Cigar-Butt Investing: One Puff of Profit or Just a Whiff of Trouble?

A Strategy With Limitations

Dear Investor,

Imagine you're strolling down the street, and you spot a cigar butt on the ground. It's got one puff left in it, not much of a smoke really, but it's free. That last puff? All profit. Warren Buffett uses this metaphor to describe a strategy he calls "cigar-butt investing."

Cigar-butt investing is a value investing strategy characterized by purchasing stocks of companies considered mediocre and undervalued. This approach focuses on buying businesses at prices much lower than their net-asset values, aiming to capitalize on the "last puff" of profitability.

These investments may not offer a rewarding experience, but the “bargain purchase” makes up for it.

Sounds enticing? Well, there are some problems with this approach.

Erosion of Value Over Time

One of the significant issues with cigar-butt investing is the erosion of value over time. Mediocre businesses fail to create value for their shareholders and, over time, actually destroy business value.

This can lead to a gradual decline in the value of the business, shrinking the initial margin of safety, even if the stock price remains stable. Investors must possess both the insight to recognize this decline and the luck to have stock prices rise in time to sell before a potential drop following the intrinsic value of the business.

As Buffett himself stated in a shareholder letter, “Time is the friend of the wonderful business, the enemy of the mediocre.”

Timing and Pain

Another problem lies in the timing of the purchase and the potential pain associated with holding a portfolio of such stocks. While these bargain stocks might seem attractive when abundant, the situation becomes dangerous if the broad market enters a rapid decline, then poorly managed companies get sold off more than the market.

If the economic decline persists, many of these companies may suffer operating losses, and some may even face bankruptcy. Holding such a portfolio during bear markets or recessions can be painful.

A quick sale of these deep-value bargains becomes necessary, even if stock prices don't rise, due to the rapid erosion of business value. Profits are generally maximized within the first year of purchase, making the decision to sell at the right time a difficult one.

Dating without Intent, and a Lack of Options

Buffett made an amusing comparison of buying these average businesses to dating without the intention of getting married. It's a fling, a temporary thrill, and you better know when to call it quits before things get ugly.

Diversification Challenges

Diversification is an essential element in managing the risks of a portfolio. In the context of cigar-butt investing, it becomes increasingly challenging to diversify when market valuation is high.

At such times, it might become nearly impossible to find enough stocks to satisfy your requirements. The difficulty in creating a diversified group raises concerns about the limited room for errors and disasters caused by single stocks.

If you own 50 stocks, even a few bankruptcies won’t impact the whole portfolio that much. However, the situation looks different with only 5 stocks.

Conclusion

Cigar-butt investing, while intriguing in theory, presents many challenges and potential pitfalls in practice. The erosion of value over time, timing difficulties, emotional pain, challenges in diversification, and the high chance for the investment to turn sour make this a high-risk strategy.

While the strategy may occasionally prove profitable, the overall assessment suggests that investors might be wise to seek more sustainable and less volatile investment paths. (More on that in the next newsletter)

This simple quality ratio improves your returns.

So next time you see that cigar-butt on the street, maybe it's best to just leave it there. There's probably a reason why someone else threw it away.

After all, wouldn't you rather invest in a fresh, high-quality cigar and enjoy it from the start?

Until the next issue. 👋

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Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.