A Closer Look at One of Warren Buffett’s Preferred Investing Styles Earlier in His Career

no smoking

The term “Cigar Butt Investing” was popularised by Warren Buffett as a way to describe how he invested when he first started out managing money. But, what exactly is cigar butt investing?

One more puff left

This style of investing involves buying into companies that can still deliver pleasing share market returns without the need for their businesses to have any bright prospects for growth. How? By investing in companies which carry such a low valuation that any slight positive events to their businesses can be major catalysts that can drive their share prices higher.

Investing in companies with dirt cheap prices also presents an added advantage: Additional bad news that surface regarding the businesses of such companies might not negatively affect their share prices at all.

To describe such an approach, Buffett used the analogy of finding a leftover cigar butt on the street. It is dirty and unattractive, but it still has one free puff left; that last free puff is the profit that investors seek. When I recently talked about the mistakes I made when investing in shares of Eratat Lifestyle (SGX; FO8), one of the ‘positives’ I thought the company had was its dirt-cheap valuation. That characteristic the company’s shares had could have classified it as a cigar-butt type of investment.

The main risks

The example with Eratat Lifestyle is also a reminder of the key risks of using such an investment strategy. In utilising the cigar butt approach, you might encounter the risk of buying into companies which have (1) managements with questionable integrity, and/or (2) rapidly deteriorating future prospects.

If you end up investing in companies that display either or both of those characteristics,  you might just have fallen into a value trap.

It also pays to remember this important point: Even if a company is trading below its theoretical liquidation value (signifying very cheap prices), as a minority shareholder, we are in no position to influence such a company to liquidate itself or improve its capital allocation process. Therefore, the company might remain “cheap” for the remainder of its life as a publicly-listed entity.

Despite having benefitted from it earlier in his career, Buffett has commented in some of his annual Berkshire Hathaway shareholder letters that this type of strategy – cigar butt investing – can be foolish (small “f”).

His main concern is that the longer an investor holds on to such mediocre companies (companies that are given very low statistical valuations often have mediocre businesses), the worse the investment outcome will be for the investor as the company’s business prospects deteriorates. For his part, Buffett is now more well-known for making long-term investments in companies with great businesses that have growing and defensible profits.

Foolish Summary

Although you might come across companies that might seem to be legitimately too cheap to be ignored, it is also important to focus on a piece of Buffett’s advice: “Time is the friend of the wonderful business, the enemy of the mediocre.”

Be very aware of your investing time frames with cigar butt companies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.