Investing in cigar butts is a form of distressed asset investing. In this strategy, you buy low-priced stocks of distressed companies that are expected to be worth more than their current price. You let the stock go up, then sell it for a quick profit. This should not be confused with value investing, in which you invest for the long term in companies that the market has undervalued. Investing in cigar butts is a short-term approach to buying generally weak businesses. You can work with a financial adviser if you are unsure if this is right for your portfolio or you can read on to find out more.
What is the Cigar End Theory?
Investing in cigar butts is a term coined by famous investor Warren Buffet. In a letter to Berkshire Hathaway shareholders in 1989, he explained the theory as a way to quickly capture value from weak companies. According to his letter:
“If you buy a stock at a low enough price, there will usually be a hiccup in the company’s fortunes that will give you a chance to offload with a decent profit, even if the company’s long-term performance may be terrible. I call it the “cigar butt” approach to investing. A cigar butt found on the street that is only a puff away may not offer much smoke, but “l ‘buying at a good price’ will make this puff quite profitable.
For example, suppose you find a struggling company whose stock price has been lowered to $0.75 per share. This company is still in business, otherwise it would not be commercial, but it is either weak or failing and the market has started to bet against it.
In a situation like this, the company may very well experience a last-minute increase in value. Late investors might be interested in playing cheap stocks or the company might be looking for someone to acquire it. More often than not, the simple liquidation and liquidation of everything the company owns generates an injection of cash that drives the stock price higher. This price might not exceed $1 per share, but the extra $0.25 is profit for a late investor.
If someone finds a smoking cigar on the street, what they found is 90% garbage. But they can still extract the last 10% of smoke from it for free. The same goes for investing in cigar butts. The stock can be generally a bad investment, but it can still generate a last minute profit.
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How do you identify cigar butt companies?
The general way to determine an investment in a cigar butt is by using what is known as the Net Present Value of Assets (NCAV) of a company. The formula is:
In other words, you start with the total value of all business assets. Then you subtract the company’s debts, liabilities from anything it owes preferred shareholders (since they get paid first). This tells you what the business would be worth if it were completely liquidated and paid off all of its debts.
Then you divide that by the number of common shares outstanding. What you are left with is how much each shareholder would receive if the company were liquidated tomorrow, paid off all of its debts, and distributed the rest to its shareholders.
If this number is higher than the current stock price, the company may be a cigar butt investment. Even if the company is doing poorly, in the worst-case scenario, a final liquidation would return more to shareholders than what the company is currently selling. This makes it a potentially profitable short-term investment.
Advantages and Disadvantages of Cigar Tip Investing
It is essential to understand that investing in cigar butts is not a value-based investment. You are not looking for a long-term investment in good companies that are trading below their real value. Instead, you’re looking for weak companies that are likely to experience a final jump in 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 income. Cigar butt businesses are a way to generate quick profits with relatively low investments. Although a given profit margin is usually quite small, you can make a lot of these investments given their turnover.
But don’t let the lure of quick money fool you. There are a lot of very real downsides to investing in cigar butts, which is almost always the case with investment strategies that focus on market timing. As Buffet explained in the same shareholder letter quoted above:
“Unless you’re a liquidator, this kind of approach to buying companies is foolish. First of all, the original “bargain” price probably won’t turn out to be such a steal after all. In a difficult business, hardly a problem is solved than another surface – there is never a single cockroach in the kitchen. Second, any initial advantage you get will quickly be eroded by the low return the business earns.
For example, if you buy a company for $8 million that can be sold or liquidated for $10 million, and you quickly take either price, you can earn a high return. But the investment will be disappointing if the business is sold for $10 million in ten years, and in the meantime has earned and distributed annually only a few percent of the cost. Time is the friend of wonderful affairs, the enemy of mediocre ones.
In other words, of the many issues here, two are critical: First, all other investors can also calculate the NCAV. So if the broader market thinks that stock is only worth $1, even though the NCAV formula says the company could liquidate for $1.50, it’s worth asking why. The answer usually has to do with issues in the underlying business, issues that mean your increased profits won’t come easily…if at all.
Even if this is the case, we do not know over what period. People are working hard to save even struggling businesses. There is absolutely no guarantee that this company will hiccup and if it does, there is no guarantee that it will anytime soon. You could be stuck holding that sliding stock for years. Even if you eventually realize that $0.25 per share profit, the opportunity cost of long-term investing will be substantial.
Investing in cigar butts is an interesting approach and one that Warren Buffet credits with earning his first million. However, there’s a reason it now warns investors, and it shares the same risk profile as any other strategy that promises to time the market.
The essential
Investing in cigar butts is a short-term investment strategy where you buy undervalued stocks of struggling companies. When it works, you can get a last gasp of value through short-term trading. This is one of many investment strategies you might consider for your own portfolio.
Tips for investing
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There are many smart ways to trade and invest, but if you’re unsure which way to go, you might want to consider working with a financial advisor. A professional can help you create an investment strategy that matches your long-term goals. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three approved financial advisors who serve your area, and you can interview your advisor for free to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goalsstart now.
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It’s probably not a good idea to try to time the market as it can cause a lot of pain if you don’t know what you are doing and even professionals can lose their shirts.
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