Warren Buffett's greatest trade 🤝
Plus a charted review of the macro crosscurrents 🔀
Stocks made new record highs, with the S&P 500 reaching a closing high of 5,088.80 and an intraday high of 5,111.06 on Friday. For the week, the S&P gained 1.7%. The index is now up 6.7% year to date and up 42.3% from its October 12, 2022 closing low of 3,577.03.
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As prices have climbed, valuations have followed. While they’re not at all-time highs, valuations are currently above long-term averages, raising doubts about whether it’s a great time to buy.
This is a bit of a quandary for investors.
Perhaps we can gain some insight from arguably the greatest stock market investor of all time: Warren Buffett.
How a new investment philosophy changed Berkshire forever 💰
Buffett’s new annual letter to Berkshire Hathaway shareholders opened with a thoughtful tribute to Charlie Munger, his long-time partner who died in November.
He highlighted the huge impact Munger had on how he thought about investing. From the letter (emphasis added):
…Charlie, in 1965, promptly advised me: “Warren, forget about ever buying another company like Berkshire. But now that you control Berkshire, add to it wonderful businesses purchased at fair prices and give up buying fair businesses at wonderful prices. In other words, abandon everything you learned from your hero, Ben Graham. It works but only when practiced at small scale.” With much back-sliding I subsequently followed his instructions.
Many years later, Charlie became my partner in running Berkshire and, repeatedly, jerked me back to sanity when my old habits surfaced. Until his death, he continued in this role and together we, along with those who early on invested with us, ended up far better off than Charlie and I had ever dreamed possible.
In case you aren’t familiar, Ben Graham wrote the finance classic The Intelligent Investor. Also known as the “father of value investing,” Graham was Buffett’s professor at Columbia Business School and later his boss.
Under Graham’s guidance, Buffett mastered the idea of “buying fair businesses at wonderful prices,” or stocks trading at less than their intrinsic value.
One colorful iteration of this is “cigar butt” investing. Buffett explained in his 1989 letter to Berkshire shareholders:
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.
Buffett had a lot of success with this approach.
However, the issue with “cigar butt” investing is that there aren’t many opportunities, and the opportunities tend to be small.
Munger’s suggestion to flip the script and add “wonderful businesses purchased at fair prices” expanded the range of opportunities that Berkshire could pursue for its growing portfolio.
It’s this kind of thinking that justified Berkshire amassing shares of Apple starting in 2016 at a time when many questioned how much further the stock could run.
“He'd made so much money in the other technique that it was hard for him to leave something that had worked so well,” Munger said in a 2019 interview. “But it was not going to scale. So when he started looking for investment values in great businesses that were temporarily under pressure, it changed everything for the better. Now we could scale up to the big time.”
The greatest trade 🤝
Great trades are rarely simple analytical exercises where outcomes match expectations. They often challenge your instincts, and they require that you balance humility and discipline with a willingness to change your mind.
While it’s hard enough to sell a stock that’s created a ton of wealth for you, it’s a whole other thing to step away from a working investment strategy you’ve been mastering for your entire career.
But this is what Munger urged Buffett to do, and the change has so far been a winning move for Berkshire and its shareholders.
I’d argue Buffett’s greatest trade didn’t involve any single financial security. Rather, I’d say his greatest trade was selling “cigar butt” investing and buying the investing philosophy championed by his right-hand man.
Credit to Munger for making the recommendation. Credit to Buffett for executing the trade.
Getting back to the stock market 📈
It’s hard to argue the stock market is clearly undervalued. In other words, you might not say buying the S&P 500 today is comparable to buying a “fair business at a wonderful price.”
But could you compare it to buying a “wonderful business at a fair price”? Does the S&P represent an opportunity that could generate attractive returns in the years to come?
Well, it sure looks a lot more attractive than a cigar butt.
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