Warren Buffett learned investing from Benjamin Graham, widely regarded as the father of value investing. He studied under Graham at Columbia Business School and later worked for him. Yet the approach that made Buffett famous differs from his teacher’s in an important way.
Warren Buffett and the Interpretation of Financial Statements opens with that shift, and it is worth understanding even for people who never intend to buy a share. It is a story about the difference between a good deal and a good business. This article describes Graham’s approach, what Buffett noticed about it, how his thinking changed, what each approach does well, and why the same distinction applies to suppliers, equipment, hiring, markets and the kind of business a founder chooses to build.
Graham’s approach: buying a dollar for fifty cents
Graham’s method grew out of the market crashes of the late 1920s and early 1930s. He observed that markets regularly swung between excessive optimism and excessive pessimism. In pessimistic periods, shares in some companies traded for less than the business was conservatively worth, sometimes for less than the cash and other liquid assets it held.
His approach was to buy these neglected shares at a large discount, wait for the market to correct its mistake, and sell. The book describes his disciplines as including a firm price limit relative to earnings, selling once a share had risen by a set amount, and selling anyway if nothing happened within a couple of years. To manage the risk that some cheap companies were cheap for good reason, he spread his money across a large number of holdings.
Two of Graham’s lasting ideas
Graham’s writing, especially Security Analysis (1934, with David Dodd) and The Intelligent Investor (1949), introduced ideas that remain influential:
- The margin of safety. Buy only when the price is well below a conservative estimate of value, so that errors in judgement or bad luck still leave room for a satisfactory result.
- The market as a moody partner. Graham described the market as a partner who offers to buy or sell every day at prices driven by mood. The investor’s job is to take advantage of the partner’s moods, not to be guided by them.
It was a careful, defensive, statistical approach, and it worked. Buffett used it successfully for years.
What Buffett later called “cigar butts”
Buffett has described this style as picking up discarded cigar butts that still have one free puff left. The business is unattractive, but bought cheaply enough, it yields a small profit before being discarded. The image captures both the method’s strength (it can be profitable) and its limit (the profit is small and one-off).
What Buffett noticed
The book describes how, reflecting on these methods, Buffett noticed two things.
First, some of the bargains never recovered. They were cheap because the business was genuinely weak, and some failed. Diversification softened the damage but also diluted the results.
Second, and more important, a few of the companies sold under the strict exit rules kept growing for years afterwards. Selling them after a modest gain had meant giving up most of what they would eventually be worth.
Studying those companies, Buffett found they shared a competitive advantage that lasted. They could charge more, sell more or spend less than competitors, year after year. And because the advantage persisted, the value of the business kept rising for as long as it was held.
Other influences
Widely published accounts of Buffett’s career also credit his long-time partner Charlie Munger with pushing him towards quality, arguing that paying a fair price for an excellent business was better than paying a low price for a mediocre one. The purchase of See’s Candies in 1972 is often cited as a turning point. Buffett paid more than Graham’s rules would have allowed, and the business went on to produce large and growing profits for decades while needing very little additional capital.
The shift: from price to quality
That realisation changed the question. Instead of asking only “is this cheap?”, Buffett increasingly asked “is this an exceptional business, and will it stay exceptional?”
Several consequences followed.
A fair price could be enough. If the business keeps growing in value, there is no need to wait for an extreme bargain.
Holding periods became very long. The longer an exceptional business is held, the more its advantage compounds.
Concentration replaced wide diversification. If you can identify a few exceptional businesses, owning many mediocre ones dilutes the result.
Risk looked different. A durable business is unlikely to fail, so a falling share price became an opportunity rather than a danger.
Tax was deferred. Holding rather than trading postponed capital gains tax, leaving more money compounding.
Buffett did not abandon Graham’s core idea that price matters and that you should not overpay. He combined it with an emphasis on business quality and time.
The two approaches side by side
| Graham’s approach | Buffett’s later approach | |
|---|---|---|
| Main question | Is it cheap relative to value? | Is it exceptional, and will it stay so? |
| Source of return | Price correcting to value | Business value compounding |
| Typical holding period | Short to medium | Very long |
| Diversification | Broad | Concentrated |
| Attitude to quality | Secondary | Central |
| Attitude to price | Must be very low | Must be fair, never extreme |
| Main risk | Buying a business that keeps declining | Overpaying, or misjudging durability |
Neither approach is simply right. Graham’s method suits investors who cannot judge business quality confidently and want protection through low prices and diversification. Buffett’s later approach requires the ability to identify durable advantages, which is harder and riskier if done badly. The book’s emphasis on reading financial statements is, in effect, a guide to developing that ability.
Why compounding changes the calculation
The difference between the two approaches is ultimately about time. A bargain produces a one-off gain when the price corrects. A durable business produces a gain that keeps growing.
An illustration: suppose an investor buys a mediocre business at half its value and sells it two years later at full value. The gain is 100% over two years, roughly 41% a year. Impressive, but then the money must find a new bargain, and good bargains are not always available.
Another investor buys an excellent business at a fair price, and its value grows at 15% a year for twenty years. The total gain is more than fifteen-fold, with no need to find a new opportunity every two years and no tax paid along the way until the shares are sold.
The first approach requires a constant supply of new bargains and good judgement every time. The second requires one good judgement and patience.
A lesson beyond investing
The same shift applies to almost any long-term decision. It is tempting to optimise for the bargain: the cheapest supplier, the lowest-cost hire, the discounted equipment. Sometimes that is right. But a cheap choice that fails, or needs replacing, often costs more in the end than a sound choice at a fair price.
Suppliers. The cheapest supplier may be unreliable, forcing expensive workarounds, rush orders and unhappy customers. A dependable supplier at a fair price often costs less over time.
Equipment. Discounted equipment that breaks down frequently or becomes obsolete quickly can cost far more than a reliable machine bought at a fair price.
Hiring. A capable person paid fairly usually produces far more than the difference in salary compared with a cheaper, less capable hire.
Markets. A market that is cheap to enter because nobody else wants it may be unattractive for good reasons. A market with lasting needs and room for a differentiated offer may justify a higher entry cost.
Acquisitions. Buying a struggling competitor cheaply can bring its problems with it. Paying a fair price for a sound business usually works out better.
In each case, the margin of safety still matters: do not overpay, even for quality. But the first question should be whether the thing being bought will keep delivering value, not only whether its price is low.
Where bargain thinking still helps
None of this means bargains should be ignored. Graham’s discipline remains valuable in many business decisions, especially where quality is easy to verify and the item is not central to the business’s advantage.
Commodity inputs, standard office equipment, generic services and surplus stock are often best bought at the lowest sensible price, because one supplier’s version is much like another’s. Second-hand equipment can be an excellent bargain when its condition can be checked and its remaining life is known. Buying assets from a business that is closing can provide good equipment at a fraction of its cost.
The useful distinction is between things where quality differences matter to the business’s position and things where they do not. For the first group, pay a fair price for quality. For the second, hunt for bargains. Many businesses get this the wrong way round: they cut costs on what customers notice and overspend on what they do not.
What this means for building a business
For anyone building a business, the deeper lesson is about what to aim for.
A business designed only to make money once, or to be sold quickly, behaves like one of Graham’s bargains: worth a modest gain if things go right, and then the founder must start again. A business designed around a lasting advantage behaves like one of Buffett’s compounding holdings: it keeps producing value year after year.
The second is harder to build. It requires choosing problems that last, customers who return, a position competitors cannot easily copy and the patience to let reputation accumulate. But it is worth far more, to its owners, its customers and the people who work in it.
A worked example
Two people each start a small landscaping business. This is an illustration.
The first focuses on winning one-off jobs at the lowest price. Equipment is bought second-hand at the cheapest available price, staff are hired on the lowest rates, and every quote is cut to the bone. Work is plentiful but margins are thin, equipment breaks down often, staff turnover is high and customers rarely return.
The second focuses on commercial maintenance contracts for a few property managers. Equipment is reliable, bought at fair prices; staff are well trained and paid fairly; quotes reflect the reliability of the service. Fewer clients are won at first, but those clients renew year after year and refer others.
After five years, the first business is still chasing the next cheap job. The second has a steady base of recurring contracts, predictable revenue and a reputation that wins work without competing on price. The first optimised for bargains; the second built a business with a lasting position.
Common mistakes
Treating every low price as an opportunity. Some things are cheap for good reasons.
Assuming quality justifies any price. The margin of safety still applies.
Selling excellent assets too early. Compounding needs time.
Ignoring the cost of replacement. Cheap choices that must be redone are rarely cheap.
Building a business to flip rather than to last. The value of durability is often underestimated.
Questions to ask
- Is this cheap because it is undervalued, or because it is weak?
- Will this asset, supplier, hire or market keep delivering value for years?
- Am I paying a fair price, with a margin of safety, for something of lasting quality?
- What would it cost to replace a cheap choice that fails?
- For your own business: are you building something that makes money once, or something that compounds?
Bringing it together
Graham taught Buffett to buy businesses for less than they were worth, and to protect himself with a margin of safety. Buffett kept that discipline but added a crucial insight: the most valuable businesses are those whose advantage lasts, and they are worth holding for decades at a fair price.
The shift from bargains to quality is a lesson that reaches far beyond investing. Whether choosing suppliers, equipment, people or markets, or deciding what kind of business to build, the question is not only “is it cheap?” but “will it keep delivering value?” The answer to the second question usually matters more.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Historical details are summarised from the book and widely published accounts. Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
