Last week I was holidaying in France, and when I go away I like to take a stack of reading that I don’t normally have time for. Among my stack were Buffett’s shareholder letters; I’ve read them before but they are always worth a re-read. Upon reading them I came across his thoughts on ‘cigar butt’ investing and wanted to do an article on them because there seems to be a lot of mis-information about them floating on the web.
I have never been a fan of ‘cigar butts’, and if I recall my positions that have had the highest gains, these have been in growing and strong companies. The market seems to realize true value far more quickly when a company is performing well – and if it doesn’t the business is growing intrinsic value for every year you are waiting.
This is somewhat of a controversial topic though. Proponents of cigar butt investing have many examples of its successful application and usually vehemently defend it. I don’t deny it can produce satisfactory investment returns, but it just isn’t my style. And regardless, sometimes it is worth stirring the hornet’s nest to stimulate debate.
Buffett on cigar butts
Every value investor comes across companies like this, the one selling for half of book value and barely making a profit each year. These are known as the ‘cigar butts’ and as Buffett says in his 1989 letter
“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.”
It’s no secret that Buffett’s earliest years in his partnership were among his best in terms of investment returns, and this is the period in which he followed the Ben Graham style of cigar butt investing. Many commentators state that the only reason he doesn’t still follow this style is because of the size of his portfolio and his preferred ‘hands off’ approach to investing now.
But Buffett himself describes cigar butt investing in much stronger terms than many would suggest. The fact that he describes Berkshire Hathaway among his worst investments may be seen as him being his usual humorous self, but he is very sincere and clear in his 1989 letter.
“My first mistake, of course, was in buying control of Berkshire. Though I knew its business-textile manufacturing-to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.”
Here Buffett is suggesting his earlier years had some element of fortune that his cigar butts produced such high investment returns, a run of luck that had run out by the time he was owner of Berkshire.
His next comments couldn’t be clearer of his position on the subject.
“Unless you are a liquidator, that kind of approach to buying businesses is foolish. 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.“
To describe this type of investing as ‘foolish’ may come as a shock, indeed I was surprised he used such a word considering his friends like Ben Graham and Walter Schloss had used the strategy successfully for years.
Buffett on turnarounds
I think of turnarounds as a subset of cigar butts, those ‘with catalyst’ if you like. They are no new phenomenon, in fact Buffett also writes extensively on the subject. You’ve probably heard of recent high profile cases like JCP and Blackberry where turnarounds have been spectacular failures. You will find no shortage of commentators betting on turnarounds in many stocks, but you’ll have a harder time finding successful ones. So is it worth investing in these situations? Here is what Buffett says on the matter.
“A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.
“I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
He seems to be talking more from an owner-operator point of view than a passive investor in the stock. But that makes for an even stronger case against investing in these situations, as an owner operator has a far higher chance of success than a small shareholder.
He also goes on to describe some of the reasons why it is hard to turnaround companies outside of their bad economics. Often it is not only public opinion which you have to change, but also attitudes within the business. For large organisations this can be like trying to do a 180 turn in an oil tanker.
“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’
1. As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction.
2. Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds.
3. Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.
4. The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
It’s fair to say that Buffett’s advice on the matter is to avoid them. Concentrate on the ‘1 foot hurdles’ rather than relying on a turnaround being successful.
I’ll end this article with one of Buffett’s personal stories of both a cigar butt and turnaround that didn’t work out as he’d hoped.
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“Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild, Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras-unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o three years later I was lucky to sell the business for about what I had paid. After ending our corporate marriage to Hochschild, Kohn, I had memories like those of the husband in the country song, “My Wife Ran Away With My Best Friend and I Still Miss Him a Lot.”
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