One of the greatest trades Warren Buffett (Trades, Portfolio) ever made was his investment in Federal Home Loan Mortgage Corp., which is more commonly known as Freddie Mac (FMCC, Financial).
I am calling this a trade because, unlike most of the Oracle of Omaha's other highly profitable investments, he sold the stock after a decade, which turned out to be an incredibly astute decision. The trade also relied heavily on timing. In the decade that he owned the business, the investment returned 1,500%.
To understand how this trade played out, we need to take a trip back to 1988. That was the year Buffett bought his Freddie Mac stake for $4 per share.
A Buffett-style business
Buffett acquired such a significant stake in Freddie Mac through Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) that the conglomerate eventually became the company's largest shareholder, with a 9% ownership interest.
When he first stumbled across the business, it appeared to be a traditional Buffett-style investment. It was earning a return on equity in the mid-20% range and seemed undervalued by the market. Despite the high return on equity, the stock was trading for less than eight times estimated earnings.
In an interview with Fortune Magazine in 1988, Buffett laid out his reasons for buying:
"'You've got a low price-earnings ratio on a company with a terrific record... You've got growing earnings. And you have a stock that is bound to become much better known to equity investors.'"
As well as these qualities, the company was benefiting from the growing demand for residential mortgages, low delinquency rates and a near-monopoly on the U.S. mortgage market. The economics of this business in 1988 were incredibly favorable. Buffett wanted to buy as much stock as he could get his hands on.
However, his love affair with the company ended in 2000. Berkshire had sold all of its shares by the end of that year. This was an incredibly successful trade for the conglomerate, and for a man who does not like to sell top-performing investments, the decision to divest the position may have seemed strange to investors at the time.
Too much risk
Buffett's view of Freddie Mac changed when the company started taking on too much risk. According to his testimony to the U.S. Financial Crisis Inquiry Commission in May 2010, Buffett sold the financial group because "They were trying to - and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort."
When a large financial enterprise starts to target regular earnings increases, he argued, trouble is not far away. There is a lesson here for investors. Buffett has said there are only two reasons he would want to sell a stock. First, if something changes, and secondly, to free up capital.
It seems that in 2000, Buffett had noticed a change in Freddie Mac's strategy, which troubled him. Rather than waiting around to see what happened next, he started to sell the position and take profits.
This would not have been possible if he had not been paying close attention to the company. Buffett spends hours reading annual reports and analyzing company performance every day, and this gives him a competitive edge in a highly competitive market space.
Research reduces risk
Many investors would not have seen the change in Freddie Mac's business model. Many others might have praised the company for targeting steady growth.
However, it seems as if Buffett's own research had shown him companies that target growth while taking on too much risk could become unstable. He had the confidence in his own research and conclusions to execute a trade off the back of this information.
Buffett's experience with Freddie Mac shows just how important it is for investors to do their own detailed due diligence and use research to reduce risk when analyzing investment opportunities.
Thorough research and a broad understanding of the business environment, in general, is a simple strategy for building a mental model to deal with any investment question.
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