Understanding Cigar Butt Investing!
Lessons from Graham and Buffett...
Introduction:
In the world of investing, there's often a temptation to follow the crowd, especially with short-term funds that promise big fees and quick returns. Human psychology plays a significant role in this, as people tend to stay within groups, making it challenging to step away from the market's noise and focus on long-term objectives. However, only a small percentage of investors—perhaps 5%—manage to resist the crowd mentality and focus on their own strategies.
The question every investor must ask is: Why are you investing? Is it to generate maximum returns with minimal risk, or is it to be part of the latest stock conversations in social circles? More often than not, people follow the same stocks that appear in newspaper headlines or financial channels like CNBC. However, the real opportunities often lie elsewhere, in places that are overlooked and underappreciated, where things are virtually free and ignored by the majority.
This is where the concept of "Cigar Butt" investing comes into play—a method introduced by Benjamin Graham, the father of value investing.
The Roots of Value Investing: Benjamin Graham:
Benjamin Graham is often credited as the pioneer of value investing. He laid the foundation for modern investment principles and even played a role in establishing security analysis as a formal profession, contributing to the creation of the Chartered Financial Analyst (CFA) program. His books, Security Analysis and The Intelligent Investor remain investment classics that continue to influence investors globally.
Graham's approach to investing centred around the distinction between investment and speculation. He believed that true investment offered the safety of the principal and a reasonable rate of return. Anything else, especially investments driven by short-term market movements or borrowed money, was speculation. He also emphasized that owning equities should be viewed as owning a piece of a business, rather than just a piece of paper whose price fluctuates.
The "Mr. Market"
One of Graham's most famous metaphors is the concept of "Mr. Market," a fictional character who represents the stock market's mood swings. Mr. Market is erratic—some days he's overly optimistic, bidding up stock prices, and other days, he's pessimistic, offering shares at rock-bottom prices. Graham argued that investors should not let Mr. Market guide their decisions. Instead, investors should take advantage of his mood swings, buying when prices are low and avoiding overpaying when he's too optimistic.
The Evolution of Warren Buffett's Strategy:
Warren Buffett, a disciple of Benjamin Graham, began his investment journey by closely following Graham's methods, including the "Cigar Butt" approach. This strategy involves buying companies that are cheap, often because they are in trouble or have been neglected. Like a discarded cigar butt that still has a few puffs left, these companies could offer one last burst of value before they burn out completely. While this method focuses on finding bargains, it doesn't prioritize long-term business quality.
Over time, Buffett fine-tuned his approach to incorporate higher-quality businesses. He shifted away from purely focusing on price to considering factors like management quality, competitive advantage, and long-term business prospects. This evolution marked a departure from Graham's original teachings, emphasizing the importance of owning businesses with strong fundamentals rather than just looking for undervalued "cigar butts."
Investment vs. Speculation: A Timeless Principle
Graham's principles, including the distinction between investment and speculation, are still relevant today. With the advent of technology and the ease of trading, the average holding period for stocks has drastically reduced—from several years to mere months. This shortened time horizon has made it more tempting to speculate rather than invest, contributing to the rise of short-term-oriented funds.
However, the lesson from Graham and Buffett remains clear: long-term success in investing often comes from focusing on solid fundamentals, patience, and avoiding the herd mentality.
The spotlight may shine brightly on popular stocks, but the true gems often lie in the shadows, waiting to be discovered.
Benjamin Graham's Balance Sheet Focus:
Graham believed that predicting the future perfectly is impossible, so it’s better to focus on what’s already known—the past and the present. Instead of fixating on future projections, he emphasized a detailed analysis of a company's balance sheet, paying as much attention (if not more) to it as to the profit and loss statement. Earnings, according to Graham, can be volatile—sometimes up, sometimes down—and it's essential not to overemphasize a single quarter or year’s performance. Instead, he recommended averaging earnings over a minimum of five years to get a more accurate picture.
The Concept of a "Net-Net"
One of Graham's key strategies was finding “net-net” stocks—companies that are essentially available for free. This occurs when a company's net working capital (the difference between current assets and current liabilities) exceeds its market capitalization. In such cases, the company is significantly undervalued. However, Graham acknowledged that there could be reasons for such undervaluation. Investors might overlook the company, or management might be expected to waste the cash on its balance sheet. Another possibility could be shareholder disinterest in unlocking the company’s value.
Buffett’s Cigar Butt Investing: Opportunities and Risks
Buffett’s description of “cigar butt” investing paints a vivid picture: imagine finding a discarded cigarette on the street that has one puff left. You pick it up for free, taking that last puff. Similarly, cigar butt investing involves finding stocks that have been discarded by the market but may still hold some value. While this can be profitable, it also carries risks, as some of these companies are discarded for valid reasons.
Problems like fictitious cash (as in the case of Satyam Computer Services) or hidden management issues (like price manipulations at Optic) can arise, making these investments risky.
Buffett has warned that time is a friend to wonderful companies but an enemy to mediocre ones. A good company will grow its sales and earnings over time, increasing its intrinsic value. On the other hand, a bad business’s intrinsic value might decline over time due to industry changes or poor management.
The Contrast Between Graham and Buffett’s Approaches
Buffett’s evolved philosophy leans towards buying quality companies at a fair price, rather than just cheap companies with questionable prospects. He famously said, "It is far better to buy a wonderful company at a fair price than to buy a fair company at a wonderful price." This contrasts with Graham's emphasis on buying stocks purely because they are cheap, even if it means taking on risks like bad management or declining industries.
To put it simply: Buffett wants five-star food at a discount, while Graham is willing to eat at a roadside stall as long as it's cheap enough. However, in rare cases, investors might find five-star quality at roadside prices, which is the ideal scenario where both approaches converge.
Conclusion: A Balanced Approach
While both Graham and Buffett’s strategies offer valuable lessons, today’s investors should carefully balance price and quality. Cigar butt investing can still offer opportunities, but it comes with risks that require a deep understanding of a company's fundamentals. Investors should remain cautious of hidden problems and focus on businesses that have the potential to grow over time.
"Time is the friend of a wonderful company but the enemy of a mediocre one." -Warren Buffett
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