The cigar butt investing approach describes the practice that Warren Buffett used for years at the beginning of his investment career. Buffett adopted this approach from his mentor Benjamin Graham, who developed the concept of so-called "net net stocks" during the Great Depression in the 1930s.
More...
What exactly is the cigar butt investing approach?
Essentially, the cigar butt investing approach focuses on buying distressed companies that are trading on the stock market at a high margin of safety or below their balance sheet assets based on a conservative assessment of their true economic value.
Warren Buffett likened this method of investing in equities to picking up a discarded cigar butt on the street for one last puff. The stub may be ugly and damp, but the puff is free.
When investing in net-net stocks, Benjamin Graham looked for shares in companies trading at less than two-thirds of their net current assets (current assets - current liabilities). Even if the share price only returned to the value of net current assets, this would mean a gain of 50%.
The cigar butt approach is therefore a successful investment strategy because the shares that investors buy using this method are, by definition, absurdly cheap. So wrote Warren Buffett in his 2014 letter to Berkshire Hathaway shareholders:
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. - Chairman’s letter 2014
Disadvantages of Cigar Butt Investing
Although cigar butt investing was very successful for Warren Buffett in his early years, he abandoned the approach - under the influence of Charlie Munger - as his career progressed.
In his 1989 shareholder letter, Buffett wrote under the heading "The Mistakes of the First Twenty-Five Years (condensed version)" that while the cigar butt investing approach was rewarding, buying companies with such an approach was foolish (unless you were a bankruptcy trustee).
Companies that are apparently cheap on the stock market usually have problems. Such problems can be company-specific, industry-related or macro-related. In any case, they are the reason why the companies' shares trade at a discount to their intrinsic value on the stock market.
The key question in cigar butt investing is whether the existing difficulties are temporary or permanent. After all, if the problems cannot be solved within a manageable period of perhaps 3 to 5 years and the share price closes the gap to the actual value of the company, the supposed bargain purchase may be a value trap.
The success of the cigar-stump approach depends on a temporary rise in the price of an investment, which may occur too late or perhaps not at all. For example, suppose an investor buys a stock at 60% of its calculated value and plans to sell it once the stock market prices the company at its full value.
If the price increases within 3 years, the average annual return on the investment would be 18.6%. If the share takes 5 years to rise in price, the return is still an attractive 10.8% per annum. If, however, the share needs 10 years, the annual return to be achieved would be considerably less attractive at 5.2%.
Moreover, there is always the possibility that the company's business fundamentals will continue to deteriorate over time, leading to a reduction in the actual economic value. This is why Warren Buffett said, "Time is the friend of a good business and the enemy of the mediocre."
For the same reason, Benjamin Graham also recommended selling stocks after a holding period of 5 years if the stock market has not realised the actual value during that period. But even if investing in a cigar butt works, the tax due on the proceeds of sale reduces the return.
Warren Buffett's investment philosophy today
Although Warren Buffett achieved great success with the cigar butt approach, he has stopped using this strategy. Today, he focuses on high-quality companies that have economic moats. One important reason for this was that Buffett's financial resources have grown considerably over the years.
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.
Moreover, if investors hold companies with high quality (good management, good economic prospects) for a very long period of time, they have the advantage that the compound interest effect can work unhindered and is not interrupted by recurring tax payments.
Nevertheless, the cigar butt investing approach offers private investors in particular the opportunity to maximise their profits by using their structural advantage of investing with small sums and also buying undervalued shares with lower market capitalisation.
However, due to the increased risk, this should be done using a statistical group approach, such as that used by Walter Schloss. Schloss was always broadly diversified and held more than 100 stocks in his portfolio during most of the time. He thus achieved an average annual return of 20% over a 47-year period.
[…] Source link […]