What is Cigar Butt Investing? And How Does it Work?
An Overview of Cigar Butt Investing: Warren Edward Buffett goes down in history as one of the greatest investors. He can also be credited for popularising value investing which also turned him into a billionaire and also an investment guru. But did the same strategy make him a millionaire as well? The answer is ‘No’.
Today we look at the approach Warren Buffett adopted in his early years popularly known as the Cigar Butt Investing.
What is the Cigar Butt Investing approach?
A person who does not have any money would go around picking discarded cigars on the street to enjoy a few puffs which would cost him nothing. Cigar butt investing too runs along the same lines. In Warren Buffetts’ words “Cigar Butt approach to investing is where you try and find a really kind of pathetic company but it sells so cheap that you think there is one good puff left in it”.” Though the stub might be ugly and soggy”, the bargain purchase would make “ the puff all free”.
Warren Buffett, however, adopted the approach from his mentor Benjamin Graham, “ The father of value investing”. Graham, however, gave it a more respectable name i.e. the Net-Net approach or Deep Value investing.
In this approach, the companies picked are those that are in their final stages. But a final surge in the prices occurs which is the free puff which allows you to take a puff i.e. profit and discard the Cigar Butt i.e. sell the stock.
[Our net stocks strategy] gave such good results for us over a forty-year period of decision making that we eventually renounced all other common-stock choices based on the regular common stock procedures, and concentrated on these ‘sub-asset stocks.’ ” – Benjamin Graham
Benjamin Graham started with the Cigar Butt approach during the onset of the great depression. During this time the shares of companies would trade at very low prices. At this point, the fact that the companies were making no profit did not matter as you could buy the companies for less than their net liquidating value. One would get both the Goodwill and the factory for nothing like the discarded cigar.
Benjamin Graham unlike Warren Buffett believed that the past and the present were more important than the future. He also did not believe in giving the management of a company added weightage over the company’s value and hence came the Cigar Butt approach.
How to know if the discarded Cigar has a puff left?
Differentiating a Cigar Butt with the last puff from waste can be done by calculating the Net Current Asset Value (NCAV).
Benjamin Graham’s criterion for a Cigar Butt approach was to buy stocks that traded at below 2/3rd of the company’s NCAV. Hence even if the stock price returns to the NCAV, it would result in at least a 50% gain.
But what if the shares do not rise at all?
In a situation where the prices do not increase, the next step would be to keep buying the shares at the reduced value. This is done to increase ownership and finally liquidate the company. Here, after the debts are paid off the remaining amount would be paid off to shareholders which as calculated in NCAV would result in a profit as the shares were bought below NCAV.
The downside to this approach
It is important to note that even though Warren Buffett started off with this approach unlike his guru he gave it up. In “ Mistake of the First 25 Years” in the annual letters, he said that although the Cigar Butt strategy was rewarding, buying businesses with such kind of approach was foolish (unless you were a liquidator). Let’s go through the reason why this may be so.
1. Never is there just one cockroach in the kitchen
Often there is not just one but a couple of reasons why a company is on the verge of winding up. And even though when we think the problem is solved another one surfaces.
2. Time is the friend of a good business and the enemy of the mediocre
The Cigar Butt approach is dependent on a temporary spike in the price or liquidation that may never occur. Say you purchase shares at Rs.60 and later are able to recover Rs. 100 from the sale or through liquidation. But if it takes you 10 years till you are able to get this return the investment would be poor. Also, there is a good possibility that during the course the company does everything to ensure business continuity.
This may include spending on its current assets or increasing the debt. Both would result in deteriorated NCAV. And also a waste of time as the shares even though bought below NCAV would reap higher returns elsewhere.
“ It is not much fun to buy a business where you really hope this sucker liquidates before it goes broke.” – Charlie Munger
It is noteworthy that even though Warren Buffett stopped using the Cigarette Butt investment strategy he considers his purchase of Berkshire Hathaway a Cigar Butt. Warren Buffett regardless did not continue with this approach.
Unlike Benjamin Graham, Warren Buffett also gave importance to future prospects, growth potential, and management. As per the approach later adopted instead of us looking around for Cigar Butts it is better to look for unsmoked discarded cigars i.e. companies with high quality (good management and good prospect) that trade below their intrinsic value. And then enjoy the next two hours patiently smoking through the cigar. I.e. holding the shares for a long period of time and reaping huge rewards.
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Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.
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