Warren Buffett's investing strategy: How "Cigar Butt" investments made him millions!
Benjamin Graham taught Buffett to look for companies whose assets were worth more than their stock prices.
Cigar butt investing, a strategy famously used by Warren Buffett in his early days, involves seeking out companies that have fallen out of favor in the market and are trading below their liquidation value. While this approach was once highly successful for Buffett, it may not present the same prospects for today's investors.
What is Cigar Butt Investing?
Cigar butt investing, as coined by Warren Buffett, is a straightforward value investing strategy. Imagine picking up a discarded cigar butt from the sidewalk, which still has one puff left. Similarly, in the stock market, you search for companies that have temporarily stumbled but still hold some value. The goal is to invest in these companies, wait for their recovery, and then sell for a profit.
Warren Buffett learned this strategy from his mentor Benjamin Graham and applied it during his early career. He even used it in his first investment partnership, achieving remarkable returns, averaging 31 per cent annually over 12 years.
However, Buffett eventually abandoned this strategy in 1969, realizing it wouldn't work on a larger scale. The "cigar butt" approach worked best when managing smaller sums of money.
Buffett's investment philosophy evolved over time, especially after meeting Charlie Munger in 1959. Munger emphasized investing in high-quality companies with sustainable competitive advantages, shifting Buffett's focus away from cigar butt investing.
Finding Cigar Butt Companies
Cigar butt investing centers on buying undervalued companies trading below their estimated liquidation value. To determine a company's liquidation value, you need to assess what it's worth if you were to sell all its physical assets. Benjamin Graham taught Buffett to look for companies whose assets were worth more than their stock prices.
One way to calculate a company's liquidation value is through Net Current Asset Value per Share (NCAVPS):
NCAVPS = (current assets - (total liabilities + preferred stock)) / outstanding common shares
NCAVPS represents a company's liquidation value, excluding intangible assets like goodwill and intellectual property. It's the value you'd get if the company sold all its physical assets.
Buying stocks trading below NCAVPS allowed investors to potentially get more than what they paid for, assuming the company didn't go out of business.
However, Buffett cautioned that active involvement in managing these undervalued companies was often necessary to realize a positive return. He illustrated this with his experience with Sanborn Map, where he played a key role in unlocking shareholder value.
It's essential to note that this approach is challenging for the average retail investor because it requires hands-on management.
Cigar Butt vs. Value Investing
Cigar butt investing should not be confused with traditional value investing. It focuses on weaker companies trading at a discount to their liquidation value, typically for short-term gains. In contrast, value investing involves seeking out undervalued, high-quality companies for long-term investments.
Do These Opportunities Still Exist Today?
The investment landscape has changed significantly since Buffett's cigar butt investing heyday in the 1950s. Increased competition, technological advancements, and shifts in the nature of assets have made this strategy less effective.
1. Competition: As more investors adopted this strategy, profits were reduced due to increased fancy of using this strategy, it lost its competitive edge.
2. Technology: Technology has made financial analysis more accessible, reducing the competitive advantage of manual analysis. Anyone can now access tools to evaluate a company's net asset value.
3. Changing Assets: Companies today possess a higher proportion of intangible assets, making it harder to determine their fair value through the traditional liquidation approach.
In conclusion, while cigar butt investing once yielded significant returns for Warren Buffett, it may not be as effective in today's market environment. Investors seeking strategies for today's markets should explore alternative approaches, such as factor investing and identifying high-growth stocks.