What did Benjamin Graham think about intangibles?

And how did his protégé, Warren Buffett, update that philosophy?

At the time of writing, American investor Warren Buffett is worth about $US117.5 billion, which makes him the country’s most successful investor of all time. And he learned everything he knows from a man called Benjamin Graham.

Buffett read Graham’s book “The Intelligent Investor” while studying under the famous economist at Columbia Business School. Buffett said the book changed his life so radically that he named his first son (Howard Graham Buffett) after the influential professor.

In a short obituary after Graham’s death in 1976, Buffett highlighted three key life lessons from the economist:

1)     Do something foolish: “Investors need an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period — or even to look foolish — is also essential”;

2)     Do something creative: “A remarkable aspect of Ben’s dominance of his professional field was that he achieved it without the narrowness of mental activity that concentrates all efforts on a single end”;

3)     Do something generous: “Walter Lippmann spoke of men who plant trees that other men will sit under. Ben Graham was such a man.”

But the biggest lesson Buffett learned was the importance of finding the difference between the current (market) price of a company and its intrinsic value. Graham’s core philosophy involved acting on that gap with a proportionate investment in the required direction.

One way of thinking about the intrinsic value of a company is the sum of its tangible and intangible assets. Most retail investors can easily see a company’s tangible assets – things like cash holdings, property, machinery, etc. – but they often struggle to correctly value its intangible assets. It takes focus, research and perpendicular reasoning to spot intangible assets.

Buffett is famous for strictly investing in companies that he fully understands. Even when presented with a great opportunity, if he isn’t sure about the fundamentals of the company, then he will hold off. One of Buffett’s strategies is always to locate, codify and leverage a firm’s intangible assets – particularly the pieces that few others know to look for. That’s the real gap between current and intrinsic value, as outlined by Benjamin Graham all those years ago.

Graham wasn’t the only one Buffett listened to. Indeed, Buffett once said, “Boy, if I had listened only to Ben, would I ever be a lot poorer.” But Graham was certainly an influential figure in the career of America’s most successful investor.

So, who was Benjamin Graham and did he say anything insightful about intangible assets that might be useful to us today?

The father of value investing

Often called the “Father of Value Investing,” Graham (originally Grossbaum) was born on 8 May, 1894, in London. His family emigrated to the US before his first birthday, settling in New York City.

In the hustle and bustle of the Big Apple, Graham didn’t really fit in due to his family's modest financial circumstances. These humble beginnings incentivised him to discover how to never be in poverty again which likely played a role in shaping his lifelong interest in investment. Later in his life, Graham experienced the horrific market downturn of 1929, which reinforced his desire to achieve a safer position of family wealth.

Graham's parents placed a high value on education at which he excelled. He eventually attended Columbia University, where, like Buffett years later, he studied under distinguished economists like James Angell and John Bates Clark.

Following his graduation, Graham pursued postgraduate studies at the New York Stock Exchange (NYSE) Institute where he developed a keen interest in risk management and the preservation of capital which would later manifest in his groundbreaking concept of value investing and looking at a company’s intangible assets.

In his seminal co-authored work "Security Analysis," first published in 1934, Graham suggested that markets are too often driven by emotions and short-term fluctuations, leading to mispricing of assets. By closely analysing a company's basic structure and buying stocks trading below their intrinsic value, investors could capitalise on the market's irrational behaviour.

Focus on the tangible

Like most investors in the 20^th century, Graham primarily focused on analysing tangible assets. After all, he came of age at a time when well over 80% of the average company value was in physical assets, particularly machinery and factories.

However, that doesn’t mean he disregarded intangible assets. Quite the contrary. Here’s Graham in his book Security Analysis:

"It may be pointed out that under modern conditions the so-called "intangibles" e.g. goodwill or even a highly efficient organisation, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities…”

Here Graham recognised that certain intangibles, such as brand, patents and “goodwill” (a catch-all term that really doesn’t help with understanding the nitty-gritty of intangible assets), could contribute to a company's overall value.

Yet Graham is also advising caution when incorporating intangibles into valuations, pointing out that their value must be linked back to something material and tangible, like cashflow:

“Such intangibles may have a very large value indeed, but it is the income account and not the balance sheet that offers the clue to this value. In other words, it is the earnings power of these intangibles, rather than their balance sheet valuation, that really counts.”

These statements are neither dismissive nor encouraging for intangible assets. Instead, they are great examples of the kind of investor Graham was – cautious and focussed.

Because of Graham’s rough experience of the 1929 economic crash, he had scars that never fully healed which created an investment model best summed up by Buffett as: never lose money. To Graham, thinking about anything that didn’t appear on the balance sheet was imprudent at best and dangerous at worst. It’s an interesting sentiment.

Nevertheless, his demand that intangible assets be linked directly with earnings potential remains great advice today. Highlighting intangible asset value is pointless unless its value can be precisely articulated. It’s a bit like a machine sitting idle in the yard: the asset quickly becomes a liability if it isn’t being used.

An intangible world

But the business world has evolved considerably since Graham’s day, and intangible assets are now often 100% of the gap between current price and intrinsic value.

As the physical 20^th century merged into the largely non-physical Information Age, intangible assets came to dominate the business landscape. The financial sector has slowly recognised the importance of intangibles and now regularly incorporates them into their valuation and investment decisions.

If Graham were alive for this revolution, I like to think he would have reacted to the importance of intangible assets is a similar way to his protégé Warren Buffett.

But, to do that, Graham would probably need his own “Charlie Munger” (who is Buffett’s 2IC). Buffett said Munger was key to expanding his aperture to understand the changing business world.

“Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons.

“My guess is the last big time to do it Ben’s way was in ’73 or ’74 when you could have done it quite easily,” Buffett said.

What’s funny and ironic is that in evolving Graham’s philosophy, Buffett is pointing to a timeless fundamental of investing: Past performance is no guarantee of future results. If you don’t evolve with the times, you will be left behind.

But the larger lesson is that this doesn’t mean you throw the baby out with the bathwater. Graham’s philosophy about caution when including intangibles in valuations continues to inform Buffett’s investment approach, but Buffett has found it highly lucrative to add to Graham’s theories, especially about intangibles, and through this process become the best investor in American history.

I’m sure Graham would be proud of his protégé.