Once upon a time, the markets were chaotic and unpredictable. A lone voice emerged as a beacon of stability as the world got to know the wit and wisdom of Warren Buffett. Markets are still chaotic, but at least we've got this one steady voice saying the same things over and over again. Yet Buffett once did the unthinkable: he completely pivoted in his stock-picking philosophy and created yet another famous quote from the Oracle of Omaha:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Notably, Buffett had been using a style of investing that made a great deal of sense at the time, learned from his mentor, Benjamin Graham. This involved finding companies with an intrinsic value far lower than they were selling and waiting for the market to realize the discrepancy. What caused Buffett to drop this style in favor of his current approach?
Ben Graham likened the sort of businesses he recommended finding to a discarded cigar butt he found on the sidewalk in a big city. Graham could pick up the metaphorical cigar, draw on a few free puffs, and then discard it himself, in a manner of speaking. For him, it was merely tedious to identify such bargains, especially since information traveled at a much, much slower pace than today.
Back in the 1930s and 40s, when Graham was formulating the ideas behind his magnum opus, electronic trading was several decades away, and individual stocks would often sell for even less than their net cash position, meaning that the company could theoretically just sell all of their equipment to pay off their debt, and still have more cash than the stock was selling for.
You could even find stocks selling below book value, which is considerably harder today (and the companies you find almost always have something else going on that detracts from their value). To Graham, this was free money, and he'd take a few puffs before selling at a hefty profit based on this strategy.
A Titanic Shift
So, what changed for Buffett? Why doesn't he just use cigar-butt-style investing to manage Berkshire Hathaway? First, Berkshire is a very, very large company. Any investments they make need to move the needle to a degree, meaning they need to be big. Like, bigger than cigar-butts big.
Second, while cigar-butt investing works well, it also means you have to go out and find new bargains frequently, since your goal isn't necessarily to own the thing forever, but instead to take profits as soon as the market realizes the terrible mistake it has made in pricing this stock.
Ultimately, though, it was Charlie Munger, Buffett's right-hand man and superinvestor in his own right, who convinced Buffett himself to shift his position. In Berkshire's 1989 letter to shareholders, we get to see behind the curtain.
Ultimately, the "wonderful business at a fair price" argument wins, especially since cigar butts need to be replaced frequently, and there aren't always such "fish in a barrel" opportunities nowadays.
You Do You
So, Warren Buffett's style evolved, and he made a conscious decision to start buying higher quality businesses at prices likely closer to their intrinsic value. This touches on an important concept: just because something is selling at a discount doesn't necessarily mean you should buy it.
First, the underlying earnings of the business may be on the decline, and this can be due to a multitude of factors, including poor management, a decline in an entire sector, or other reasons. Second, every investor is on their own time horizon and needs to plan accordingly.
You might find something that is selling for well below what you feel is its intrinsic value, but without a catalyst to unlock the rise in price, you may well be waiting for a very long time. Of course, that's no problem if your favorite holding period is forever, but if you have a specific financial goal to meet, you need to take that into account.
On the flip side, you're not hindered by "needing to move the needle" at a multi-billion dollar company. This means you can do some "bottom-feeding" and keep your eyes peeled for lower market cap companies that larger institutions are forced to ignore due to the needle effect.
You're also unconstrained by any sort of time horizon other than your own, whereas institutional investors have to take their clients' needs into account, along with the whims of the market, quarterly performance targets, and even worse. Your advantage over these titans is that you don't have to follow any of those rules when you're finding stocks.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Andrew Smith