Explainer on Cigar Butt Investing: Features, Advantages, Limitations, and Suitability Explained

If you saw something valuable on sale, how would you respond? You’ll probably buy that item without wasting any more time. But what if we told you that there’s also a chance to find something similar in the stock market?

You read correctly – today’s blog will introduce a term called “Cigar Butt Investing.”

Overview

The CEO of Berkshire Hathaway and legendary businessman, Warren Buffett, applied the cigar butt investment approach. 

Cigar Butt Investing, or “Trouble asset investment,” works on the theory that “if someone wants to smoke but doesn’t have any money, they can pick up abandoned cigars on the street and have a few free puffs.” 

Similarly, when the market drives a stock down to a particular point and it begins selling at a price significantly below book value, investors would invest a portion of their capital in it and wait for it to rise before selling it for a profit.

This type of investing strategy is extremely risky because the stock price will be under pressure for a long period and may correct to a lower level than anticipated.

Did you know?

Warren Buffett is known to have employed this strategy in his early investing days; later, he switched to value-oriented investing. 

Features

1.    It is typically compared to the value investing principle, with a primary focus on stressed businesses that are trading at significantly reduced prices. 

2.   It usually targets businesses that the majority of shareholders have neglected.

3.    These investing techniques have no long-term potential; instead, their primary focus is on making short-term profits. 

4.    Investing in cigar butt companies is limited to individuals who actively manage their portfolios.

5.    Those who are willing to assume a high level of risk and receive higher returns might consider investing in this way.

Historical Success

Here are a few examples of successful cigar butt picks made by the most famous investor of all time, Warren Buffet, to demonstrate the long-standing efficiency of this method.

One of the most well-known investments made by Warren Buffett is “Western Insurance Securities,” a company whose stock traded below its liquidation value and was valued at a discount to book value of about 55%. While the stock was only trading at $3 per share, the company’s earnings were $20 per share. Buffet later added that the company had excellent management. 

Creighton’s PLC was Warren Buffett’s other popular choice. In 2013, the company was trading at a P/E ratio of 4.5x, one-third below liquidation value. He bought the stock because the CEO controls a sizable chunk of the company’s equity, and the company’s balance sheet is steady. The company reached the market P/E of 22.25x after 4 years of growth, yielding an overall return of 640% and an annualized return of 65% for the investor.

Advantages

1.   It gives investors a chance to purchase equities for a substantial discount on their real worth. 

2.    The strategy allows a risk-taking investor to book profits in the short run. 

3.     The strategy allows investors to be flexible and opportunistic because they can focus on short-term gains and swiftly spot undervalued opportunities without thinking about long-term positions.

4.    Investors can profit from inefficient companies by adopting an aggressive or contrarian attitude, particularly when those companies are unfavorable to investors or are undergoing issues of some kind.  

Limitations

1.    Cigar butt stocks are frequently cheap for a variety of reasons, including weak fundamentals, unfavorable market circumstances, etc. As a result, even if the market recognizes their full value, stock prices may not rise. 

2.    In comparison to general equities, stocks that experience significant declines are regarded as volatile and dangerous investment opportunities. 

3.     It is not always possible for an undervalued stock to return to its normal price because some stocks experience ongoing losses that ultimately lead to a permanent loss of capital.

How to understand if a discarded Stock has a few puffs left?

Benjamin Graham’s criteria to perform the cigar butt approach is to buy stocks that traded at below 2/3 of the company’s net current asset value per share.

To calculate the net current asset value per share, use the following formula:

Net Current Asset Value/Share = (Current Assets – Inventory – Total Liabilities – Preferred Stocks)/Outstanding Shares

After this calculation, you will know what every shareholder would get if the company were liquidated tomorrow. After making all the calculations, if the number is greater than the stock’s current price, then we can say that the company has some puffs left in the Cigar.

Is Cigar Butt Investing Suitable for Investors?

Identifying stocks that are trading below their liquidation value requires a high level of competence, and finding distressed companies requires extensive study on the part of the investor. Additionally, investing in companies that have already demonstrated a correction carries a high risk. It may result in further corrections for a longer period before the stocks return to their initial value. Therefore, it is not advised that a risk-averse individual engages in Cigar Butt investment. 

Is Cigar Butt Investing Same as Value Investing?

Cigar Butt investment is often equated with value investing. However, value investing necessitates identifying a company whose financials are sound and has a high growth potential. Finding weaker companies whose business is likely to collapse and are trading at a significant discount is necessary for cigar butt investing.

Conclusion

To sum up, we can conclude that although Warren Buffet employed this strategy when he first started investing but he stopped utilizing it later in life and now focuses more on value investing as these kinds of possibilities are hard to come by under the current market conditions. 

Although there are many ways to invest in the market, it is advised that you speak with a financial advisor and take your risk tolerance into account before making any decisions. 

Frequently Asked Questions (FAQs)

Q1. Who popularized Cigar Butt Investing?

Ans. Cigar Butt investing was made popular by Warren Buffet as he used this strategy in his early days of investing, but later he chose to opt for value investing.

Q2. Is Cigar Butt investing suitable for all investors?
Ans. No, Cigar Butt investing is not suitable for investors who have long-term investment horizons and who don’t want to take risks with their capital and prefer less volatile investments.

Q3. What is the risk in Cigar Butt Investing?
Ans. The price of an undervalued stock may not return to its normal level because some stocks continue to lose money, which ultimately results in a permanent loss.

Q4. What kind of investment style is Cigar Butt investing?
Ans. Investing in a cigar butt requires active management on the part of the investor, who must choose stocks and allocate their portfolio accordingly.

Q5. Is there any alternative to Cigar Butt investing strategies?
Ans. Yes, there are various alternative trading strategies available other than Cigar butt investing. You can use strategies like traditional value investing, growth investing, and index investing.

Disclaimer: The securities, funds, and strategies mentioned in this blog are purely for informational purposes and are not recommendations.