WHAT IS CIGAR BUTT INVESTING?

Cigar butt investing is a value investment strategy popularized by Warren Buffett in his early career. The concept is simple – like picking up a discarded cigar butt on the sidewalk that has one puff left, you look for companies that have been temporarily beaten down but still have some value left in them. The idea is to invest in these companies, wait for them to recover and then sell them at a profit. 

“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.”

– Warren Buffett, “Shareholder Letter” (1989)

BUFFETT, GRAHAM, AND CIGAR BUTT INVESTING

Warren Buffett has often credited Benjamin Graham as his mentor and teacher. Cigar butt investing was one of the strategies that Graham preached and Buffett applied during his early investment career. In fact, Buffett’s first investment partnership, Buffett Partnership Ltd., used this cigar butt investing strategy. 

Not only was this investing strategy successful, but Buffett actually earned the highest returns of his career during the 1950s by investing in cigar butt companies. Over the 12 years he ran the fund, he returned 31% per year on average.

Buffett Partnership Returns (1957-1968)

Despite earning exceptional returns for more than a decade using this strategy, Buffett decided to close his fund in 1969. He explained in a letter in 1989 that he believed this strategy would no longer work as the fund had grown too big and because of this, he couldn’t find enough undervalued stocks to buy that would offer a worthwhile return on his investment. 

“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 the decade by far the best of my life for both relative and absolute performance” 

– Warren Buffett , “Chairman’s Letter” (1989)

It’s also worth noting that Buffett’s investment strategy changed substantially over time, particularly over the years after he met Charlie Munger in 1959. Munger had a huge impact on Buffett’s investment strategy as before he met Munger, Buffett thought about valuation mostly in terms of hard numbers. Whereas Charlie believed that instead of looking for cigar butts, investors should focus on high-quality companies that have a sustainable competitive advantage. 

Charlie said that “some businesses were worth paying up a bit to get in with for a long term advantage.” When analyzing an investment, Munger thought more about its softer qualities rather than just the hard numbers that Buffett was looking at during the 1950s. 

This led to a shift in Buffett’s investment philosophy and he moved away from cigar butt investing towards investing in wonderful companies at a fair price.

HOW DO YOU FIND CIGAR BUTT COMPANIES?

Cigar butt investing is based on the idea of purchasing undervalued companies that are trading for a price below their estimated liquidation value. This means an investor needs to figure out what the company is worth if you were to sell all of its assets. Graham taught Buffett to find the companies whose assets were worth more than the stock price was trading for. 

How do you figure out a company’s liquidation value? 

One way to do this is by calculating a company’s net current asset value per share (NCAVPS). 

NCAVPS = (current assets – (total liabilities + preferred stock))/ outstanding common shares

Basically, the net current asset value represents a company’s liquidation value, which is just the total value of its physical assets such as inventory, fixtures, real estate, and equipment. However, it excludes intangible assets such as goodwill, brand recognition, and intellectual property. Said another way, if a company were to go out of business and forced to sell all of its physical assets, that value would be the company’s liquidation value.

This measure was created by Benjamin Graham as he observed that investors often ignored asset values and focused only on a company’s earnings.

Graham found that buying a stock that was trading below its NCAVPS provided an opportunity to purchase a company at a price less than the value of its current assets. He taught Buffett this early on and told him that sometimes you could buy a company that owns $1 in assets but is only trading for 50 cents. As long as the company didn’t go out of business, investors could receive substantially more than what they paid for.

However, Buffett has cautioned that many of the companies he invested in using this strategy were undervalued for a reason, and that active involvement in the management of these firms was often necessary to achieve a positive return on investment.

For example, Buffett found that the company Sanborn Map was trading for 69 cents on the dollar. Buffett acted quickly and bought every share he could find, eventually owning 43.8% of the company and gaining control. However, when he proposed the board payout $65 per share to the shareholders, they refused. 

Undeterred, Buffett  used his hedge fund’s shareholdings to get himself elected to the board. At his first board meeting, he discovered the reason the stock was so cheap was because the other board members were primarily focused on selling maps cheaply to the company’s biggest customers, who they worked for. They owned almost no stock in the company and were not concerned with maximizing shareholder value. 

Buffett persisted in his efforts to increase the value of the company and proposed again that the investments be sold and the proceeds paid to the shareholders. Again, the board refused. However, at the next board meeting, Buffett proposed that the investments be used to buy out any shareholders who wanted to sell. To avoid a proxy fight, the board accepted and agreed on a price of $65 per share, resulting in a 44.4% return on his investment.  

This was an example of a company that Buffett saw as an opportunity while others saw it as a failing map business to stay away from. Buffett looked past the steadily declining profits and recent 80% drop in profit to the asset value, and instead looked at its $65 per share in cash and investments and saw an opportunity. 

However, I wanted to share this story as it’s worth pointing out Buffett’s success in cigar butt investing involved not only finding these undervalued (cheap) companies, but also taking a very active role in order to make the investment work out in his favor. In general, such an approach is not replicable or feasible for the average retail investor. 

I think it’s also important to note that cigar butt investing should not be confused with value investing. This approach does not involve seeking out undervalued, high-quality companies for long-term investments. Instead, the focus is on identifying weaker companies that may be nearing the end of their value potential but are trading at a significant discount to their liquidation value. In general, this strategy is intended more for short-term gains, as opposed to the long-term approach of value investing that often requires 10-20+ year holding periods.

DO THESE OPPORTUNITIES STILL EXIST TODAY?

The investment landscape has evolved significantly since the 1950s when Warren Buffett leveraged this cigar butt investing strategy. Today, these opportunities are much harder to come by and profit from due to a few reasons. 

Firstly, as more investors caught wind of this highly profitable strategy, it surged in popularity and the competition among investors increased. As a consequence, the profits of this strategy were arbitraged away by the increasing number of market participants trying to exploit it. 

Secondly, advancements in technology have transformed the way investors can conduct financial analysis, particularly in terms of the availability and speed of financial information. Investors now have access to a wide range of financial tools that allow them to assess various financial metrics and calculate a company’s net asset value in relation to its market price. This ease of access to information has dramatically reduced the competitive advantage that once existed for investors like Buffett who painstakingly conducted manual analyses to identify these undervalued companies. These manual laborious tasks have now been largely replaced by accessible technology available to everyone, reducing the opportunities to profit in this strategy.  

Another key reason why this strategy may not be as effective today as it was in the past is because the nature of assets that companies possess has changed drastically over time. Intangible assets, such as patents, goodwill, and brand recognition generally make up a greater proportion of a company’s overall asset value, making the process of arriving at a company’s “fair value” much more complicated. This leaves the traditional liquidation approach, which worked well for manufacturing companies with easily definable assets, less effective in today’s digital world.

While cigar butt investing is an approach that once made Buffett millions, there are many reasons to believe why it may not be as effective today. If you are new to stock investing, and interested in learning more about specific investing strategies that may be better suited to outperform in today’s markets, I recommend checking out my articles on factor investing and how to find 100 bagger stocks.