to the market averages. Warren paid 5 times book value for the stock. Those raised on the strict principles of value investing taught by Ben Graham howled. Warren, they cried, had turned his back on the master.

In 1989, Berkshire owned 7 percent of the outstanding shares of Coca‐Cola. Warren invested one third of Berkshire's portfolio in the company, a $1 billion bet. Ten years later, Berkshire's investment in Coca‐Cola was worth $11.6 billion. The same investment in the S&P 500 Index over the same time period was worth $3 billion. Was Warren's purchase of Coca‐Cola a value investment? Or did he bow to the growth camp of investing, which during the 1990s had the support of the market's momentum?

Warren asks us to consider, how should we determine what is an attractive investment? Most investors, he said, choose between two customary approaches—“value” and “growth” investing—as if the two concepts are, by design, mutually exclusive. “Most analysts feel they must choose between the two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross‐dressing.”¹⁷

“Value investing,” Warren explains, “typically connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price–earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and therefore is truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics—a high ratio of price‐to‐book value, a high price‐to‐earnings ratio and a low dividend yield—are in no way inconsistent with a value purchase.”¹⁸

The above paragraph, which appears on page nine in the 1992 Berkshire Hathaway Annual Report, in 102 words crystallizes Warren's sense of value investing. For him, value investing is not exclusively buying companies with low price‐to‐earnings ratios; neither is a value investor precluded from buying companies with high price‐to‐earnings ratios.

Warren did admit to suffering “fuzzy thinking” from the growth versus value debate when he was much younger. But he now understands “the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”¹⁹

In 1992, Warren publicly moved away from Ben Graham in one respect—not from Graham's fundamental investment philosophy, which emphasizes buying stocks with a margin of safety and nurturing the necessary temperament, but from the simple accounting‐factor methods Graham used to identify value. Which then leads to an important question: what good are low price accounting factors in identifying value?

The essence of classical value investing (hereby defined as the methodology outlined by Graham and Dodd) is to locate low‐valuation stocks that are down in price because investors have overreacted to recent bad news. Likewise, classic value investors believe this same overreaction can occur with popular growth stocks that are bid up in anticipation of better things to come. In their eyes, stocks that are priced high relative to current earnings are overvalued.

At the heart of value investing lies a contrarian spirit. Value investors are driven to buy what the market is selling and sell what the market is buying. Indeed, the success of classic value investing rests on the concept of mean reversion, whereby low‐priced stocks eventually go up while high‐priced stocks eventually decline. On the cover page of Security Analysis, Graham inserted a quote from the Roman lyric poet Quintus Horatius Flaccus, known as Horace: “Many shall be restored that are now fallen and many shall fall that are now in honor.”

However, Warren eventually learned a painful lesson: “What is required is thinking, rather than polling.”²¹ Over the years, classic value investing outlined by Graham and Dodd has been defended and promoted by leading academicians including Eugene Fama and Kenneth French. Their widely read and cited papers helped to launch and give credence to hundreds of value investment firms. Soon everyone who referred to themselves as a value investor was buying stocks with low prices‐to‐book value, earnings and dividends while avoiding high‐multiple stocks. Warren did exactly the same, until his actual experience of owning wholly controlled business purchased at low prices based solely on these metrics sometimes generated poor economic results for Berkshire.

What slowly became evident to Warren Buffett 30 years ago is today troubling the classic value camp. Since the 2008 financial crisis, classic value stocks have dramatically underperformed the higher‐multiple growth stocks. The persistence of this relative outperformance has now lasted for over 10 years. Classic value investors have bemoaned their plight, steadfastly arguing that once value investing returns they will again have their day in the sun. Many of them liken the underperformance of classic value stocks to the period in the late 1990s when growth stocks, on the back of the technology and internet revolution, substantially outperformed their slower‐growing classic value stocks. Value investors claim it is only a matter of time before the growth charge of outperformance will necessarily end badly as it did during the 2000–2002 bear market.

But there are fundamental differences between the technology companies of late 1990s and growth companies today. The price momentum of the growth stocks in the late 1990s was accompanied by little underlying economic fundamental support. At that time, investors were tabulating eyeballs, not earnings, to justify valuations. Unfortunately, the prices paid for eyeballs became grossly overvalued largely because those eyeballs did not translate into earnings. Today, however, we can measure the outperformance of growth stocks by clearly tabulated sales, earnings, and cash flows. A second important difference between today and 2000 is interest rates. The 10‐year U.S. Treasury note yield was 6.00 percent in 2000. Today, it's less than 1.00 percent. Lower interest rates increase the value of stocks, particularly growth stocks.

There are now notable thinkers who are confronting this persistent tug‐of‐war between the performance of value stocks and growth stocks. In a widely circulated and thoughtful analytical paper, “Explaining the Demise of Value Investing”, Baruch Lev at New York University's Stern School of Business and Anup Srivastava at the University of Calgary's Haskayne School of Business argue there is a perfectly reasonable and economically defensible reason why classic value stocks have struggled to outperform the market, a market that is increasingly becoming weighted to the faster‐growing growth companies.²²

Lev and Srivastava note that since the birth of value investing, marked by the publication of Security Analysis, the investments made by corporations were primarily in plant, property, and equipment. Tangible assets are defined by physical structures, largely brick and mortar. Accounting rules dictate the capitalization of these tangible assets must be fully reflected on a company's balance sheet net of depreciation charges. Accordingly, from the broad swath of American businesses, most were largely defined by their book value. By their calculation, Lev and Srivastava note the median market‐to‐book ratio of public companies hovered around 1.0 until the mid 1980s. In that world, the market value of a company reflected by its price being either higher or lower than its book value was a reflection of whether a stock was over‐ or undervalued.

However, in the 1980s, American business models began to change. The investment made in tangible assets—plant, property, and equipment—which had defined the growth of corporations since the Industrial Revolution was now giving way to the investment in intangible assets including patents, copyrights, trademarks and brand marketing. Whereas tangible assets are defined by physical properties, intangible assets are defined by intellectual property. Because accounting rules are still rooted in the industrial era, companies must immediately expense all intangible investments. In short, investments in intangible assets do not add to book value. Although it can be argued intangible investments do work to increase a company's intrinsic value, nowhere is this investment tabulated in the Graham and Dodd approach.

Lev and Srivastava note that since 1980, there has been a steady decline in the amount of money companies invest in tangible assets and a corresponding steady increase in the money invested in intangible assets. In the mid 1990s, the rate of growth of intangible investing surpassed the growth in tangible investing. “Currently in the U.S., the intangible investment rate of the corporate sector is roughly twice that of the tangible investment rate and it keeps growing.”²³

What does this mean for classic value investors? Simply put, a company that invests in intangible assets must subtract this cost from current earnings while not adding the investment to book value, which in turn makes a stock with a high price‐to‐earnings and a high price‐to‐book value appear expensive. But if one were to shift the valuation methodology from Generally Accepted Accounting Principles (GAAP) to the economic earnings of adjusted cash flow and return on capital, companies that look expensive from a GAAP perspective may actually appear attractive to an investor with a business‐owner mindset.

What should not be lost is that Warren's revelation as a value investor coincided with his actual experience of owning companies decades before academicians finally reached the same conclusion. In this instance, we can say Warren's a posteriori knowledge based on his experience of owning businesses outwitted the a priori reasoning of financial mathematicians.

While classic value investors continue to pine for the good old days, Lev and Srivastava warn that better news may not be forthcoming. Examining the enterprise profitability of large value stocks compared to the returns of growth stocks, they discovered that the median return on equity (ROE) and the median return on net operating assets (RNOA) could not be more different. Whereas the growth stocks have achieved their highest profitability in the past 10 years, the classic value stocks have sustained their worse level of profitability in over 50 years. What makes matters worse, the profitability needed to help classic value stocks invest in innovation and growth in order to improve their economic performance is lacking. Without the internal funds from operations needed to invest in higher‐returning projects, these classic value stocks are now trapped in their own low valuations. The margin of safety evidenced by the difference between price and current assets may at first look attractive but in reality many of these stocks are value traps.

On a side note, and recently cited, Eugene Fama and Kenneth French, who gained fame by introducing the Fama French Model in 1992, are now revisiting their previous assumptions. Fama and French claimed 28 years ago that value stocks, defined as low price‐to‐book‐value companies, exhibited a “value premium” which drove their excess returns above the stock market. From 1963 to 1991, large‐cap value stocks exhibited a 0.42 percent premium, leading to their outperformance over this time period. However, between 1991 and 2019, the value premium dropped to 0.11 percent, largely negating the relative outperformance of low price‐to‐book‐value stocks.²⁴

This data shows that the excess performance of value stocks, based on price‐to‐book ratios, has effectively declined over the last nearly 30 years, coinciding with Lev and Srivastava's observations as well. Professors Fama and French have reserved reaching a final conclusion. As French explained, “28 years of data on falling returns is not enough to determine whether the value factor has actually stopped working. It simply [could have] experienced a long run of bad luck.”²⁵

Ben Graham deserves all the high praise for his value formulas that worked exceptionally well for the better part of 50 years. He helped investors thoughtfully navigate the stock market when there were no navigational instruments. But today, the best we can say about Graham and Dodd accounting‐factor multiples is that they are value markers. They represent the market's expectations for a stock. A high stock price relative to earnings or book value is a reflection of high investor expectation for a stock, while conversely a low price to earnings or book value reflects low expectations. However, we cannot determine whether or not a stock is mispriced merely by tabulating a simple ratio.

Michael Mauboussin, head of Consilient Research at Counterpoint Global, noted author of several books and adjunct professor of business at Columbia University, wrote an important research paper, “What Does a Price‐Earnings Multiple Mean; An Analytical Bridge between P/Es and Solid Economics.” It has helped to clarify the persistent confusion of using price‐to‐earnings multiples for valuation purposes.²⁶ Mauboussin points out that P/E ratios remain the primary tool analysts use to value stocks. A recent survey from a sample group of 2,000 investors found that 93 percent use multiples for valuation, with the overwhelming majority using P/E ratios. But Mauboussin is quick to point out the problem. “Multiples are not valuation. They are shorthand for the process of valuation.”²⁷

Investors simply don't spend enough time understanding what the price‐to‐earnings multiple means, explains Mauboussin. You have to reconcile how a multiple may actually miscalculate the current business model as well as the possibility the current multiple may change in the future. To make his point, Mauboussin loops in Aswath Damodaran, a professor of finance at the Stern School of Business at New York University and a leading expert on valuation. Damodaran says, “There's nothing wrong with pricing. But it's not valuation. Valuation is about digging through a business, understanding the business, understanding the cash flows and risk, and then trying to attach a number to a business based on the value of a business. Most people don't do that. They price companies. The biggest mistake in valuation is mistaking pricing for valuation.”²⁸

After Warren clarified his views on value investing as it relates to price‐to‐earnings ratios, he identified in clear language the critical variables investors must focus on to determine business valuation. “Leaving the question of price aside,” he wrote, “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is the one that must or will do the opposite—that is, consistently employ ever‐greater amounts of capital at very low rates of return.”²⁹ In Warren's Money Mind, it is always about the compounding. Most importantly, it is about value‐creating, compounding companies.

To better appreciate the valuation differences between businesses with a high return on capital versus those with low return and their impact on price‐earnings multiples, we need to return to Michael Mauboussin. In 1961, finance professors Merton Miller and Franco Modigliani published a paper titled “Dividend Policy, Growth, and the Valuation of Shares.” Mauboussin believes this paper “ushered in the modern era of valuation.”³⁰ Miller and Modigliani asked a rather simple question: “What does the market really capitalize?” They measured earnings, cash flows, the future opportunities to create value, and dividends. What did they learn? Surprisingly, all these measures collapsed into the same model. The value of a stock, they determined, is the present value of the future free cash flows. But it was what they did next that most warrants our attention.

To help investors grasp the valuation impact of future cash flows, Miller and Modigliani offer a formula that breaks down a company into two parts. The value of a firm (stock, business) is equal to “steady‐state value + future value creation.” They define the steady‐state value of a company as being equal to the net operating profit after tax (normalized) divided by the cost of capital plus additional cash. Mauboussin explains, “The steady‐state value of a firm, calculated using the perpetuity method, assumes the current net operating profit after tax (NOPAT) is sustainable and that incremental investments will neither add, nor subtract, value.”³¹

Turning to future value creation, Miller and Modigliani calculate a company's future value as the investments the company makes multiplied by its return on capital minus the cost of capital times the competitive advantage period over the cost of capital. Said differently, the positive future value creation of a business becomes the cash it produces over time but only if the cash return as a percentage return on the company's invested capital is above the cost of that capital. Yes, this is a mouthful. But Miller and Modigliani are simply tabulating the same thing Warren has stated. The best business to own, the one that will create the most future value, is a company that generates high returns on incremental capital (above the cost of that capital) and then reinvests the cash profits back into the company to continually generate a high return on capital for an extended period of time.

Most important, Mauboussin thoughtfully helped his students appreciate Miller and Modigliani's future value creation returns as it relates to price‐to‐earnings multiples. The central thesis being that a company that earns on investment above the cost of capital creates value. A company that earns on investment below the cost of capital destroys shareholder value. And a company that generates returns equal to the cost of capital neither creates nor destroys shareholder value no matter how fast or slowly it grows.³²

Rarely do investors ever think a faster‐growing business can actually destroy their investment. But consider the following calculations: Assuming an 8 percent cost of capital, all equity financed for a period of 15 years, Mauboussin tells us a company that earns 8 percent return on capital is worth a 12.5 price‐to‐earnings multiple. And no matter whether the company grows at 4 percent per year or 8 percent or 10 percent, its multiple remains the same. But a company that earns only a 4 percent return on invested capital against a cost of capital of 8 percent is worth only 7.1 times earnings at a 4 percent growth rate or a 3.3 multiple for a 6 percent growth rate, and then summarily begins destroying shareholder value the faster it grows. Finally, a company that earns 16 percent on invested capital with an 8 percent cost of capital is worth 15.2 times at a 4 percent growth rate, 17.1 times for a 6 percent growth rate, 19.4 times for a 8 percent growth rate, and 22.4 times for 10 percent growth rate.

In a nutshell, when a company earns above the cost of capital, the faster it grows the more valuable it becomes. The lesson here is a rapidly growing company with a high price‐earnings ratio can actually be a terrific value proposition if its cash returns on capital exceed its cost of capital.

When valuing stocks, if we first begin with a company's cash return, its return on capital and its growth rate, what can we say about price‐to‐earnings multiples? One thing is for sure, it is not a simple‐minded claim that stocks with a high price‐to‐earnings ratio are overvalued while those with a low price‐to‐earnings ratio are undervalued. The next time an analyst or media commentator tells you a stock is selling for x times earnings per share, you should immediately be wondering how much actual cash does the company generate? What is the company's return on invested capital compared to its cost of capital? Finally, what is the future growth rate of these cash flows and how long will these returns last?

Classic value investors need to keep Michael Mauboussin, Aswath Damodaran, Merton Miller, and Frances Modigliani as well as Baruch Lev and Anup Srivastava in the forefront of their mind as they make a determination of the economic vitality of their companies, even those companies sporting low price‐to‐earnings‐ratios.

Stage Two: Valuing a Business, Not a Stock

The tug of the war between calculating how much intrinsic value should be determined by present factors and how much by future factors is at the root of the evolutionary development of value investing. It's what moves us from Stage One to Stage Two.

Graham emphasized the present over the future. When Warren was captain of the Buffett Partnership, Graham's present factors were the navigation maps needed to reach his goal. But when he changed ships and began to steer his new vessel, Warren had to think about the future compounding factors needed to increase the value of Berkshire. He needed a new map. In doing so, Warren turned his attention to understanding the competitive position of companies, the future prospect of sales, earnings, and cash returns of these companies. And importantly, he focused on management's ability to allocate capital in order to maximize the compounding effect that comes with value creation.

To help us better appreciate the differences between booking the present and perhaps modest opportunity, over a future but greater investment return, Warren shared a surprising investment primer—the very first lesson written by Aesop the Greek storyteller 2,600 years ago.³³ In “The Hawk and the Nightingale,” Aesop tells of a hawk who sets out to search for food one sunny afternoon when he spots a nightingale sitting on a branch. The hawk swoops down and quickly clutches the nightingale with its claws. The tiny nightingale turns to plead for his life; “I am such a tiny bird, I won't be able to satisfy your hunger.” The hawk laughs. “Why should I let you go? It's always better to eat what you have than seek a larger catch that I have not yet caught.” At that moment, the hawk made an investment calculation Aesop summarized as “a bird in hand is worth more than two in the bush.”

But according to Warren a bird in hand is not always worth more than two in the bush until you have answered three important questions. First, “How certain are you that there are indeed birds in the bush?” Second, “When will they emerge and how many will there be?” Lastly, “What is the risk‐free interest rate?”³⁴ Mathematically speaking, Warren tells us if there are two birds in the bush and it takes us five years to retrieve them with interest rates at 5 percent, then we should bet on the bush, for it provides a 14 percent compounded annual return.³⁵ Warren notes “Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to farms, manufacturing plants, bonds, and stocks.”³⁶

Setting aside for a moment the question of interest rates (which is not inconsequential, as higher interest rates can make an investment proposition unwise), let's focus instead on the first two questions: How certain are we there will be two birds in the bush and when exactly can we expect to get them? As this relates to stocks, Warren tells us “an investor needs some general understanding of business economics as well as the ability to think independently to reach well‐founded conclusions.”³⁷

The time Warren spent attending Columbia University and studying with David Dodd and Ben Graham and even the two years he spent with Graham‐Newman did little to advance his understanding of long‐term business strategies and economic compounding. It wasn't part of the curriculum. Warren's eventual education in the inner workings of a company and management decision‐making came from the school of hard knocks. The actual ownership of long‐term businesses purchased by Berkshire left an indelible impression on Warren's thinking. It was real‐life experiences, the kind of lessons that a college course and textbook could never fully explain.

In 1965, the Buffett Partnership took over the management of Berkshire Hathaway on the heels of a successful proxy battle for control. That year Warren added the responsibilities of an operating manager of a textile company to his position as general partner of his investment partnership. Even though Kenneth Chase had been appointed president of the company, replacing the outgoing Seabury Stanton, for all practical purposes Warren was overseeing Berkshire; he even wrote the company's annual report.

Ben Graham had long since moved on from Wall Street. He was living comfortably in California, no longer interested in investing. Charlie Munger, Warren's newfound friend, was in the early years of his own investment partnership. Although Warren and Charlie stayed in touch, the cement that bonded their partnership was still several years away. Warren was running solo and for the first time in his life he was in charge of a publicly traded company with stockholders' equity of $22 million. But he was not alone.

In 1958, Common Stocks and Uncommon Profits by Philip Fisher was published. Warren read the book and a few years later went to visit Fisher. “I sought out Phil Fisher after reading his book. When I met him, I was as impressed by the man as by his ideas.”³⁸ Phil Fisher also took an instant liking to Warren. When asked, he usually agreed to meet with up‐and‐coming investment professionals at least once, but rarely twice. Fisher divided people into two buckets; you got either an A or an F. Warren was one of the rare investors who got not only a second meeting but several thereafter. Phil Fisher was always proud he tagged Warren with an A long before his well‐deserved fame.³⁹

What did Fisher see in the young Warren Buffett? He was particularly impressed with how Warren evolved as an investor over the years without compromising his core principles—integrity, temperament, and an insistence on a margin of safety in his purchases. Most professional investors, Fisher noted, learn one craft, one approach to investing. For example they only buy stocks with low price‐to‐earnings ratios. They continue to build their craft but never change. In contrast, he watched Warren Buffett continue to evolve decade after decade.

For example, Fisher pointed out that no one would have predicted that Warren, with his original training in value investing, would invest in franchise media stocks in the 1970s. But what happened? Throughout the 1970s, Warren added The Washington Post Company, Knight‐Ridder Newspapers, Capital Cities Communications, and American Broadcasting Company to Berkshire's portfolio. Nor, added Fisher, based on Warren's previous approach would they have predicted that in the 1980s he would be buying consumer‐brand value stocks sporting above‐average P/Es. Yet Warren began to populate Berkshire's portfolio with some of the best consumer‐product companies in the world—General Foods, R.J. Reynolds, The Gillette Company, and The Coca‐Cola Company. In Warren's mind, these stocks were cheap based on off‐balance‐sheet analysis. The brand value of these companies were worth billions but carried on the books at $1. It was clear to Warren there was more value in the intangible assets of these companies than cash, inventory, and real estate.

It was Warren's ability to change and to do it successfully that impressed Fisher. Most people who attempt to evolve, fail. Warren didn't fail, Fisher said, because he remained true to himself and never lost sight of who he was and where he was going.

For his part, what did Warren learn from Phil Fisher? It turns out, a lot.

While Ben Graham was teaching advanced security analysis at Columbia, Phil Fisher was beginning his career as an investment counselor. After graduating from Stanford's Graduate School of Business Administration, Fisher began work at the Anglo London & Paris National Bank in San Francisco. In less than two years, he was made head of the statistical department. Sound familiar? Fisher weathered the 1929 stock market crash, then undertook a brief career with a local brokerage firm before starting his own counseling firm. On March 31, 1931, six years after the launch of the Graham‐Newman Corporation, Fisher & Company began soliciting clients.

At Stanford, one of Fisher's business classes required him to accompany his professor on periodic visits to companies in the San Francisco area. The professor would get the business managers to talk about their operations, and often helped them solve an immediate problem. Driving back to Stanford, the student and the professor would recap what they observed about the companies and managers they had visited. “That hour each week,” Fisher later said, “was the most useful training I ever received.”⁴⁰

What Fisher learned from interviewing management and learning about their company's successes and challenges was applied to the investment process at Fisher & Company. At the core, Fisher believed superior long‐term profits came from investing in companies with above‐average economic potential and the most capable management. To isolate these companies, Fisher developed a point system that qualified a company according to the characteristics of its business and management. That point system became Chapter 3 of his landmark 1958 book Common Stocks and Uncommon Profits and Other Writings. No doubt Warren carefully studied Chapter 3, which is titled “What to Buy—The Fifteen Points to Look For in a Common Stock.”

The one characteristic that most impressed Fisher was a company's ability to grow sales and profits over the years at rates higher than others in its industry. In order to do so, Fisher believed a company needed to “possess products or services with sufficient market potential to make possible a sizable increase in sales for at least several years.”⁴¹ Fisher's approach helped to further reinforce Warren's deep appreciation of compounding sales and earnings alongside the importance of a product's brand value in driving repeated consumer purchases year after year.

Fisher also believed superior investment returns were rarely obtained by investing in marginal companies. Those companies can produce adequate profits during expansion periods but see their profits decline rapidly during difficult economic times. Warren was already learning firsthand the dismal returns of marginal companies owned by Berkshire.

Fisher was also sensitive to a company's long‐term profitability. He was attracted to companies that could grow into the future without requiring additional financing. Fisher knew if a company is only able to grow by issuing equity, the increase in the number of shares outstanding would cancel out any benefit that stockholders would receive from the company's growth. We will learn in the next chapter, “Business‐Driven Investing,” that the key for investors is to not focus solely on companies that are growing overall sales and earnings but to find those that are able to do so without issuing additional common shares.

Fisher was aware that superior companies possess not only above‐average business economics but, equally important, are directed by people who possess above‐average management capabilities. Fisher asked, Does the business have a management of unquestionable integrity and honesty? Do the managers behave as if they are in partnership with the stockholders, or does it appear they are only concerned with their own well‐being? One way to determine management's intention, he said, is to observe how management communicates with its shareholders. All businesses, good and bad, will experience a period of unexpected difficulties. Commonly, when business is good, management talks freely; but we learn more when business declines. Fisher asks, Does management talk openly about the company's difficulties or does it clam up? How management responds to business difficulties, he said, tells you a lot about who is running the company.

Students of Warren Buffett can easily make the connection between Fisher's teachings and how Warren himself has learned to distinguish between good and bad managers. Additionally, we see Fisher's counsel of how managers ought to behave reflected in Warren's own behavior as the manager‐partner of Berkshire.

Fisher also believed that to be successful, investors should invest only in companies that are well within an investor's ability to actually understand what the company does and how it generates profits for its shareholders. This is echoed in Warren's popular adage that investors should invest only within their “circle of competence.” Fisher said that his early mistakes came from attempting “to project my skill beyond the limits of experience. I began by investing in outside industries which I believed I thoroughly understood but did not have comparable background knowledge.”⁴²

To show people how to strengthen and expand their circle of competence Fisher outlined in his book a random inquiry approach to gathering information he called “scuttlebutt.” In Common Stocks and Uncommon Profits Chapter 2 is titled “What ‘Scuttlebutt’ Can Do.” The chapter is only three short pages, but its message to investors was commanding. And I am sure when Warren read those three pages he broke out into a smile because it was the same advice he got when he was eleven years old reading Minaker's book One Thousand Ways to Make $1000—“read everything published about the business you intend to start, to get the combined experience of others, and begin your plans where they left off.”

It is understood, said Fisher, that investors must read the financial reports of their companies, but that this research by itself is not enough to justify an investment. The essential step to prudent investing is to uncover as much as possible about the company from people who are familiar with the company. Think of it as a kind of business grapevine. Fisher's scuttlebutt investigation led him to interview customers and vendors. He sought out former employees as well as consultants who had worked for the company. He contacted research scientists in universities, government employees, and trade association executives. He also interviewed competitors. “It is amazing,” Fisher said, “what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross section of the opinions of those who in one way or another are concerned with any particular company.”⁴³

Another investment principle Fisher imparted to Warren was to not overstress diversification. Although Fisher admitted diversification was widely acclaimed, he believed having too many eggs in too many baskets actually increased the risk of a portfolio. It never occurs to an advisor, he explained, that owning a stock without sufficient knowledge of the company, its products, and management team may be more dangerous than having what is thought to be inadequate diversification.

The differences between Graham and Fisher are apparent. Graham, the quantitative analyst, emphasized only those factors that could be measured with certainty: fixed assets, current earnings, and dividends. Graham did not interview customers, competitors, or managers. As we know, this playbook worked fine for Warren while managing the Buffett Partnership. But when he was running Berkshire, he required different thinking, a different education.

Fisher, the qualitative analyst, emphasized those factors that he believed increased the future value of a company: the competitive strategy of the company and management capabilities. To guide him toward compounding the future value creation of Berkshire, Fisher's book was like the postgraduate education Warren needed. It came at the right time from the right person.

The education of Warren Buffett is best understood as a synthesis of two distinct investment philosophies from two legendary investors. “I'm 15 percent Fisher and 85 percent Benjamin Graham,” he once said.⁴⁴ But that was in 1969. Ahead for Berkshire was the purchase of See's Candies, The Washington Post Company, Capital Cities, and The Coca‐Cola Company. “Although [their] investment approach differed,” said Warren, they “parallel in the investment world.” More important to him was the personal dimension. “Much like Ben Graham, Fisher was unassuming, generous in spirit and an extraordinary teacher.”⁴⁵

There was, however, one important lesson Graham provided for Warren that was lacking from Phil Fisher's teachings—how to think about valuation and the criticality of always operating with a margin of safety. To this day, the margin‐of‐safety concept is of paramount importance for successful investing. It is, quite simply, nonnegotiable. But since buying stocks with low prices relative to earnings, book value, and dividend had been disqualified as valuation signals, Warren was left to take one more investment course to determine how to accurately value a stock.

John Burr Williams, an American economist, was born in Hartford, Connecticut, on November 27, 1900. He was educated at Harvard University where he studied mathematics and chemistry. Williams was drawn to investing and enrolled at Harvard Business School in 1923. He soon discovered that to be a good statistician, he also had to be a good economist, so he returned to Harvard in 1932 for a PhD in economics. His goal: to learn what had caused the 1929 Wall Street crash and the economic depression of the 1930s.

John Burr Williams had the great fortune to study with Joseph Schumpeter, an Austrian economist who had recently immigrated to the United States. Schumpeter would become famous for his book Capitalism, Socialism, and Democracy and for introducing the concept of “creative destruction.” Williams signed up for Schumpeter's class “Economic Theory,” and when it came time to choose a topic for his doctoral dissertation, he sought Schumpeter's advice. Schumpeter suggested “the intrinsic value of a common stock” would fit Williams' background and experience. Williams later commented that perhaps Schumpeter had a more cynical motive: The topic would keep Williams from “running afoul” of the rest of the faculty, “none of whom would want to challenge my own ideas on investments.”⁴⁶

Before winning faculty approval for his dissertation and to the great indignation of several professors, Williams submitted his work to Macmillan for publication. They declined. So did McGraw‐Hill. Both felt the book was too long and had too many algebraic symbols. Finally, in 1938 Williams found a publisher in Harvard University Press, but only after he agreed to pay part of the printing cost. Two years later, Williams took his oral exam and, after some intense arguments over the causes of the Great Depression, passed.

Williams' book, The Theory of Investment Value, was published four years after Graham and Dodd published Security Analysis. In his book, Williams proposed an idea. The intrinsic value of an asset should be calculated using “the evaluation by the rule of present worth.” Today, in finance, present worth is known as net present value (NPV) and is calculated as the value of an expected future income stream determined on the date of valuation. In The Theory of Investment Value, Williams suggested the intrinsic value of a common stock is the present value of its future net cash flows, in the form of dividends. Williams' model is called the dividend discount model (DDM).

For Warren, the appeal of John Burr Williams and his book resides in two important concepts. First, Williams referred to dividends as future coupons. This connects neatly to Warren's viewpoint that his company's profits each year were a form of coupon paid to Berkshire. Second, and very important, Williams linked his idea of the present value of future net cash flows to the margin‐of‐safety concept Warren learned from Graham.

Although Williams did not use the term “margin of safety,” he did write this: “Investment value, defined as the present worth of future dividends, or future coupons and principal, is of practical importance to every investor because it is the critical [italics his] value above which he cannot go in buying and holding, without added risk. If a man buys a security below [italics his] its investment value he need never lose, even if its price should fall at once, because he can still hold for income and get a return above normal on his cost price; but if he buys it above investment value his only hope of avoiding a loss is to sell to someone else who must in turn take the loss in the form of insufficient income. Therefore all those who do not feel able to foresee the swings of the market and do not wish to speculate on the mere changes in price must have recourse to estimates of investment value to guide them in their buying and selling.”⁴⁷

In many ways, John Burr Williams was channeling Ben Graham back to Warren—two renditions of the same essential concept: how to think about purchasing common stock below intrinsic value while avoiding purchasing stocks above intrinsic value. But instead of using accounting‐factor multiples (price‐to‐earnings, price‐to‐book value), Williams gave Warren a different method: calculating the net present value of the future profits of a business. It was perfect. It coincided with what Warren was doing at Berkshire and it was exactly what he needed to move forward.

In 1992, the same year Warren disavowed the low P/E method of picking stocks, he introduced John Burr Williams to the Berkshire shareholders. In that year's annual report, he wrote (including the italics), “In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at the appropriate interest rate—that can be expected to occur during the remaining life of the asset.” Warren, speaking for himself, continues: “The investment shown by the discounted‐flows‐of‐cash calculation to be the cheapest is the one that the investor should purchase—irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low price to its current earnings and book value.”⁴⁸

Although John Burr Williams' theory is elegant and mathematically correct, it is far from simple to calculate. As Warren has said, “Every business is worth the present value of its future free cash flows and if you could tabulate all the money a company will disgorge between today and judgment day you would get a precise figure.”⁴⁹ But therein lies the challenge. “A bond has a coupon and maturity date that define future cash flows; but in the case of equities,” said Warren, “the investment analyst must himself estimate the future coupons.”⁵⁰

Williams recognized the same challenge. In Chapter 15 of The Theory of Investment Value, titled “A Chapter for Skeptics,” Williams writes “Are long‐range forecasts too uncertain?” He admits no one can possibly look into the future with certainty. Even so, Williams asks, “Does not experience show that careful forecasting—or foresight as it is often called when it turns out to be correct—is very often so nearly right as to be extremely helpful to the investor?”⁵¹

Warren agrees. Returning to Aesop's proposition, he empathizes. Sometimes making an estimate is a difficult task. How soon will the investor get the birds; how many birds are actually in the bush; and what will be the interest rates? “Usually, the range must be so wide that no useful conclusion can be reached,” said Warren. “Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. The investor does not need brilliance or blinding insights. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.”⁵² A rough approximation is enough for Warren. “Our inability to pinpoint a number doesn't bother us: we would rather be approximately right than precisely wrong.”⁵³

In Value Investing: From Graham to Buffett and Beyond the authors Bruce Greenwald, Judd Khan, Paul Sonkin, and Michael van Biema divide the value investing approach to selecting stocks into three distinct camps. The “classic” approach focuses on tangible assets. The “mixed” approach puts emphasis on private market value or replacement value. The “contemporary” approach is used by value investors like Warren Buffett, those described as business‐owners. They favor franchise values and can spot value hiding in plain sight.⁵⁴

The reference to “hiding in plain sight” is a nod to Edgar Allan Poe. “The Purloined Letter,” written in 1844, is one of three detective stories written by Poe featuring the world's first literary detective, C. Auguste Dupin. Poe considered “The Purloined Letter” to be the best of his tales of ratiocination—the art of reasoning.⁵⁵

The plot of the story is simple. A man steals a confidential, personally damaging letter in order to blackmail a woman. The police are engaged and search for the letter in the thief's home but they cannot find it. A senior police officer turns to Dupin for help.

In short order Dupin finds the letter lying in a card rack on the writing table in full view for all to see. The blackmailer, anticipating the police would assume the letter would be hidden in an elaborate place, did the exact opposite. He hid it in plain sight. Dupin explained why the police overlooked the obvious: “They consider their own ideas of ingenuity; and in searching for anything hidden, advert only to the modes in which they would have hidden it.”

The beauty of a detective story is revealed by the reader's psychological limitations. In “The Purloined Letter” the preconceptions of the police were so powerful they were blind to see what was right in front of them. It is a form of confirmation bias. Investors also suffer from confirmation bias—forming preconceived ideas of what should be happening in the stock market without acknowledging what is obvious.

It reminds you of the story of two Wall Street bankers walking to lunch when one spots a $100 bill on the sidewalk and bends over to pick it up.

“What are you doing?” his friend asks.

“Picking up this $100 bill. What does it look like?”

“Don't bother,” the friend replies. “If it was really a $100 bill someone would have already snatched it.”

Investors have always been obsessed with what is hidden in the market, believing only that which is hidden has value. This is sometimes true, but not always. We can also say that which is transparent is often thought to be fairly priced but there are cases when it is not fully valued. Case in point, no pun intended, is the story of Warren's purchase of The Coca‐Cola Company.

The first sale of a Coca‐Cola bottle was in 1886. The company went public in 1919 at $40 per share. Seventeen years later, Warren was selling nickel bottles of Coke at his sidewalk table business. But he never bought a share of Coca‐Cola for the Buffett Partnership, and it took 23 years before he pulled the trigger to buy a position for Berkshire.

“I carefully avoided buying a single share,” said Warren. “Instead [I] allocated major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, and trading‐stamp issuers. Only in the summer of 1988 did my brain finally establish contact with my eyes. What I then perceived was both clear and fascinating. After drifting somewhat in the 1970s, Coca‐Cola became a new company with the move of Roberto Goizueta to CEO.”⁵⁶

During the 1970s, Coca‐Cola was a fragmented and reactive company rather than an innovator setting pace with the beverage industry. Paul Austin, who had been president since 1962, was appointed chairman of the company in 1971. Although Coca‐Cola continued to generate millions in earnings, those profits were not reinvested in the higher‐returning soda business but allocated to water projects, shrimp farms, a wine business, and a modern art collection bought at the whim of Austin's wife. From 1974 to 1980, the company's market value rose an average rate of 5.6 percent, vastly underperforming the Standard & Poor's 500 Index.

In May 1980, Austin was ousted by Robert Woodruff, the company's 91‐year‐old patriarch, and replaced by Roberto Goizueta. Raised in Cuba, he became the first foreign‐born chief executive officer of Coca‐Cola. And he hit the ground running. Goizueta put forth the company's “Strategy of the 1980s,” a 900‐word pamphlet outlining the corporate goals for Coca‐Cola. The plan was simple. Any division in the company that did not add substantially to earnings growth and effectively increase the return on equity of the company would be sold. The proceeds were to be reinvested back into the syrup business, the fastest growing and highest returning part of the company.

In 1980, when Goizueta took over, profit margins at Coca‐Cola were 13 percent. By 1988, when Warren first bought shares in Coca‐Cola, profit margins had climbed to a record 19 percent. In 1980, the return on equity for Coca‐Cola was slightly above 20 percent. In 1988, return on equity had increased 50 percent to 32 percent. By 1992, it was near 50 percent.

Any money that could not be prudently reinvested back into the syrup business was earmarked for dividend increases and share repurchases. In 1984, Goizueta authorized the first‐ever buyback, announcing it would repurchase six million shares of stock. Over the next 10 years, Goizueta repurchased 414 million shares of Coca‐Cola, representing 25 percent of the company's shares outstanding at the beginning of 1984.

Warren observed what was happening at Coca‐Cola and understood how Goizueta's actions would substantially increase the intrinsic value of the company. As long as Goizueta did not dilute the economic performance of Coca‐Cola by adding subpar businesses and continued to use excess cash to buy back stock, the intrinsic value of Coca‐Cola would be substantially higher than what the market was thinking.

Using John Burr Williams' dividend discount model to calculate the discounted present value of Coca‐Cola's growth in owner‐earnings, the company was worth $20.7 billion at a 5 percent growth rate for a 10‐year forecast period followed by a 5 percent growth rate into perpetuity; $32.4 billion at a 10 percent growth rate; or $48.3 billion at a 15 percent growth rate. The market value of Coca‐Cola when Warren was purchasing the stock averaged $15.1 billion. So depending on your estimate for growth, Warren was purchasing Coca‐Cola “approximately” as low as a conservative 27 percent discount to intrinsic value and “approximately” as high as 70 percent. Stage One value investors observed the same Coca‐Cola that Buffett purchased and because its price to earnings and price to book value were all so high, they considered Coca‐Cola overvalued.⁵⁷

To help investors appreciate the difference between the Stage One and Stage Two approaches to value investing, Tom Gayner, co‐chief executive officer and chief investment officer of Markel Corporation, offers a thoughtful metaphor: it's the difference between a snapshot, which freezes one specific moment, and a full‐length movie, which unfolds over time.⁵⁸

Gayner was trained as an accountant and reminds us that accounting is important because it is the language of business. No surprise, then, that, when Gayner began investing he emphasized the quantitative approach he learned as an accountant—the same approach taught by Ben Graham.

Gayner calls quantitative investing “spotting value.” It is like a camera that takes a snapshot. In that snapshot, time is standing still. This approach, said Gayner, worked spectacularly well after the Great Depression and World War II. Buying mathematically cheap stocks was a profitable investment approach for decades—until it didn't work any longer. Why? Because as the stock market evolves, the participants learn what is working. What began with just dozens of investors, then hundreds, then thousands, eventually became tens of thousands of investors all picking the same cheap stocks, and so the profit gap closed. Graham and Dodd's value approach to picking stocks no longer provided an excess return.

The evolution of value investing, Gayner said, can be seen as a segue from spotting value with a snapshot to understanding that value unfolds over time like a movie. Charlie Munger concurs. “The days of locating stocks selling at a 25%–50% discount to some liquidating value, a price that someone else would pay to buy the business, when it was easy as moving your Geiger counter over low multiple stocks is over. The world has wised up. The game has gotten harder. You have to get into Warren's thinking.”⁵⁹ So let us say that how Warren thought about the intrinsic value of Coca‐Cola was very much like watching a movie directed by Goizueta as it unfolds.

Moving from Stage One to Stage Two value investing is challenging. The fundamental movie‐making in Stage Two is more difficult than taking a snapshot in Stage One. Financial missteps can be made if an investor's version of how they think their movie will turn out differs from reality. Even so, fundamental movie‐making is the key component in understanding Stage Two value investing.

“It's extraordinary how resistant some people are to learning anything,” said Charlie. What's really astounding,” Warren added, “is how resistant they are even when it's in their self‐interest to learn.” Then in a more reflective tone, Warren continued, “There is just an incredible resistance to thinking or changing. I quoted Bertrand Russell one time saying, ‘Most men would rather die than think. Many have.’ And in a financial sense, that's very true.”⁶⁰

Stage Three: The Value of Network Economics

The transition from Stage Two to Stage Three value investing is less about adding new financial metrics and more about introducing new business models. In Stage One, business models were defined by their physical structure. To grow a business in Stage One required growing the physical aspects of the company—more plant and property. In Stage Two, growing a business was levered to the intangible components of a business—the attractiveness of the product, its brand value, and delivery of the product through various outlet channels. The service aspect in Stage Two, which drove the sales and earnings of the business, required significantly less capital than Stage One.

In Stage Three investors are learning, slowly at first but now more confidently, the value‐creating aspects of knowledge, information, and entertainment, all of that made possible by new technologies including more powerful personal computers and smartphones all connected together to the global internet. In Stage Three, the cost of the physical input to business models has gone down while the value output has grown exponentially. In Stage Three, billions of dollars in market value is being created by companies generating hundreds of millions in earnings, all made possible by fractions of the capital employed compared to the Industrial Revolution.

Value investors have always been fascinated by growth but admittedly conflicted in how to confidently estimate a necessary margin of safety for that growth. For most, Aesop's two birds in a bush were always out of reach. Although most value investors were slow to learn how to value growth, nothing stopped academicians from studying the attributes of economic growth.

The first notable was Joseph Schumpeter. Schumpeter's view of the economy as being dynamic, innovative, and change‐oriented came from involvement with the Historical School of Economics, a broad approach to economic theory that developed in Germany in the nineteenth century. According to Christopher Freeman, a British economist who is considered the preeminent researcher in innovation studies and who devoted much of his study to Schumpeter's work, “The central point of Schumpeter's whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and ‘creative destruction.’”⁶¹ Schumpeter came to believe economic growth occurred over a series of long cycles, what he called waves, with each picking up speed through time.

In 1962, Everett Rogers, an assistant professor of rural sociology at Ohio State University, published the first edition of Diffusions of Innovation. He was 31 years old. Today, Rogers is a renowned academic figure. His book, now in its fifth edition, was the second most cited book in all of social sciences in the early 2000s. Rogers sought to integrate Schumpeter's rolling waves into one distinct wave to explain how, why, and at what rate technological ideas spread. He categorized technology adopters as “innovators, early adopters, early majority, late majority, and laggards.”

But it was Carlota Perez, a British‐Venezuelan scholar, who connected the dots: Schumpeter's economic change begins first with innovation, which then attracts entrepreneurial activities, leading to a burst of financial investment. Perez's research focused on the concept of techno‐economic paradigm shifts, showing how the financial markets paralleled, at times unevenly, the life cycle of technology revolutions.

In her book Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages, Perez identifies five technological revolutions from the 1770s to 2000s. The first, the Industrial Revolution, began in 1771 when Arkwright's water‐powered cotton spinning mill opened in Cromford, England. The second, in 1829, the Age of Steam and Railways, opened with the test of the Rocket steam engine for the Liverpool‐Manchester railway. The third is the Age of Steel, Electricity, and Heavy Engineering, which began when Carnegie's Bessemer plant opened in Pittsburgh in 1875. The fourth is identified as the Age of Oil, the Automobile, and Mass Production. It began in 1908 when the first Model‐T rolled out of the Ford plant in Detroit. Today, says Perez, we are in the midst of the fifth technology revolution, which she calls the Age of Information and Telecommunications. It began in 1971 in Santa Clara, California, when Intel unveiled the microprocessor.⁶²

The new technologies of the fifth revolution include microelectronics and computers, software, smartphones, and control systems. The new infrastructure includes global digital telecommunications with cable, fiberoptics, radio frequencies, and satellites providing internet, electronic mail, and other e‐services.

The principles of the fifth technology revolution include information intensity, decentralized structures, and globalization. Information intensity means knowledge as capital is the value added. When the network structures are decentralized, markets can be segmented, creating a proliferation of powerful niches. Global communications enable instant globalized interactions between local operators, which lead to economies of scope and scale that in turn create a total addressable economic market that is unparalleled in history.⁶³

Perez's life cycle of a technological revolution is not too dissimilar from Rogers' diffusion of innovations theory. Perez's life cycle comprises four different phases. In phase one, the paradigm begins to take shape. Products are invented, companies are formed, and industries are born. Growth is explosive; innovation continues at a high rate. In phase two, we see the full constellation of new industries, new‐technology systems, and new infrastructure. In phase three, the innovations are fully reflected in the market's potential for these new products and services. Lastly, in phase four the last new products arrive in the marketplace while the earlier ones are fast approaching maturity and market saturation.⁶⁴

Importantly, Perez goes further than Rogers and further than Schumpeter; she points out that the “trajectory of a technological revolution is not as smooth as the stylized curves” reflected in the textbooks.⁶⁵ The reason, she believes, is the participation of financial markets in the funding of a technological revolution.

Perez describes a standard flow of events that occur with all technological revolutions. Every revolution moves through two surges, each of which is in turn made of two phases. She defines the first surge as the installation period. “It is a time when the new technologies irrupt in a maturing economy and advance like a bulldozer disrupting the established fabric and articulating new industrial networks, setting up new infrastructure and spreading new ways of doing things.” The second surge is called the deployment period. At this point, Perez says, “the whole economy is rewoven and reshaped by the modernizing power of the triumphant paradigm, which then becomes the normal best practice, enabling the full unfolding of this wealth generating potential.”⁶⁶

To some degree, that echoes what others have described. However, between the first surge (installation) and the second (deployment) is where Perez says the “stylized curve” gets interrupted. She calls it the turning point. She explains: in the first phase of the installation period, which she calls “irruption,” there is a period of massive investment in the technological revolution. At this point “the revolution is a small fact and a big promise.” Then, money is poured into new businesses and new infrastructure at a frantic pace; this is the second phase of the installation period, called “frenzy.” The stock market booms, forms a bubble, then collapses—the turning point. With the collapse comes an economic recession. But the recession creates the conditions for institutional restructuring, a financial rebalancing of technology's future market potential. “The crucial recomposition happens at the turning point which leaves behind the turbulent times of installation and paradigm transition to enter the ‘golden age’ that can follow.”⁶⁷

In the second surge, the deployment period, there are two distinct phases—“synergy” and “maturity.” Perez calls the synergy phase the “golden age,” a time when companies achieve coherent growth with increasing externalities of production, employment, and customers. During this time, increasing real economic return in the form of sales, cash earnings and high returns on capital becomes evident. This is then followed by a “maturity” phase where the market becomes saturated, the technology matures and the last of the new entrants come to market.

Perez's roadmap allows investors to easily track the events of the 1970s and 1980s—first came the period of “irruption,” followed by the “frenzy” investment period in the 1990s, leading to a stock market bubble, the 2000 market crash, and economic recession that followed. Now, says Perez, we are firmly on the other side of the turning point, and it appears we are in the midst of the golden age of investing in this fifth technological revolution. Synergies between capital, infrastructure, labor, service, and customers are now reaching a comprehensible level. It is quite possible the golden period of investing in the Age of Information and Telecommunications could last for many years to come. How long before the “maturity” phase begins is unknown, but for many industries and companies the total global addressable market remains quite large.

Schumpeter, Rogers, and Perez have all given investors a thoughtful way to think about growth from a macroeconomic perspective. What is still lacking is how to think about the competitive advantage of any one company in this technological revolution. For this insight, we must turn to another academician, a soft‐spoken Irish economist named Brian Arthur.

Arthur was born in Belfast, Northern Ireland, in 1945. He received an electrical engineering degree from Queens University Belfast in 1966, then headed to the U.S. to continue his studies: a master's degree in mathematics from the University of Michigan, then a PhD in operations research and a master's in economics from the University of California at Berkeley in the same year. In 1996, he was named to the Morrison Chair of Economics and Population Studies at Stanford. He was 37 years old, the youngest person ever to hold that endowed chair. He was awarded the prestigious Schumpeter Prize in Economics in 1990 for his work in “Evolutionary Economics: Theory and Practice.”

Soon after arriving at Stanford, Arthur began to record his observations about the economy in a personal journal. One page, entitled “Economics Old and New,” was divided into two columns in which he began to list the characteristics of both concepts. Under “Old Economics” he wrote “rational” and “reversion to the mean.” Everything was “in equilibrium.” It was economics based on classical physics, on a belief the system was structurally simple. Under “New Economics” Arthur wrote people were “emotional not rational.” The system was “complicated not simple” and it was “ever changing not static.” In Arthur's mind, economics was more akin to biology than physics.

Brian Arthur made a personal connection to the Nobel‐winning economist Ken Arrow, who introduced him to a close‐knit group of scientists working at the Santa Fe Institute in New Mexico. Arrow invited Arthur to present his latest research at a conference of physicists, biologists, and economists at the Institute in the fall of 1987. The conference was organized in the hope that the ideas then percolating within the natural sciences, namely the science of complex adaptive systems, would stimulate new ways to think about economics. At the time, it was not widely known that John Reed, chairman and CEO of Citigroup, had funded the conference with the hope of finding new ideas about how capital markets actually work to offset the mistakes his own economists were continually making.

Common to the study of complex adaptive systems is the recognition the system is composed of multiple agents, each reacting and adapting to patterns the system itself creates. Complex adaptive systems are in a constant process of evolving over time. Although these types of systems were familiar to biologists and ecologists, the conference group at the Santa Fe Institute thought perhaps the concept should be expanded and maybe now was the time to include the study of economic systems and stock markets with an overarching idea of complexity.

Today, economics studied as a complex adaptive system is called “complexity economics,” a term Arthur coined while writing an article for Science in 1999. In standard physics‐based economic theory, markets exhibit diminishing returns. The law of diminishing returns is a fundamental principle of standard economics. It states that adding one more factor of production while holding constant other factors, namely demand, will at some point yield lower incremental returns per production unit. Said differently, the law of diminishing returns refers to a point at which the level of profits gained is less than the money invested.

However, complexity economics sees companies that are not destined to long market cycles of diminishing returns. According to Arthur, there are some companies that demonstrate increasing economic returns. “Increasing returns,” he explains, “are the tendency for that which is ahead to get further ahead and for that which loses advantage to lose further advantage.” Whereas diminishing returns is a feature of the older, brick‐and‐mortar economy, “increasing returns reign in the newer part—the knowledge‐based industries.”⁶⁸

The principle of increasing returns, says Arthur, is especially significant in the technology‐specific industries where network effects are common. A network effect is a phenomenon whereby a product or a service gains in value as more and more people use it. Networks have been around a long time, Arthur notes, but in the new knowledge‐based economy the digital network is the value‐creating symbol. And digital networks are far different from brick‐and‐mortar networks. There will certainly be competition between networks in the new‐technology‐based economy, Arthur predicts, but in the end, after the shakeout, “of the networks, there will be few.”⁶⁹

Each day after studying legal and political ethics in the doctorate program at Johns Hopkins University, Bill Miller stopped by the Baltimore office of Legg Mason Wood Walker brokerage firm. His wife, Leslie, was the assistant to Legg Mason's top stockbroker, Harry Ford. Waiting for Leslie to wrap up for the day, Miller could be found sitting in a corner, reading research reports.

A graduate student in philosophy spending afternoons reading stock reports might seem a bit odd. But for Bill Miller, who started out as a nine‐year‐old cutting grass with a push mower for a quarter in the hot Florida sun, finding new ways to make money was not out of bounds.

One day, a young Bill Miller noticed his father reading the newspaper—not the usual sports page but the finance section. When he asked his father to explain all those numbers, his father said, “If you'd owned a share of this company yesterday, you'd have 25 cents more today than yesterday.” The stocks go up by themselves, his father continued.

“You mean if you know about stocks you can make money without doing any work?” Bill asked.

“Yes.”

“Well, I want to make a lot of money but I don't want to do any work so I want to know about stocks.”⁷⁰

In high school Miller read his first investment book, How I Made $2 Million in the Stock Market. At age 16, he invested his $75 savings in RCA stock and made a handsome profit. He was hooked. From then on, investing was always a part of his life. Miller did not take the typical business school route. He attended Washington and Lee University in Lexington, Virginia, graduating with honors in 1972 with a degree in European history and economics. It was at Washington and Lee that he was introduced to Benjamin Graham and began to seriously study investing. “Once someone explains the value concept to you, either you get it or you don't.” said Miller. “I found the concept to be congenial. It made sense.”⁷¹

After graduating from college, Miller served overseas as an Army intelligence officer. From there, he pursued his doctorate in philosophy. Bill Miller was on a pathway to teach philosophy and one decision away from writing his doctoral dissertation at Johns Hopkins University when Professor Michael Hooker forewarned him there were no teaching jobs to be found. Hooker, who recalled seeing Miller in the faculty library every morning reading The Wall Street Journal, encouraged him to pursue a career in finance instead. That led Miller to take a position as a financial officer then treasurer at the manufacturing company J.E. Baker Company. One of the perks of the treasurer's position was the responsibility of overseeing the company's investment portfolio. Miller soon discovered this was the part of the job he enjoyed the most.⁷²

Hanging around the Legg Mason office soon paid off for Miller. Raymond “Chip” Mason, the founder and chairman of Legg Mason, “recalls that Miller would show up and when his wife was ready to leave, he was so immersed in research reports that Leslie would prod him to go.”⁷³ It wasn't long before Leslie introduced her husband to Ernie Kiehne, the head of research at Legg Mason. It so happened that Kiehne was planning to retire, and he and Chip Mason were looking for a successor. Thus, in 1981, Bill Miller joined Legg Mason and became Ernie Kiehne's understudy. The following year, Chip Mason launched the Legg Mason Value Trust mutual fund to showcase the firm's research prowess. Kiehne and Miller were named co‐portfolio managers.

The Value Trust is the perfect case study to observe the evolution of the three different stages of value investing. In the beginning, Value Trust was managed based on the precepts outlined by Graham and Dodd, a classic Stage One. The mutual fund was widely diversified, owning over 100 stocks, and nearly all showed low price‐to‐earnings and low price‐to‐book‐value ratings. The Graham and Dodd approach was favored by Ernie Kiehne and had been practiced by stockbrokers at Legg Mason since Chip Mason founded the firm in 1962. But soon after Value Trust was launched, Miller's influence slowly began to change the complexion of the portfolio. Miller focused on a company's future cash flows and return on equity, a hallmark of Warren Buffett's approach to value investing. Along the way, Miller steadily reduced the number of stocks in Value Trust and, like Warren, began to concentrate his positions around his best ideas. By the late 1980s, Value Trust had morphed into Stage Two value investing.

In October 1990, Ernie Kiehne turned the reins of Value Trust over to Bill Miller. He became the sole portfolio manager and starting in 1991 embarked on a record of outperformance that has never been equaled. From 1991 through 2005, the Legg Mason Value Trust beat its benchmark, the Standard & Poor's 500 Index, 15 years in a row.⁷⁴

In hindsight, it is easy to see Value Trust evolving from Stage One to Stage Two value investing. After all, Warren Buffett had been illuminating the second approach for much of the 1980s. But when Miller took full control of Value Trust he was poised to move the portfolio to Stage Three, a value investing approach focused on companies that had never been thought as value propositions.

In 1993, Miller arranged to meet John Reed, CEO of Citigroup, in New York. At the time America's largest bank had been struggling but looked cheap in Miller's mind. His meeting with Reed confirmed the company was on the right approach, embracing cost controls and returning money to shareholders. Before leaving, Reed mentioned that Citigroup had funded a research project at the Santa Fe Institute that might interest the portfolio manager of the Value Trust. The lectures and presentations from the conference were now collected in a book titled The Economy As an Evolving Complex Adaptive System, edited by Phillip Anderson, Kenneth Arrow, and David Pines.

Miller got a copy, read the book, then headed to New Mexico.

High in the hills of the Sangre de Cristo Mountains, the southernmost tip of the Rocky Mountains, lies the Santa Fe Institute. It is a multidisciplinary research and education facility where physicists, biologists, mathematicians, computer scientists, psychologists, and economists have come together to study complex adaptive systems. These scientists are attempting to understand and predict immune systems, central nervous systems, ecologies, economies and the stock market, and they are all keenly interested in new ways of thinking.

When Miller arrived at the Institute he met Phil Anderson and Ken Arrow, both Nobel laureates. Anderson was studying the science of emergent properties. Arrow was laying the foundations for understanding the emergent growth theory and the economics of information. Miller was also introduced to Murray Gell‐Mann, who had become a fixture at the Institute. Gell‐Mann had collaborated with Richard Feynman and was awarded the Nobel Prize for his work on the theory of elementary particle physics, what he would call “quarks.” Miller also met Geoffrey West, a British theoretical physicist, who was working on the universal laws of growth as it applied to organisms, cities, and companies. And it was here that Miller became friends with Brian Arthur.

Arthur explained to Miller his thoughts on increasing‐returns economics. Then he went further, showing that companies that are experiencing increasing returns have certain attributes that further solidify their dominance within an industry. They talked about network effects. Arthur pointed out that people prefer being connected to a larger network rather than a small one. If there are two competing networks, one with 25 million members and one with five million members, a new member will tend to select the larger network because it is more likely to fulfill their need for connections to other members, offering more services and benefits.

Network effects are demand‐side economies of scale. So for network effects to take hold, it is important to get big fast. This thwarts the competition from becoming established.

Miller and Arthur discussed the concept of positive feedback, a behavioral component of human nature described by B.F. Skinner, a behavioral psychologist. Positive experiences give us pleasure or satisfaction and we want to relive them. Someone who has a positive experience when using a technology product, or any product for that matter, will have a tendency to return to that product. The net effect of positive feedback in business is that the strong get stronger and the weak get weaker.

Another behavioral component of human psychology as it relates to technology investing is called lock‐in. When we learn one way of doing something we have little interest in learning another. Technology products, specifically software, can be difficult to master in the beginning. Once we have become proficient using a certain product or software we fiercely resist changing to another. We become path dependent—more comfortable repeating the same technological functions. Changing requires learning a new set of instructions, often very difficult instructions. Consumers become satisfied, content with how they use technology. This is true even if a competitor's product is deemed superior.

All these factors—network effects, positive feedback, lock‐in, and path dependency—result in high switching costs. Sometimes switching costs are literal, as when switching technologies and software costs so much money that customers can't be persuaded to change. But in many cases, attributes like positive feedbacks, lock‐in, and path dependency also form a psychological dissuasion that is a form of high switching costs.

Warren Buffett taught us the best business with the best long‐term prospects is called a franchise—a company that sells a product or service that is needed or desired and has no close substitute. Warren also said he believed the next great fortunes would be made by people who identify new franchises. After his first visit to the Santa Fe Institute, Miller came away with a strong belief the new‐technology companies being added to the stock market were the modern‐day equivalent of Warren's franchise factor.

When Miller returned to Baltimore he found the menu of value stocks in the market contained the usual suspects: banks, energy companies, industrials including depressed paper companies. Also on that menu—personal computer stocks. Investors had come to believe personal computer stocks were just another commodity product. The stocks historically traded between 6 and 12 times earnings. Value investors would buy PC stocks at 6 times earnings and then sell them at 12 times earnings. So, in 1996, during a slowdown in PC sales, value investors started buying again. So did Miller. He bought Dell Computer, which soon traded back to twelve times earnings along with the other personal computer stocks. At that point the value investors sold their stock. Value Trust held its position.

Many know the folklore of Michael Dell, the brilliant kid who sold personal computers from his college dormitory, turning a part‐time job into a multibillion‐dollar company. But few appreciate how Dell's model of direct selling to consumers generated historic levels of profitability. Most personal computer companies, like Gateway, Compaq and Hewlett‐Packard, sold to retailers who in turned raised prices then sold to their customers. Because Dell sold its computers direct to the consumer, their prices were cheaper.

To buy a Dell Computer, a customer would call the 1‐800 number (or later, connect via the internet), and order a monitor, keyboard, and desktop tower with specifications for memory and speed. The operator would take the order, ask for the customer's credit card for payment, and promise the computer would be delivered to their home or business in the coming weeks. That night, Dell received payment from the customer's credit card company for a computer it would assemble from components it had ordered from a supplier whose invoice it was not obligated to pay for 30 or maybe even 60 days. So the Dell business model was growing its direct PC business largely on the cash receivables from its customers. It is called “negative working” capital. Not only did Dell drive sales faster and higher than other competitors because its direct model allowed for cheaper prices, it also became the first corporation in history to generate a return on capital above 100 percent. It would eventually hit a high‐water mark of 229 percent return on capital.

The fact that Miller didn't sell Dell Computer in lockstep with the other value investors was not big news. But when Dell became the largest position in Value Trust, selling at 35 times earnings, it caught the eye of many value investors and caused a fair amount of consternation. What was Miller thinking, they asked? If he wanted to own a personal computer stock why not Gateway, which was trading at 12 times earnings? Bill's answer was simple: Dell earns 200 percent return on capital while Gateway earned 40 percent. Dell was five times more profitable than Gateway but only three times the price‐to‐earnings ratio.⁷⁵

Miller's investment methodology and approach were transparent. It was there for all to see. He was following the same investment approach as Warren—a discounted cash‐flow model. But he was also channeling Warren's observation that “the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return.” Think back to Michael Mauboussin's illustration on justifiable price‐to‐earnings ratios. If a company was growing at a 10 percent rate earning 16 percent return on capital against a cost of capital of 8 percent, it was worth 22.4 times earnings. Dell Computer was growing much faster than 10 percent and it was earning 200 percent on invested capital with a capital cost of 10 percent. What should the stock have been selling for? Miller was simply following the valuation of Dell Computer to its logical conclusion. “From a theoretical view,” he said, “there are fundamental flaws using the backward‐looking stuff” like price‐to‐earnings ratios. “At the end of the day, 100 percent of the value of any equity depends on the future, not the past.”⁷⁶

Miller's frequent trips to the Santa Fe Institute energized him. He knew the market was in the midst of a new‐technology revolution and he also knew he had a roadmap in how to determine a technology company's competitive advantage. The literature on how to think about technology companies and investing was growing. Libraries were being formed. Geoffrey Moore, an organizational theorist, burst onto the scene in 1991 with the publication of his bestseller, Crossing the Chasm. Brian Arthur organized his research writing and published Increasing Returns and Path Dependence in the Economy in 1994. Ken Arrow wrote the foreword. In 1997, the highly respected Harvard management professor Clay Christensen wrote The Innovators Dilemma: When New Technologies Cause Great Firms to Fail. The following year Carl Shapiro, a professor of business strategies, and Hal Varian, an economist specializing in microeconomics and information economics, published the seminal book of the time—Information Rules: A Strategic Guide to the Network Economy. Hal Varian became the founding dean of the School of Information at Berkeley and later was appointed chief economist of Google.

That same year, Geoffrey Moore followed up his bestseller with another titled The Gorilla Game: An Investor's Guide to Picking Winners in High Technology, coauthored with Paul Johnson and Tom Kippola. In the book they outlined the investment case for Oracle and the relational database business; Cisco and the economics of network hardware; and a detailed analysis of the growing importance of customer service software. All turned out to be prophetic.

Paul Johnson earned his economics degree from the University of California, Berkeley, before obtaining his MBA from The Wharton School at the University of Pennsylvania. It was at Wharton that Johnson learned that value creation was a function of returns on capital. In class one day, he was asked how a company grows in value. Johnson was stumbling through the reasoning embedded in the Capital Asset Pricing Model when his professor cut him off and pointed him in the direction of William Fruhan, a Harvard Business School professor. Fruhan authored three books, but it was his second one, Financial Strategy: Studies in the Creation, Transfer, and Destruction of Shareholder Value, published in 1979, that planted the seed in corporate finance of a new way to think about what exactly was needed to increase a company's market value. In Chapter 2, “The Levers That Managers Can Utilize to Enhance Shareholder Values,” Fruhan succinctly explained, “The economic value of any investment is a function of the future cash flows anticipated from that investment, and the cost of capital required to finance the investment.” He went on to say, “Cash flow from an investment can also be increased if a firm can reduce the capital intensity of its business below that of its competitors.”⁷⁷

What Fruhan spotlighted was the notion that a firm's value was related not only to its cash‐generating abilities but also to the cash return on its cost of capital. To the degree a firm earned high cash returns on capital, it increased the value of the firm. And one way to do this was to reduce the capital required to generate the cash return compared to competitors. Think Dell Computer. What Fruhan did for Johnson was to open his eyes to the value‐creation levers—cash, return on capital, and cost of capital.

After Wharton, Johnson earned his analytical stripes at CS First Boston before moving to Robertson Stephens & Co., where he became managing director and senior technology analyst, following the telecommunications and computer networking equipment industries. In the 1990s, the Four Horsemen of the technology industry were Dell, Cisco Systems, Intel, and Microsoft. Johnson covered Cisco.

In December 1996, Johnson penned a research report titled “Networking Industry: A New Way to Listen to the Music: ROIC.” It was Johnson's thesis that for long‐term investors, value creation is a function of how much economic value is created by the funds a company invests and deploys. Johnson's viewpoint was that return on invested capital (ROIC) was the superior method to determine value creation, more informative than the traditional markers commonly used: earnings per share (EPS) or earnings before interest, taxes, depreciation and amortization (EBITDA).

Two months later, in February 1997, Johnson sent Warren Buffett an open letter pitching Cisco Systems. “Dear Warren, If you think Coke is a good investment,” he wrote, “take a look at Cisco.” Johnson's reasoning was that the strategy that helped drive Coca‐Cola's intrinsic value higher—namely, reinvesting profits in a business with high return on capital—was also available with Cisco.

Coca‐Cola, Johnson acknowledged, was indeed a great business. From 1991 to 1996, Coke had generated an annual ROIC between 25 and 35 percent against a weighted average cost of capital of 14 percent. But Cisco, he pointed out, had over the same period generated an annual ROIC in the range of 130 percent to 195 percent against a weighted average cost of capital Johnson estimated at 18 percent.

In his letter Johnson quoted Warren's own words from the Berkshire Hathaway 1992 Annual Report to Shareholders: “The best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return. Growth benefits investors only when the business in point can invest at incremental returns that are enticing—in other words, only when each dollar used to finance the growth creates over a dollar of long‐term market value.”

Both Bill Miller and Paul Johnson were observing firsthand that for every one dollar that Dell Computer and Cisco Systems reinvested back into their companies, they were creating multiples of dollars in market value.

Bill Miller's definition of value comes from the finance textbooks outlined by John Burr Williams and emphasized by Warren. Value for any investment is the present value of the future free cash flows of that investment. Miller is quick to point out that nowhere in the textbooks does it say that value is defined in terms of low price‐to‐earnings ratios. But what Warren, Miller, and Johnson gleamed from their study of businesses is the value of the future cash flows is greatly enhanced by the high incremental returns on investment made possible by the cash flows.

What separates Miller from other value investors is not that he defined value differently but rather that he was willing to look for value anywhere it might be. Most important, he didn't rule out technology companies as businesses that might contain value. “We believe and continue to believe that technology can be analyzed on a business basis,” he said, “that intrinsic value can be estimated, and that using a value approach in the tech sector is a competitive advantage in an area dominated by investors who focus exclusively, or mainly, on growth, and often ignored by those who focus on value.”⁷⁸ Classic value investors, accustomed to relying on simple accounting metrics, were not able to get their hands around technology companies.

Having owned Dell Computer, Miller could have purchased another technology hardware company that earned high returns on capital like Cisco Systems, but he decided to move in a different direction. In late 1996, Miller began to purchase America Online (AOL) for the Legg Mason Value Trust. Steve Case, AOL's founder and chief executive officer, brought the internet to 29 million people in quick fashion. Once AOL's network reached 50 percent market share for online customers, Miller figured it had created an entity that was impregnable. Furthermore, he concluded, as strong as Microsoft was at the time, it couldn't overtake AOL.

Following Brian Arthur's roadmap, Miller could see the power of the network effect that was building inside AOL. It began as a simple communications system but then began to differentiate itself by the various channels it offered its members, including email, chat rooms, message boards, and instant messaging. AOL's positive feedback numbers were evident. As AOL offered more new features, more people had positive experiences and were eager to come back. Miller was able to measure individual usage, and he knew AOL subscribers were spending more and more time on the site.

From a technology perspective AOL was not daunting. Members quickly mastered sending and receiving email in a certain way and didn't care to change. Even when other providers offered more bells and whistles, AOL members were not interested in changing. The lock‐in effect was working.

Even more interesting is what happened when the company switched to flat‐rate prices. Hundreds of thousands of internet users recognized the good deal and the number of subscribers jumped astronomically, so much so that the system became hopelessly jammed. Anyone trying to access the service heard nothing but constantly busy signals. New customers were angry. Old customers were furious. Media coverage was intensely negative. But did people change to another provider? No. Despite the busy signals and the negative publicity, AOL membership continued to grow.

Miller employed a standard discounted cash flow model for determining the intrinsic value for AOL. To provide an ample margin of safety, he discounted the cash flows at 30 percent, three times as high as the discount rate he was using for IBM. Miller started purchasing AOL at average prices of $15 per share, but believed the business was worth approximately $30 per share. By 1998, he thought the value of AOL's business was near $110 on the low side and as high as $175, still using a conservative discounted cash flow. AOL split the stock four times between 1998 and 1999. Value Trust made 50 times its original investment in AOL. The position soon became a 19 percent weighting in the portfolio, and along with Dell Computer and other technology stocks, Value Trust's investment in the new‐economy stocks reached 41 percent of its portfolio.

Miller had become an enigma in the value camp of investing. But what he did next stupefied Wall Street.

In 1994, Jeff Bezos left the venerable New York hedge fund D.E. Shaw. After reading a research report that forecast internet commerce growth would reach 2,300 percent, Bezos enacted what he called the “regret minimization framework”—a decision plan for avoiding any potential regrets he would have for not participating in the greatest business growth opportunity of our time. He made a list of the top 20 products that could be marketed online, then narrowed the list to the most promising five: computer hardware, software, computer discs, videos, and books. Bezos loaded his station wagon and drove to the state of Washington and was soon selling books out of the garage of his house on Northeast 28th Street in Bellevue.

Bezos incorporated his new company on July 25, 1994, under the name Cadabra. He soon changed the name to Amazon.com. A year later Amazon was selling books to all 50 states and 45 countries and within two months was ringing up sales of $20,000 per week. On May 15, 1997, Amazon offered a public offering of its stock at $18 per share. Miller bought Amazon on the IPO for Value Trust but then sold it after the stock quickly doubled. Two years later, in what The Wall Street Journal called the most audacious move of his career, Miller invested in Amazon again, this time at $88 per share.⁷⁹

By the end of 1999, Amazon was trading at the lofty price of 22 times sales. It had been losing money since its launch, but Miller felt it was not losing as much money as the market was thinking. Cash was coming into Amazon by the bucketloads, but Bezos was reinvesting the money back into the business as fast as he could. Because Amazon had jumped out to an early lead in online sales of books, Miller believed the company had an unassailable lead on its competitors. The network effects were already in place. Furthermore, Miller understood the competitive advantage of Amazon's business model. It would be able to grow rapidly without the need for massive capital infusions either with debt or equity issuance.

Investment professionals at Legg Mason Capital Management would, of course, be expected to understand investment strategies and portfolio management as well as basics like accounting and finance. But to be on Bill Miller's team, more was expected; it also required an appreciation of the insights that can be gained from studying philosophy. William James, the father of American pragmatism, cast a bright light on Miller's investment team. So too did the teachings of Ludwig Wittgenstein.

Ludwig Josef Johann Wittgenstein, an Austrian‐born philosopher who taught at the University of Cambridge from 1929 to 1947, is considered one of the preeminent philosophers of the twentieth century. The equally famous philosopher Bertrand Russell termed Wittgenstein “perhaps the most perfect example I have ever known of genius as traditionally conceived.”⁸⁰ Wittgenstein's field of study included logic, mathematics, the philosophy of the mind and the philosophy of language. His theory of language has helped us appreciate that words have meaning—that the words we choose form a description, which ultimately provides an explanation.

In 1953, Ludwig Wittgenstein's second and last book, Philosophical Investigations, was published posthumously. After his death in 1951, his friends and colleagues gathered all his personal writings, notebooks, and papers, and organized them for publication. The resulting book is now recognized as one of the most important works of philosophy of the twentieth century.

On page 200 of Philosophical Investigations is a diagram, a simple triangle hand‐drawn by Wittgenstein. Below this figure he wrote, “This triangle can be seen as a triangular hole, as a solid, a geometrical drawing, as standing on its base, as hanging from its apex; as a mountain, as a wedge, as an arrow or pointer, as an overturned object, which was meant to stand on the shorter side of the right angle, as a half parallelogram, and as various other things.” In all, Wittgenstein tallied 12 different descriptions of a rather plain‐looking three‐sided pencil sketch. His point was clear. How we see the world is shaped by how we describe it. The world is compatible with many very different descriptions.

If there can be multiple descriptions of a simple one‐dimensional triangle, imagine the number of descriptions for things with greater complexity. That is why, for example, there is not one description of what is occurring in the stock market, but several. Likewise, there is not only one description for a company. Analysts and portfolio managers who worked with Bill Miller were constantly challenged to come up with alternative descriptions, to redescribe the companies they were analyzing.

When Amazon became a public company Wall Street provided a simple description. The market believed Amazon was the online equivalent of the leading bookstore, Barnes & Noble. Analysts compared and contrasted the accounting factor multiples for both companies and concluded Barnes & Noble was much cheaper than Amazon. Hence, a smart investor should buy Barnes & Noble and sell Amazon. Later, as Amazon began to sell more than just books, analysts compared Amazon to Walmart. Using the same valuation markers, analysts recommended a pair trade of going long Walmart while shorting Amazon.

Miller also analyzed Amazon but what he saw didn't look much like Barnes & Noble. As an online retailer Amazon had minuscule capital expenditures per $100,000 sales compared to the brick‐and‐mortar competitors. Furthermore, Amazon collected revenues from its customers via online purchases but didn't need to pay the suppliers—book publishers—for three to six months. Often publishers would accept book returns with no penalty. Miller had seen this business model before. And after he met with Jeff Bezos to discuss Amazon's business model it confirmed what he thought. Amazon wasn't Barnes & Noble—it was Dell Computer.

Amazon and Dell had approximately the same gross and operating margins. They had the same direct‐to‐customer model and recognized revenues immediately while paying suppliers later. Amazon and Dell had the same capital velocity, the same negative working capital model and the same cash conversion cycle. Both companies were fueling their growth not through the income statement but via the working capital account on the balance sheet. Both had the same operating mantra—get the cash in the door as quickly as possible—meaning their customers helped pay for the company's expansion. Like Dell, Amazon became a company that generated returns on capital greater than 100 percent.

Miller also thought Wall Street was wrong in describing Amazon as a perpetual money‐losing operation. At a Grant's Interest Rate Observer conference in 2000, Miller passed out a questionnaire asking the attending fund managers to guess the cumulative cash loss of Amazon since its initial public offering. Their estimates ranged from a low of $200 million to a high of $4 billion. The correct answer, said Miller, was $62 million. “We didn't believe the market was correctly analyzing Amazon,” he insisted. “I mean, these guys were pros.”⁸¹

Wittgenstein's lessons for investors are particularly acute—failure to explain is caused by failure to describe. Over the next 20 years (2000–2019), despite the 2000 technology bear market and the 2008 financial crisis, Amazon's stock price gained 2,327 percent compared to the S&P 500 Index, which posted a 224 percent total return.

Miller was once called a value investor who wrapped himself in the stripes of a momentum player. Today, he is universally considered to be one of the first investors to successfully tackle the value conundrum of technology companies. Miller never strayed from the basic principles of value investing. He calculated the value of businesses using the discounted cash flow model and only purchased stocks when there was a margin of safety. “With money managers turning their portfolios north of 100 percent per year in a frenetic chase to find something that works, our glacial 11 percent turnover is anomalous,” said Miller. “Finding good businesses at cheap prices, taking a big position, and then holding for years used to be sensible investing. We are delighted when people use simple‐minded, accounting‐based metrics and then align them on a linear scale and then use that to make buy‐and‐sell decisions. It's much easier than actually doing the work to figure out what a business is worth, and it enables us to generate better results for our clients by doing more thorough analysis.”⁸²

Like Warren Buffett, Bill Miller is an educator. But unlike modern‐day hedge fund managers who say little until good performance is revealed, Miller is an open book. He is happy to tell you what he is reading as well as what books are currently piled high on his desk in a Pisa‐like to‐be‐read tower. Miller enjoys meeting colleagues at investment conferences and revels in the hours‐long dinner conversations afterwards. And he is always delighted when portfolio managers and analysts ask to go to the Santa Fe Institute to study complex adaptive systems.

Looking back, we can see that Miller's success is a result of three distinct influences. First, he was an accomplished student of accounting and finance and studied the approaches of other successful investors including Warren Buffett. Second, in his tireless pursuit of seeking to always understand what works best, he was willing to jump full force into the teachings of the Santa Fe Institute long before any Wall Street regulars showed up. Last and most important, Bill Miller is a philosopher‐investor. Better yet, he is a pragmatist.

Most investors who have been successful, but only for a limited period of time, hold a correspondence theory of truth. They believe their viewpoint corresponds to some deep, well‐founded structure of how markets operate. The correspondence theory of truth relies on absolutes. Stubbornness is a medal of honor. Now contrast this to a pragmatic approach. If you are a pragmatist, you typically have a shorter time period in which you will hold an ineffectual model. Pragmatists realize a model, any model, is there only to help you with a certain task. They apply the test of usefulness and utility while discounting the infatuation others have for absolutes.

Brian Arthur once asked Miller how a doctoral student in philosophy found his way to the business of investing. Miller replied that he wasn't an investor despite studying philosophy but rather he was intrigued with money management precisely because of his exposure to the study of philosophy. “Thanks to that training,” he said, “I can smell a bad argument miles away.”⁸³

In the second quarter of 2019, Warren announced Berkshire had purchased 537,300 common shares of Amazon.com worth then about $947 million. It was not a big purchase in terms of the size position. Indeed, Warren let it be known it was not he who bought the stock but one of his investment managers, Todd Combs or Ted Weschler. Combs joined Berkshire in 2010 to help manage a slug of Berkshire's investment portfolio. Two years later, Weschler was added to the team. Together, they manage collectively approximately 10 percent of Berkshire's common stock portfolio.

Warren met Jeff Bezos soon after Amazon went public. In 2003, Berkshire owned $459 million in Amazon bonds. At the time, there were only three things Warren purchased over the internet: The Wall Street Journal, online bridge, and books from Amazon. “I don't know if Amazon is going to weigh 150 pounds or 300 pounds,” said Warren, “but one thing I do know is that they are not anorexic. Here is a guy [Bezos] who took something that is right in front of us—selling books—and put it together with new technology to create, in a couple of years, one of the biggest brand names in the world.”⁸⁴

Fifteen years later, at the Berkshire 2019 Annual Meeting, Warren was still singing Bezos' praise. It is Olympic for someone to build from scratch a business that became the biggest in the world. Bezos, Warren noted, had done it twice, first with online retailing then later with Amazon Web Services (AWS), the world's largest on‐demand cloud computing platforms for individuals, companies, and governments on a metered pay‐as‐you‐go basis. “I have always admired Jeff,” Warren said. “I've been an idiot for not buying. I always thought he was special, but I didn't realize you could go from books to what happened here. He had a vision and executed it in an incredible way.”⁸⁵

At the annual meeting, Charlie Munger was more reserved. “We are a bit older than most,” said Charlie, “and we are not as flexible as others.” Warren added that he and Charlie grew up studying John Rockefeller and Andrew Carnegie, two of the twentieth century's greatest industrialists and richest men in history. They could have never imagined someone could build a trillion‐dollar business generating billions in earnings with so little capital employed. It was unimaginable.

At that same meeting, Charlie gave himself a pass for not buying Amazon but said he “felt like the horse's ass for not buying Google.” Now called Alphabet, Google went public in August 2004 at $85 per share and today is one of the world's largest companies, worth over $1 trillion. For years, Warren and Charlie watched GEICO send checks to Google to pay for the clicks consumers hit on the Google search engine to learn about GEICO Insurance. “We just sat on our hands,” said Charlie. Then, in an unapologetic tone, he added, “Maybe Apple is our atonement.”⁸⁶

Berkshire began buying Apple in 2016. It was announced the company purchased 9.8 million shares on May 16, 2016. By the end of the year, Berkshire owned 67 million shares at a cost of $6.7 billion for an average price of about $100 per share. The following year Warren purchased an additional 100 million shares, making Apple the second largest holding at Berkshire. At a market value of $28 billion, Apple was only slightly less than the market value of Wells Fargo at $29 billion. Then in 2018, Warren added another 90 million shares, making Apple Berkshire's largest holding by far. Twice as big as Wells Fargo. Twice as big as Bank of America. Twice as big as Coca‐Cola. In a CBS interview with Jane Pauley, Warren admitted he had been keeping an eye on Apple for several years. “I don't need to know things instantaneously. I'm not making buy‐and‐sell decisions based on instant news. When we bought Apple, it'd been something I'd looked at a long time.”⁸⁷

Warren was coming around to the idea that Apple was a very valuable product and that people were building their lives around the iPhone. “That's true of 8‐year‐olds and 80‐year‐olds. People want the product,” he said. “And they don't want the cheapest product.”⁸⁸ Today, Apple sells annually about 13 percent of the world's cell phones but captures 85 percent of the world's profits because it charges a premium price customers are willing to pay. When Warren first bought Apple, many were scratching their heads wondering why Berkshire wanted to buy a company like Motorola or Nokia, two cell phone manufacturers that had seen better days. But in another case of “failure to explain is caused by failure to describe,” Apple wasn't Motorola or Nokia, it was Louis Vuitton. There is a reason why the Apple Store on Fifth Avenue in New York and on the Avenue des Champs‐Elysees in Paris is next to the Louis Vuitton store. Apple is the luxury goods manufacturer of cell phones, and consumers have a strong affinity for its products.⁸⁹

The second value‐added component of Apple is its growing network. Over the years, Apple has built a wide array of products including the Mac computer, iPod, the iPhone, and the iPad. Next came the wearables, Apple Watch and AirPods. All these products were connected to a service component that includes the App Store, Apple Music, Apple TV, and the iCloud. Next came Apple Pay, a financial services component, and Apple Health. Today, Apple's services unit is the fastest‐growing part of the company. And that growth is the principal reason for the rapid growth in Apple's stock price over the last several years. In 2016, when Berkshire first purchased Apple, the market was assigning no value to the implied growth of the company. Today, over a third of Apple's enterprise value is attributed to future growth.⁹⁰

Apple's iPhones are profitable, but the economic returns of its service businesses are triple digit. At year‐end 2019, Apple's return on invested capital (ROIC) was 143 percent against a weighted‐average cost of capital (WACC) of 7 percent.⁹¹ The company is gushing cash. At the end of the second quarter 2020, Apple had $192 billion in cash, about 15 percent of the $1.3 trillion market value of the company. What is Apple doing with its cash? A good deal goes to maintenance capital expenditures as well as future investment opportunities. But the lion's share of Apple's cash earning is going directly to shareholders in dividends and share repurchases. Apple pays a $13 billion current annual dividend to owners of the company. However, much more is going to share repurchases. When Berkshire first purchased Apple in 2016, the company had 5.3 billion shares outstanding. At year‐end 2019, Apple's total shares outstanding tallied 4.4 billion. In the last four years, Apple repurchased 17 percent of its shares outstanding. Warren's investment in Apple is increasing each year without Berkshire having to spend a dollar.

If we step back and examine Apple, we find it is the perfect investment that straddles Stage Two and Stage Three value investing. It is a global consumer products company with strong brand value that continues to attract customers year after year. It generates high returns on capital and uses its excess cash to repurchase stock. In many ways, Apple is the Coca‐Cola Company Warren purchased 30 years ago. Furthermore, it is noteworthy that Apple, like Coca‐Cola, was “hiding in plain sight.”

Apple is also a new‐economy stock. All of Apple's products and services are powered by Apple's iOS operating system. Once a product becomes a part of Apple's ecosystem the network effects take over, and positive feedback, path dependence and lock‐in create a powerful global franchise. The switching cost for Apple's customer base is simply too high.

Interestingly, Warren does not think of Apple as being part of Berkshire's stock portfolio, but rather as one of Berkshire's own separate businesses. He refers to Apple as Berkshire's third business, alongside GEICO and Burlington Northern Santa Fe railroad. “Apple is probably the best business I know of in the world,” said Warren. “It has a valuable product which is central to people's lives.” At the 2019 Berkshire Annual Meeting, Charlie pointed out that Buffett's willingness to invest in Apple was a good sign for Berkshire. “Either you've gone crazy or you're learning,” he quipped. “I prefer the learning explanation.”⁹²

One of the greatest rewards that come from studying Warren Buffett has been to observe how he evolved, both rationally and pragmatically, over the last 65 years as an investor—from Stage One to Stage Two and now to Stage Three value investing. We heard Warren explain to his limited partners at the Buffett Partnership the investment rationale of owning Commonwealth Trust Company of Union City, New Jersey (1958), the outsized bet on Sanborn Map Company (1960), and his controlling interest in Dempster Mill Manufacturing Company (1962). Later, at Berkshire Hathaway, he explained the reasoning behind the See's Candies' acquisition and the billion‐dollar bet on Coca‐Cola. He discussed the strategic importance of owning franchise media companies and the benefit that comes from investing the float of an insurance company. Now Warren is illustrating the value of owning Apple, the largest company in the world, in the midst of the fifth technological revolution.

Philip Fisher was right. It is rare that a successful investor can evolve from one approach to a second, much less a third. To be successful past one market cycle requires mental flexibility, the proper temperament, and a burning desire to continually learn how to make money. This is an essential part of the mental construct of how a Money Mind works.

When Ben Graham retired from investing and left New York in 1956, Roger Murray took over the Value Investing Program at Columbia. Murray not only taught Graham's spring semester value investing seminar, he added David Dodd's fall class in 1961 when Dodd retired.⁹³

Murray was well known on Wall Street and enjoyed a respectable career at Bankers Trust as the chief economist, becoming the youngest vice president in the bank's history. He advised members of Congress and was the originator of the concept of the Individual Retirement Account (IRA). He was the founding director of the Investor Responsibility Research Center (IRRC) and became the 23rd president of the American Finance Association. But despite the long list of professional accolades, Murray found that being a teaching professor was the most rewarding. He was immensely liked by his students and always took great pride in the professional successes they achieved after graduation. Among Roger Murray's notable students are some of the best‐known names in our industry: Mario Gabelli, Chuck Royce, Leon Cooperman, Art Samberg, and Robert Bruce.

By the late 1960s, investment thinking across the country was beginning to change. On the heels of World War II and with the birth of the baby boom generation, the United States entered into a period of prolonged prosperity. The Dow Jones Industrial Average broke through 1,000 for the first time. Growth, not value, became the new investment mantra. A new breed of investment managers surfaced to lead the charge.

Gerald Tsai, Jr., was born in Shanghai. He moved to the United States with his parents in 1947 and graduated from Boston University with a bachelor's and master's degree in economics. Tsai began his career at Bache and Company but soon moved to Fidelity Management and Research, where he was named the fund manager of the newly formed Fidelity Capital mutual fund. Tsai's portfolio management style was momentum investing, which at the time helped to build Fidelity Investments into a mutual fund juggernaut. In 1965, Tsai left Fidelity and founded his own aggressive growth strategy, the Manhattan Fund.

Tsai's approach to investing was to concentrate his bets on growth stocks, in contrast to the value investing approach, which preached broad diversification. Tsai bought the glamour stocks like Xerox, Polaroid, and Avon Products; while value portfolios were full of slower‐growing industrials, utilities, and energy companies. Soon the published performance of Tsai's Manhattan Fund was trouncing the returns of value stocks. In short order, investors gravitated to what became known as the Nifty Fifty stocks, the fastest‐growing companies in the United States; the tried and true value stocks were left behind. It all worked out very well for investors, until it didn't. The brutal bear market of 1973–1974, the worst since the Great Depression, wiped out the Nifty Fifty growth investors, causing massive losses for individuals and their portfolios.

One might have thought value investing would have flourished again to fill the void, but the rally call for value approaches went unanswered and into the breach came a new group of investment thinkers—not investors but academicians. Born out of the University of Chicago in 1956, Modern Portfolio Theory (MPT) provided the salve for investors' wounds. MPT preached conservative returns and low price volatility. Investors rushed toward the emotionally soothing strategy. When Roger Murray retired from Columbia University in 1977, the Value Investing Program started by Ben Graham and David Dodd 50 years earlier was gone.

In 1984, Columbia Business School hosted a conference to celebrate the 50th anniversary of the first publication of Security Analysis. Warren was asked to present Ben Graham's value investing approach. Michael Jensen, a finance professor from the University of Rochester, argued on behalf of the efficient market hypothesis. Jensen, along with other academicians including Eugene Fama, believed the market quickly and accurately priced stocks, hence active management was a waste of time. No one could beat the stock market. Warren believed otherwise and offered evidence in a speech he titled “The Superinvestors of Graham‐and‐Doddsville.”⁹⁴

Warren began by recapping the central argument of Modern Portfolio Theory: The stock market is efficient, all stocks are priced correctly, and therefore anyone who beats the market year after year is simply lucky. Maybe so, he said, but I know some folks who have done it, and their success can't be explained away simply by random chance.

Still, to give the must‐be‐luck argument its fair hearing Warren asked the audience to imagine a national coin‐flipping contest in which 225 million Americans bet $1 on their guess. After each flip, the losers dropped out and the winners kept the pot and advanced to the next round. After 10 events, there would be 220,000 winners left who, by letting their winnings ride, would have gained $1,064. After another 10 tosses, there would be 215 winners, each with $1 million.

Now, Warren continued, the business school professors, analyzing this national contest, would point out that the coin‐tossers demonstrated no exceptional skill. The event could just as easily be replicated, they would protest, with a group of 225 million coin‐flipping orangutans.

Slowly building his case, Warren granted the statistical possibility that, by sheer chance, the orangutans might get the same results. But imagine, he asked the audience, if 40 of the 215 winning animals came from the same zoo. Wouldn't we want to ask the zookeeper what he feeds his now very rich orangutans?

The point, Warren said, is that whenever a high concentration of anything occurs in one specific area, something unusual may be going on at that spot, and bears investigation. And what if—here comes the clincher—the members of this one unique group are defined not by where they live but by whom they learned from.

And thus we come to what Warren called the “intellectual village” of Graham and Doddsville. All the examples he presented that day were centered on individuals who had managed to beat the market consistently over time—not because of luck but because they all followed the principles learned from the same source: Benjamin Graham and David Dodd.

Each of these investors called the flips differently, explained Warren, but they were all linked by a common approach that seeks to take advantage of discrepancies between the market price and intrinsic value. “Needless to say, our Graham and Dodd investors do not discuss beta, the Capital Asset Pricing Model, or covariance returns,” Warren said. “These are not subjects of any interest to them. In fact, most of them would have trouble defining those terms.”

Warren's 1984 speech was the intellectual defibrillator Columbia Business School needed to revive its Value Investing Program. That same year, David Dodd's family made a substantial financial contribution to the school, establishing the Graham and Dodd Asset Management Program. Robert Heilbrunn's family established a professorship in his name at the school. Heilbrunn had met Ben Graham in the 1930s, took his class and eventually became an early investor with Warren in the Buffett Partnership. Later, Helaine Heilbrunn along with Sid Lerner endowed The Heilbrunn Center for Graham and Dodd Investing, creating a permanent home for value investing at the Columbia Business School.

Mario Gabelli also took significant interest in reviving the Value Investing Program. Gabelli Asset Management Company (GAMCO) sponsored a series of four lectures in 1993 on value investing at the Museum of Television and Radio. The speaker was Roger Murray, the retired professor. He was 81 years old at the time but was said to have delivered each 90‐minute lecture without notes.

But it was Bruce Greenwald who has received the most credit for taking the helm of the newly rejuvenated Value Investing Program at Columbia and ably steering the study of value investing for the next quarter century. Greenwald joined the Columbia Business School in 1991 and was named the Robert Heilbrunn Professor of Finance and Asset Management in 1993. Later he became the Heilbrunn Center's first academic director. Greenwald attended Roger Murray's GAMCO's lectures and soon after convinced Murray to resurrect his professorial talents in a coteaching role. Together, Greenwald and Murray relaunched the value investing course Ben Graham started in 1927 and that Murray had himself taught for 21 years.

The newly resurrected value investing course at Columbia included 12 three‐hour lectures. Murray and Greenwald cotaught five, and invited seven guest speakers, including Mario Gabelli, Chuck Royce, Michael Price, Walter Schloss, and Seth Klarman, to present the final lectures. Roger Murray retired from Columbia for the second time in 1995, leaving Greenwald to manage the value course for the next 20 years.

Bruce Greenwald's intellectual firepower and determination remade the Value Investing Program at Columbia in two distinct ways. First, instead of teaching value investing as a single course in the fall and spring, Greenwald greatly enlarged the program into a wide branch system. In the 2020 academic year, there were 32 different but interrelated courses on value investing taught by 42 different professors, not including guest speakers. In addition, in 2002 Greenwald convinced Paul Johnson to initiate a value investing seminar for the Executive MBA program at Columbia. It was not only the students Greenwald was interested in teaching about value investing but the hundreds of professionals who were returning to Columbia to continue their education. Paul Johnson had taught Greenwald's value investing course twice when Greenwald was on sabbatical. You might recall Johnson as the 36‐year‐old technology analyst at Robertson Stephens who sent the open letter to Warren Buffett recommending Cisco Systems in 1996. Johnson proved to be a popular professor at Columbia so Greenwald knew he had the right teacher for the Executive program. Today, Johnson holds the record for teaching at Columbia Business School, 47 semester‐long courses.

The second initiative Greenwald undertook in remaking the Value Investing Program was to address, head on, the question of growth, especially the important question of how to value growth. For decades, growth investing was treated as the misaligned outsider never invited into the value club. But when Warren Buffett, in 1992, legitimized growth as a component to the calculation of value, Greenwald knew he had to accommodate the teaching of growth as it related to value. It seemed everywhere Greenwald looked, more and more prominent value investors were including growth companies in their portfolio.

When Greenwald joined Columbia in 1991, he was singularly focused on reenergizing the study of value investing. But behind the scenes he was already thinking about how to incorporate growth in the Value Investing Program. Greenwald publicly stepped up with the release of his soon‐to‐be popular book, Value Investing: From Graham to Buffett and Beyond, first published in 2003. He began writing the book in the late 1990s and had already decided to include a section on Intel Corporation with a chapter titled “The Value of Growth within the Franchise.” Four years later Greenwald, along with Judd Kahn, published Competition Demsytified: A Radically Simplified Approach to Business Strategy. In Chapter 16, “Valuation from a Strategic Perspective,” Greenwald summarized his view of valuation as something that should include “assets value, earnings power value, assessment of competitive advantages, and the value of growth.”

At the same time, Greenwald also began to expand the coursework at the Value Investing Program to include how to think about valuing growth companies. Michael Mauboussin joined the faculty. He had worked with Paul Johnson at Credit‐Suisse, then joined Bill Miller at Legg Mason Capital Management as chief investment strategist and later became chairman of the board of trustees at the Santa Fe Institute. Mauboussin brought the teaching of complex adaptive systems to Columbia along with how to think about the value of the new‐economy network companies. Paul Johnson needed no convincing. He was already teaching his students how to think about growth. Today, his seminar in value investing includes case studies on Apple, Amazon, and Uber Technologies. Paul's recent book, coauthored with Paul Sonkin, Pitch the Perfect Investment: The Essential Guide to Winning on Wall Street, has become popular with students at Columbia. Chapter 3 is titled “How to Evaluate Competitive Advantage and Value Growth.” Paul Sonkin was a former student of Paul Johnson at Columbia, had taught in the Business School for 16 years, and launched the school's Applied Value Investing course in 1998. Sonkin was also a coauthor with Bruce Greenwald on his book Value Investing and Beyond.

Today, a student at Columbia Business School can take a course on distressed value investing alongside a course on compounders, a study of companies that are rapidly compounding the growth of intrinsic value. Tano Santos, David L. and Elsie Dodd Professor of Finance, faculty codirector and head of research at the Heilbrunn Center, teaches a course on modern value that includes the study of disruptors, newly formed businesses that are taking market share from older, established companies. Students at Columbia can take a course on value investing in credit markets, on special situations investing, or on economics of strategic behavior, all based largely on Greenwald's book Competition Demystified. In all, the purview of value investing taught at Columbia Business School has widened dramatically.

For far too long, investors have erred by narrowly defining value investing. Warren Buffett, Charlie Munger, Bill Miller, Bruce Greenwald, Paul Johnson, and Michael Mauboussin, along with many others, have worked to widen the lens in the search for value. And in doing so, they enlarged the opportunity set for individuals to invest thoughtfully. Value does not hibernate, remaining hidden from the market's forces for years at a time. Value migrates. Sometimes value can be discovered in rapidly growing, high‐return‐on‐capital businesses. At other times it resides in the slower growing, more capital‐intensive companies. More often than not, value can be found in both camps. When a value investor claims their performance will improve once the market again recognizes value, this is an open admission that their view of value is confined, restricted to a small subset of all possible value opportunities.

As Warren and Charlie so powerfully remind us, “all intelligent investing is value investing.” They point out “the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?”⁹⁵

In the next chapter, “Business‐Driven Investing,” we examine in detail Warren's Money Mind construct as it relates to buying not a value stock, but a valued business.