02 Apr Should You Invest in Cigar Butt Stocks
Warren Buffett’s investment approach wasn’t always the same throughout his career. His current style of buying big companies with competitive advantage was different from the investment style he started with.
Likewise, the Berkshire Hathaway that we know today is a conglomerate. When Warren Buffett bought Berkshire it was an unsexy textile business with profitability issue. But the share price was way below the book value of the company and offers a lot of margin of safety so Warren invested. This was the classic Benjamin Graham’s teaching with regards to investing. Buffett has been implementing Graham’s strategy when he began his career and the former coined such stocks as cigar butt stocks.
“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.” ~ Warren Buffett.
Very often, these cigar butt stocks are small companies facing some problems which causes investors to be extremely pessimistic with them, and hence, the pessimism is priced into the stocks. However, the stock price is so depressed that it is trading way below the liquidation value of the company that even if it goes bust, some profits can be made.
It all sound too risky right? Aren’t we suppose to buy only wonderful businesses? Why buy companies with problems? How well did Warren Buffett do with his cigar butt stocks?
In fact, he did extremely well. He said this to Businessweek in an 1999 interview:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“The universe I can’t play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
There are three points to glean from what he said,
- He has made higher percentage returns on his capital buying the cigar butt stocks.
- It is advantageous to have smaller capital.
- He has to stop investing in cigar butt stocks because his capital has grown too big.
In 2014 newsletter to Berkshire’s shareholders, Buffett reiterated the story in 1950s, his cigar butt era.
“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.
Even then, however, I made a few exceptions to cigar butts, the most important being GEICO. Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares. Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.”
You and me are retail investors and we do not the problem of too much money to invest in. Buffett called it a structural advantage to have a small capital and it makes sense to go for cigar butt stocks as the potential gains would be higher. If we invert this logic, doesn’t it mean that we lose the structural advantage if we are going for bigger and well-known companies that are also in the radar of investment professionals and big funds?
Hence, we believe the cigar butt approach is more worthwhile for retail investors. The CNAV strategy which we adopted has its roots dug deep in Benjamin Graham and it is a variant of the cigar butt strategy – investing in mediocre companies at wonderful prices.