Let’s Take a Trip to Graham-and-Doddsville

The Superinvestors of Graham-and-Doddsville” is a legendary address delivered by Warren Buffett to the Columbia Business School in 1984 to mark the 50th anniversary of Benjamin Graham and David Dodd’s seminal investment book Security Analysis. Though the address is primarily about defending the value investment style of active management and disproving the efficient market hypothesis, it was this speech that taught me how to think about risk as an investor.

In university, we are taught that the primary definition of risk for investors is stock price volatility. Academic finance uses the relationship between historical price movements as a proxy for investment risk. Simply, it’s the idea that the more volatile a stock price, the more risky the investment.

Buffett argues that the notion “volatility equals risk” is flawed. He uses the example of The Washington Post Company in 1973, which was selling for $80 million in the market. At the time, Buffett estimated the intrinsic value of the company to be at least $400 million. At the $80 million valuation, Washington Post had a margin of safety of 80%, which is the discount of a company’s stock price to its intrinsic value.

He goes on to explain that if the stock price declined by 50% to $40 million, the “academics” would deem the stock highly volatile and therefore a riskier investment. On the contrary, Buffett argues that at a $40 million market value, the investment is less risky than at $80 million. The lower stock price has increased the margin of safety in the investment from 80% to 90%.

So, if risk is not defined by volatility, how does Burgundy define risk?

Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.

– Warren Buffett

Burgundy defines risk as the permanent loss of capital. One of the core pillars to which Burgundy was founded upon was “to protect and build our clients’ capital.” We start with “protect” first and foremost because of the asymmetry of negative returns. A $100 investment that loses 50% of its value is now worth $50, and the investment return required to get back to even ($100) is 100%. That’s a challenge most investors don’t want to face.

This is why Burgundy manages the downside risk of a potential equity investment by assessing the business risk, balance sheet risk and valuation risk of every potential investment. Through rigorous independent research, we choose to invest only in companies where we understand the economics of the business, where we are comfortable with the level of debt on the balance sheet, and where there is a significant margin of safety built into the price we will pay for the investment. Like Buffett, our approach to risk management welcomes volatility and the opportunity to invest in quality businesses at discount prices.

This post is presented for illustrative and discussion purposes only. It is not intended to provide investment advice and does not consider unique objectives, constraints or financial needs. Under no circumstances does this post suggest that you should time the market in any way or make investment decisions based on the content. Select securities may be used as examples to illustrate Burgundy’s investment philosophy. Burgundy funds or portfolios may or may not hold such securities for the whole demonstrated period. Investors are advised that their investments are not guaranteed, their values change frequently and past performance may not be repeated. This post is not intended as an offer to invest in any investment strategy presented by Burgundy. The information contained in this post is the opinion of Burgundy Asset Management and/or its employees as of the date of the post and is subject to change without notice. Please refer to the Legal section of this website for additional information.


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