Have you ever wondered how billionaire Warren Buffett made his first million dollars? His current investment approach is totally different than the investment approach that he practiced and preached earlier in his career. Buffett initially made his fortune using the “cigar butt” investing approach. In this blog post, I will go over the “cigar butt” approach, and talk about the feasibility of this approach.
In the 1989 Berkshire Hathaway Annual Letter to shareholders, Buffett explained, “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.” Ben Graham, Warren Buffett’s mentor, called this investment strategy “net-net“. How do you know if the discarded cigar butt has one puff left? The formula is pretty simple: Net Value = (Current Assets – Inventory – Total Liabilities – Preferred Stock) / Outstanding Shares.
If the company were to liquidate and pay off all its obligations, the Net Value is what common shareholders would most likely be left with. If the stock price is below this net value, then you can call it a “bargain purchase”. Such an undervalued stock can be compared to the discarded cigar butt, which has one more puff left.
When Buffett talks about the “Mistakes of the First Twenty-Five Years” in the 1989 annual letter, he said that although the cigar butt strategy was rewarding, buying businesses with such kind of approach was foolish (unless you are a liquidator). Why is it foolish? Warrens explains, “First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.” In other words, Buffett is saying that when the business sells at such a discount, it usually has lots of problems. Additionally, the management could take some rash decisions, which could increase the liabilities of the business and drop the liquidation value for shareholders. Lastly, when you invest in such a business, your investment might yield you little to no return for an extended period of time.
After knowing all these shortcomings with the “cigar butt” approach, how did Warren Buffett change his investment approach? How does he invest now? Warren says, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie (Munger) understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.” That is precisely how Buffett invests now. He’ll look at the history and financials of the company, and if he deems it to be have a moat (wonderful) and great management, he’ll buy it at a decent price. This is why Buffett says that he is happy when the stock price of the company drops as he can buy more shares at that discounted price.
In conclusion, “Cigar Butt” approach has many risks and limitations. In theory, it sounds great to buy a business for $0.75 when it is currently worth $1. There is the $0.25 of free puff left in that business. However, that might not be the wisest allocation of your money in the long run. Now, Buffett prefers to buy a great business for $1.25, when it is currently worth $1, but is definitely going to be worth $15 in 10 years.
Hope you learned a little and found this blog post helpful. We talked about the “Cigar Butt” approach, and the downsides associated with that approach. We also talked about Warren Buffett’s current investment strategy. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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