Are you ready to be a contrarian cigar butt investor?

How would you feel about a star value manager with the track record shown in the chart below. While he beat the market in the wake of the dot-com bubble, he has only matched the performance of the S&P 500 since 2011. To be sure, he did beat his style benchmark (second panel).


The star manager is none other than the legendary Warren Buffett and the chart shows the relative performance of Berkshire Hathaway’s stock price relative to the S&P 500 and the Russell 1000 Value Index. Buffett’s best known recent win was his purchase of Apple in 2016 which became his largest holding, and whose relative returns are shown in the bottom panel.


I examine how he achieved his results, and offer studies of sources of alpha as examples of different investing styles.



Abandoning deep value for QGARP

Despite his reputation as a value investor, Buffett admitted in the latest Berkshire Hathaway shareholder letter that he isn’t really a classic deep value investor in the Ben Graham mold. The shareholder letter began with a tribute to his now deceased partner, Charlie Munger, who told him, “Abandon everything you learned from your hero, Ben Graham. It works but only when practiced at small scale.”


Buffett perfected the practice of “buying fair businesses at wonderful prices”, or stocks trading at less than their intrinsic value, which I characterized as Quality Growth at a Reasonable Price, or QGARP. Buffett explained deep value as “cigar butt investing” in the 1989 letter to 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.
Even though Buffett had been successful with “cigar butt investing”, it’s not scalable to a company of the size of Berkshire and the opportunities tend to be relatively small. It was Munger who persuaded Buffett to pivot to the idea of buying “wonderful businesses purchased at fair prices”, expanding the range of opportunities. As a consequence, Berkshire began taking a large position in Apple in 2016 which worked out extremely well.


Munger expanded on the reasoning behind the pivot in a 2019 interview:
“Well, it was perfectly obvious that 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. “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,” Munger said. “Now we could scale up to the big time.”
I discussed this pivot in 2018 (see Say Goodbye to Trump’s 1950’s America). I pointed out that the price to book factor had badly lagged other value factors. Returns aren’t based on assets, but on earnings and cash flows, which highlights the importance of intellectual property. Moreover, Buffett understood how platform companies like Apple, Google and Amazon were breaching the competitive moat of companies Berkshire invested in.


Today, Berkshire has accumulated a cash hoard of $168 billion: “Your company also holds a cash and U.S. Treasury bill position far in excess of what conventional wisdom deems necessary.” Buffett discussed the lack of investment opportunities in the latest shareholder letter.

There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced. Outside the U.S., there are essentially no candidates that are meaningful options for capital deployment at Berkshire. All in all, we have no possibility of eye-popping performance.

Endlessly picked over? No candidates outside the U.S.? What does that imply about market valuations?


QGARP in Japan

Here are two case studies of investing approaches. The first is Berkshire’s holdings in five Japanese trading houses, which stands in contrast to Buffett’s comment that there are no candidates outside the U.S., though Berkshire holds 9.9% in each of the five companies, which may be its maximum position.

Berkshire continues to hold its passive and long-term interest in five very large Japanese companies, each of which operates in a highly-diversified manner somewhat similar to the way Berkshire itself is run…
In certain important ways, all five companies – Itochu, Marubeni, Mitsubishi, Mitsui and Sumitomo – follow shareholder-friendly policies that are much superior to those customarily practiced in the U.S. Since we began our Japanese purchases, each of the five has reduced the number of its outstanding shares at attractive prices.
More importantly, the purchases were financed in Yen, which was a brilliant stroke.

Neither Greg [Abel] nor I believe we can forecast market prices of major currencies. We also don’t believe we can hire anyone with this ability. Therefore, Berkshire has financed most of its Japanese position with the proceeds from ¥1.3 trillion of bonds.

Since Berkshire began buying stakes in the five Japanese companies, the Tokyo market has performed well in Yen terms and the Nikkei recently reached an all-time high. However, Japanese market performance in USD terms was dragged down by Yen weakness.



Cigar butts in China?

By contrast, one cheap market that Buffett pointedly ignored is China. Berkshire once owned a substantial stake in BYD, the Chinese EV manufacturer, but sold down its position over the years.


To illustrate my point, Jeroen Blokland observed that China’s relative P/E is at an all-time low.



On the other hand, the macro fundamentals of the Chinese economy are weak. The catastrophe in real estate is nowhere near being resolved. Local government finances are constrained and under stress. The economy is facing weak consumer demand. Real-time cyclical price signals, such as iron ore (white line), look abysmal.



However, stimulus efforts are underway to support the market. The 30-year Chinese government bond yield recently reached a record low on expectations of government easing. Government inflows into the stock market are estimated to exceed 410-billion Yuan, which is far short of the 1.24-trillion Yuan during the 2015 market support episode. In addition, Beijing has “guided” quant funds that were the culprits in the recent market turmoil from accepting new inflows and phase out their existing products.