Cigar butt investing is a form of troubled-asset investment. In this strategy, you buy low-priced stock in struggling companies that should be worth more than their current share price. You let the stock bump up, then sell it for a quick profit. This should not be confused with value investing, in which you make long-term investments in companies that the market has undervalued. Cigar butt investment is a short-term approach to buying into generally weak firms. You can work with a financial advisor if you’re not sure if it’s a good fit for your portfolio or you can read on to learn more.
What Is the Cigar Butt Theory?
Cigar butt investing is a term coined by famed investor Warren Buffet. In a letter to Berkshire Hathaway’s shareholders back in 1989, he explained the theory as a way of capturing fast value from weak companies. Per his 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.”
For example, say you find a struggling company whose stock price has been pushed down to $0.75 per share. This company is still in operation, otherwise, it wouldn’t be trading, but it is either weak or failing and the market has begun betting against it.
In a situation like this, the company may very well have a last-minute surge in value. Late investors might be interested in gambling on cheap stock or the company might look for someone to acquire it. More often, simply winding up and liquidating everything that the company owns, will generate a cash infusion that bumps the share price up. That price might not go any higher than $1 per share, but the extra $0.25 is all profit for a late investor.
If someone finds a smoldering cigar on the street, what they have found is 90% trash. But they can still get that last 10% of smoke out of it for free. The same is true of cigar butt investments. The stock may be generally a poor investment, but it can still turn a last-minute profit.
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How Do You Identify Cigar Butt Companies?
The general way to determine a cigar butt investment is through what’s known as a company’s net current asset value (NCAV). The formula is:
In other words, you start with the total value of all the company’s assets. Then you subtract the company’s debts, liabilities everything it owes to preferred shareholders (since they get paid first). This tells you what the company would be worth if it liquidated completely and paid off all its debts.
Then you divide this by the number of common shares of stock outstanding. What you have left is how much every shareholder would receive if the company liquidated tomorrow, paid off all its debts and distributed the remainder to its shareholders.
If this number is more than the stock’s current trading price, then the company may be a cigar butt investment. Even if the company is doing poorly, under the worst-case scenario a final liquidation would pay out more to shareholders than the company is currently selling for. This makes it a potentially profitable short-term investment.
Pros and Cons of Cigar Butt Investing
It’s critical to understand that cigar butt investing is not value investing. You are not looking for a long-term investment in good companies trading below their true value. Instead, you’re looking for weak companies likely to experience a last gasp of value. Unlike value investing this is a short-term strategy.
The advantage of this approach is that it can give you a good source of quick revenue. Cigar butt companies are a way to turn around fast profits with relatively small investments. While any given profit margin will also usually be fairly small, you can make a lot of these investments given their turnaround.
But don’t let the lure of fast money fool you. There are a lot of very real downsides to cigar butt investing, which is pretty much always the case for investment strategies that focus on timing the market. As Buffet explained in the same letter to shareholders quoted above:
“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 surface – 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, of the many issues here, two are key: First, every other investor can calculate NCAV too. So if the entire market thinks this stock is only worth $1, even though the NCAV formula says the business could liquidate for $1.50, it’s worth asking why. The answer usually has to do with problems in the underlying business, problems that mean your profit bump won’t happen easily… if at all.
Even if it does, there’s no telling on what time frame. People work hard to save even failing businesses. There’s absolutely no guarantee that this company will hiccup and if it does there’s no guarantee it will do so soon. You might be stuck holding this sliding stock for years. Even if you do finally make that $0.25 per share profit, the opportunity cost of long-term investment will be considerable.
Cigar butt investing is an interesting approach and one that Warren Buffet credits with making his first million. However, there’s a reason that he now warns investors off of it and it shares the same risk profile as any other strategy that promises to time the market.
The Bottom Line
Cigar butt investing is a short-term investing strategy in which you buy undervalued stock in struggling companies. When it works, you can get a last gasp of value from short-term trading. It’s one of many investing strategies that you could consider for your own portfolio.
Tips for Investing
There are lots of smart ways to trade and invest but if you’re not sure what direction to take then you may want to consider working with a financial advisor. A professional can help you create an investment strategy that fits your long-term goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
It’s likely not a good idea to try and time the market as it can cause a lot of pain if you don’t know what you’re doing and even professionals can lose their shirts.
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Source: https://finance.yahoo.com/news/warren-buffets-cigar-butt-investing-140008405.html