Cigar Butt Investing: Your Ultimate Guide
This article on your ultimate guide to cigar butt investing was written by Jialin Chua. Jialin is a corporate finance and a capital markets consultant in Singapore. She uses Net Net Hunter's high performance net net checklist to identify her stocks. Download our net net checklist right now for free. Click Here. Article image (Creative Commons) by Jannes Höke, edited by Net Net Hunter.
Most value investors have heard about "cigar butt" investing but consider it a thing of the past.
However, cigar butt investing is not only still feasible, but it is also the most profitable stock investing strategy available for small private investors today.
With all the investment strategies available today, how is it possible that cigar butt investing tops them all? In this ultimate guide to cigar butt investing, we'll walk you through the basic concepts behind this strategy and show you how building a portfolio following a cigar butt investing strategy promises the best returns.
What is Cigar Butt Investing?
What exactly is cigar butt investing?
Essentially, the approach focuses on buying beaten-down companies trading below a conservative assessment of their liquidation values. Warren Buffett gave the strategy its pithy name, likening it to when an investor reaches down to pick up a cigar butt off the sidewalk. While the soggy leftovers are often unattractive, the bargain price means that last puff is pure profit.
But while cigar butt companies are often assumed to be ugly or broken firms, some businesses are actually real gems that investors have ignored. As a result, they’ve been sold off to ridiculous valuations.
Cigar Butt Investing: Top Value Investors’ Favorite Choice
Buffett, world-renowned as one of the greatest investors ever, earned the highest returns of his career from his partnership days when he invested in microcap cigar butts. Benjamin Graham eventually found the strategy so profitable that he renounced all other approaches to focus on one particular cigar butt strategy: net nets. Other leading value investors, including Charlie Munger (early in his career), David Dreman, John Neff, Peter Cundill and Walter Schloss, have also used this technique, many using the approach to earn the best returns of their career.
When reflecting back on his early career in 2014, Buffett recounted:
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950’s made the decade by far the best of my life for both relative and absolute performance.
– Warren Buffett - Berkshire Hathaway Letter, 2014
Cigar butt investing is a successful investing strategy because, by definition, the stocks are absurdly cheap on the whole. Buffett wrote the following when he was valuing the partnership’s controlling and majority ownership position in a cigar-butt stock:
Wide changes in the market valuations accorded stocks at some point obviously find reflection in the valuation of businesses, although this factor is of much less importance when asset factors (particularly when current assets are significant) overshadow earnings power considerations in the valuation process…
– Warren Buffett’s Partnership Letter, November 1966
Cigar Butt Investing Framework: Net Net Stocks
Like Buffett, Graham found the cigar butt approach highly profitable. He initially wrote about one particular cigar butt strategy, net nets, in a series of articles published during the 1930s Great Depression. He ultimately found the strategy so profitable that he renounced all other forms of stock investing and focused on net nets exclusively. He confessed:
It is clear that these issues were selling at a price well below the value of the enterprise as a private business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. … In various ways practically all these bargain issues turned out to be profitable and the average annual result proved much more remunerative than most other investments.
– Benjamin Graham, 2003
Graham's idea of intrinsic value was based on the private negotiated transactions between business people. Business people typically always ensure that assets are sold at market value, while the stock market leads to irrationally low prices for companies and the liquidation value of assets at times. Buying firms at irrationally low prices below liquidation value has proven promising for at least 90 years.
Graham found that cigar butt investing was nothing more than a low-cost quantitative method of picking stocks — net nets, which are really cheap companies that you can buy below liquidation value and worth “taking one last puff” from. Liquidation value is the value that sellers of a business could expect to receive in exchange for the business’ physical assets, making this a very conservative approach.
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. 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.
– Warren Buffett - Berkshire Hathaway Letter, 1989
Approaches to Liquidation Value
There are five main approaches to calculating a company’s liquidation value:
1. Net Current Asset Value (NCAV)
2. Net Net Working Capital (NNWC)
3. Net Tangible Assets (NTA)
4. Net Cash
5. Sum-of-the-Parts (SOTP)
The general guideline of a net net company is to have the market capitalization at two-thirds or less of its liquidation value.
Net Current Asset Value (NCAV) Calculation
Price to Net Current Asset Value (P/NCAV) is a modified working capital ratio metric that takes into consideration the total liabilities and preferred shares instead of current liabilities.
Net Current Asset Value (NCAV) Per Share = (Current Assets - Current Tax Asset - Total Liabilities - Minority Interest - Preferred Shares - Off-Balance Sheet Liabilities) / (No. Of Shares Outstanding)
Price to Net Tangible Assets (P/NCAV) = (Market Value Per Share) / (NCAV Per Share)
Net Net Working Capital (NNWC) Calculation
Price to Net Net Working Capital (NNWC) is an alternative approach to P/NCAV. It is more stringent in its calculation and looks purely at liquid and tangible asset value, excluding any prepaid expenses or even deferred taxes.
Net Net Working Capital (NNWC) Per Share = Cash And Short-Term Investments + (0.75 X Accounts Receivables) + (0.5 X Inventories) - Total Liabilities And Claims Senior To The Common Stock / (No. Of Shares Outstanding)
Price to Net Net Working Capital (P/NNWC) = (Market Value Per Share) / (NNWC Per Share)
Net Tangible Assets (NTA) Calculation
The Price to Net Tangible Assets (P/NTA) ratio is simply a modified Price to Book (P/B) ratio determined by deducting the intangible items and purely looking at the tangible assets that a company has, which reflects the real assets that we can touch and accurately quantify, such as machinery, properties and cash. Essentially, this is another way we can value the company below liquidation value after deducting its “competitive advantage.”
Net Tangible Assets (NTA) Per Share = (Shareholder Equity - Goodwill - Intangible Assets – Tax Receivables) / (No. Of Shares Outstanding)
Price to Net Tangible Assets (P/NTA) = (Market Value Per Share) / (NTA Per Share)
Net Cash Calculation
Price to Net Cash measures how much cash a company has relative to its stock price. Net cash refers to the amount of cash remaining after all financial obligations have been met.
Net Cash Per Share = (Cash and Cash Equivalents - Liabilities) / (No. Of Shares Outstanding)
Price to Net Cash = (Market Value Per Share) / (Net Cash Per Share)
The sum-of-the-parts valuation (SOTP) is an approach to valuing a firm by assessing the value of each aggregate business division and adding them up to get the total value if they were spun off or acquired by another company.
Cigar Butt Investing Problems
Undeniably, cheap companies are potentially having problems and may even be losing money. However, every business on the planet, at any given time, is either in one of two states: it is having problems, or it will be having problems. Such problems — whether company-specific, industry-driven, or macro-related — often cause a stock to become very cheap.
Right now, you visualize beaten-down shares of unloved, troubled companies — firms whose earnings have been shrinking, whose industries are perceived to be in trouble, or whose plans for growth are being questioned. These companies’ shares tumble to the point where they look relatively cheap and attractive compared to their earnings, sales, cash flow or book value, even if the businesses themselves are not particularly good.
The key question is whether these difficulties are temporary or permanent. Based on statistics, many of the problems are temporary when viewed over the subsequent 3 to 5 years.
When the typical net net stock becomes exceptionally cheap compared to its liquidation value, if something changes for the better — that is, either a change by management, or a change due to outside forces (or both) — the stock usually shoots up in share price and reverts back to its fair price. Usually, net nets will not be liquidated; even if they are, most of them bring in profit.
Cigar Butt Investing: Successful Strategy Through the Ages
Cigar butt investing has proven its effectiveness as an investment strategy from Buffett in the 1950s through today. Here are a few examples of its biggest success stories:
Western Insurance Securities
One of Buffett’s most noticeable cigar butts picks is Western Insurance Securities, which he wrote about in a column titled “The Security I Like Best” for The Commercial and Financial Chronicle in the ’50s.
The stock was priced at less than 2 times earnings and a discount to book value of around 55%. While technically not a net net, it traded well below liquidation value. As an added bonus, according to Buffett, it had great management in place.
You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.
— Warren Buffett, 1950s
Tiffany and Co.
Peter Cundill invested in Tiffany and Co., the iconic Fifth Avenue jeweller and silversmith, in the 1970s. Shares were trading below the book value of $10.50 and well below the company’s realistic liquidation value. It was indeed a gem! What’s more, the company’s balance sheet had assets that were unaccounted for.
The company owns a freehold Tiffany building on Fifth Avenue that had sat on the books valued at $1 million since 1940, even though real estate values had risen dramatically since then, as well as a 120,000-square-foot factory in Newark, New Jersey. Also, Tiffany Diamond, a massive 128.5 carat canary-coloured brilliant — the largest in the world — was carried on the books at $1, yet the company had recently turned down an offer of $2 million for it!
On top of that, there was also no goodwill reflected in the books, and the well-known blue box brand was effectively valued at zero.
Cundill sold the entire position for $19.90 within a year for a massive gain of 50%! Tiffany and Co. was subsequently sold to Avon Products at $50 per share six months after Cundill’s sale.
One of our net net stock picks, Creighton’s PLC, a British toiletry manufacturer, was trading at one-third below liquidation value with a P/E ratio of 4.5x in 2013. The firm had a rock-solid balance sheet and a CEO who owned a large chunk of the company.
The company took four years to reach the market P/E ratio of 22.25x, producing a total return of 640%, with an annualized return of 65%!
Perfect for Small-Time Investors
Buffett later in life switched his cigar butt investing strategy to analyzing the qualitative aspects of companies and buying companies with moats. This does not mean that cigar butt investing does not work anymore; it just means that the size of Buffett’s funds had outgrown the cigar butt investing strategy.
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well…
— Warren Buffett - Berkshire Hathaway Letter, 2014
Building a net net stock portfolio is best suited for small-time investors who are managing less than $10 million. Small-time investors can maximize the opportunity to exploit Graham’s strategy due to its structural advantage — the flexibility to purchase smaller market capitalization stock.
Cigar Butt Investing: How to Apply It
When applying the cigar-butt method, you can either do it as a statistical group approach (Schloss) or you can do it in a focused manner (Buffett).
Schloss achieved one of the best long-term track records of all time — an annualized return of 15.3% after four-and-a-half decades. He owned 100 stocks most of the time.
Buffett achieved an annual compound return of 24.5% net (29.5% before fees) in his Buffett Partnership, Ltd. by buying a focused group of net net stocks.
Cigar Butt Investing: Net Net Stocks
Cigar butt investing is the best strategy for small value investors even today.
It really pays to pick the best strategy with the best returns when investing for the long term. As the great Albert Einstein once said, “Compound interest is the eighth wonder of the world.”
We need to adopt a proven and resilient investing strategy. The results of many great investors beating the market using cigar butt investing has proven to withstand the test of time, and economic cycles.
Look no further, Net Net Hunter is the resource for you to look for these cigar butts to purchase!
As long as we stick by this investing strategy and fill our portfolio with net stocks, we will outperform the market. Start putting together your high-quality, high potential, net net stock strategy. Click here to get free high-quality net net stock picks sent straight to your inbox each month.