Cigar Butt Investing. Graham and Buffett Discuss

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We will discuss Sanborn Map (more of an asset investment) and
See's Candies (a franchise) next. As a supplement to Chapter 3
in Deep Value, you have the early Buffett Partnership Letters 
and the Essays of Warren Buffett.  You have a business and
investing education right there. Let's look closer at Buffett's
discussion of "Cigar-butt" investing. Since Buffett wrote this
letter in 1989, has he ever gone back to deep value investing?
Imagine Ben Graham reading this passage. What would he say to
Warren?   

What Would Warren Buffett Suggest to a New Investor Starting
Today: Buffett - Student Discussion of Investment Style
Thanks to a student contribution!

http://www.berkshirehathaway.com/letters/1989.html
Mistakes of the First Twenty-five Years (A Condensed Version)

     To quote Robert Benchley, "Having a dog teaches a boy 
fidelity, perseverance, and to turn around three times before 
lying down." Such are the shortcomings of experience. 
Nevertheless, it's a good idea to review past mistakes before 
committing new ones. So let's take a quick look at the last 25 
years.

o     My first mistake, of course, was in buying control of 
Berkshire. Though I knew its business - textile manufacturing - 
to be unpromising, I was enticed to buy because the price looked 
cheap. Stock purchases of that kind had proved reasonably 
rewarding in my early years, though by the time Berkshire came 
along in 1965 I was becoming aware that the strategy was not 
ideal.

     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.

     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 
surfaces -  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.

     You might think this principle is obvious, but I had to 
learn it the hard way - in fact, I had to learn it several times 
over. Shortly after purchasing Berkshire, I acquired a Baltimore 
department store, Hochschild Kohn, buying through a company 
called Diversified Retailing that later merged with Berkshire. I 
bought at a substantial discount from book value, the people were 
first-class, and the deal included some extras - unrecorded real 
estate values and a significant LIFO inventory cushion. How could 
I miss? So-o-o - three years later I was lucky to sell the 
business for about what I had paid. After ending our corporate 
marriage to Hochschild Kohn, I had memories like those of the 
husband in the country song, "My Wife Ran Away With My Best 
Friend and I Still Miss Him a Lot."

     I could give you other personal examples of "bargain-
purchase" folly but I'm sure you get the picture:  It's far 
better to buy a wonderful company at a fair price than a fair 
company at a wonderful price. Charlie understood this early; I 
was a slow learner. But now, when buying companies or common 
stocks, we look for first-class businesses accompanied by first-
class managements.

o     That leads right into a related lesson: Good jockeys will 
do well on good horses, but not on broken-down nags. Both 
Berkshire's textile business and Hochschild, Kohn had able and 
honest people running them. The same managers employed in a 
business with good economic characteristics would have achieved 
fine records. But they were never going to make any progress 
while running in quicksand. 

     I've said many times that when a management with a 
reputation for brilliance tackles a business with a reputation 
for bad economics, it is the reputation of the business that 
remains intact. I just wish I hadn't been so energetic in 
creating examples. My behavior has matched that admitted by  Mae 
West: "I was Snow White, but I drifted."

o     A further related lesson: Easy does it. After 25 years of 
buying and supervising a great variety of businesses, Charlie and 
I have not learned how to solve difficult business problems. What 
we have learned is to avoid them. To the extent we have been 
successful, it is because we concentrated on identifying one-foot 
hurdles that we could step over rather than because we acquired 
any ability to clear seven-footers.

     The finding may seem unfair, but in both business and 
investments it is usually far more profitable to simply stick 
with the easy and obvious than it is to resolve the difficult. On 
occasion, tough problems must be tackled as was the case when we 
started our Sunday paper in Buffalo. In other instances, a great 
investment opportunity occurs when a marvelous business 
encounters a one-time huge, but solvable, problem as was the case 
many years back at both American Express and GEICO. Overall, 
however, we've done better by avoiding dragons than by slaying them.

Subjective Value:

http://www.learnliberty.org/videos/subjective-value/

10 responses to “Cigar Butt Investing. Graham and Buffett Discuss

  1. Don’t forget to view the video.

  2. Its odd – because the old buffett partnership letters indicate that he did very well using the deep value approach. Maybe with the greater fund size and desire to work less hard (mentions this in his later letters) is what drove him to compound large sums at reasonable rates versus maximize alpha?

    • For another look at Buffett’s early days: http://www.jamesaltucher.com/2011/03/8-unusual-things-i-learned-from-warren-buffett/ I like the irreverence.

      I will wait for more folks to post before I add my two cents. Don’t forget Buffett’s interest, personality and money base for his change in tactics but not philosophy–treat shares as ownership in a business, margin of safety, etc.

      • It’s been suggested that Buffett had personality quirks, including Aspergers, and i’ve heard some anecdotes about his dislike of change. He also seems to be an innate collector. So holding positions for the very long term could well have suited his personality perfectly. Most people – me included – are more interested in making money than in collecting companies.

        I will add that I’m prepared to hold a solid growth company for a long time. It’s very difficult to be sure you’ve got the real deal, though. I think most of Lynch’s picks ended up falling apart eventually, for example.

        Greenblatt cautions against trying to identify superior businesses, and I think he’s right to say that. Newspapers were once great businesses, but their economic superiority waned with the rise of the internet. Interestingly, at the end of the 1990’s, at the height of the tech boom, there was a lot of buzz about “TMT” (Technology, Media, and Telecommunications). The big irony is that Media, that was supposed to benefit from all that technology actually proved its downfall. In the UK, telecomm companies big absurd amounts of money to acquire licences from the government to secure bandwidth. Even at the time people were saying that they were unlikely to earn economic returns from such large layouts. Take a look at the ROCE of Vodafone over the last few years: it’s mean is about 2.6%. I don’t have figures for the early 2000’s, but I doubt they were anything other than palty.

        The bizarre thing is, Buffett’s early career seemed to mostly rely on cigar butt investing, and he actually obtained excellent returns.

  3. Somewhere on my computer, I have a copy of some correspondence between a young student and WEB which addressed the conumdrum referred to above. The student’s letter noted the ‘cigar butt’ approach WEB took early in his career and then referred to all that WEB had written in his BRK shareholder letters about investing in good businesses. And the student asked WEB which approach was best, especially for someone who was just starting out. WEB’s handwritten response was “either is fine” and he added that the former was better for small amounts of money and the latter was better for large amounts of money. (If I find my copy of the correspondence, I’ll try to post it to the John’s DEEP-VALUE google group site.)

    There is something similar, I believe, in CTM’s approach. In one of his early speeches (which is reproduced in Poor Charlie’s Almanack), he likened the ‘cigar butt’ approach to scrambling around the detritus with a geiger-counter. Significantly, CTM didn’t criticise this approach as being irrational, he just noted that the easy opportunities ran out. He went on to say that the bulk of the billions made by BRK had come from the better businesses and that only the first $200-300 million came from scrambling around with a geiger-counter. I have tended to read this as a kind of imprimatur from CTM that chasing after ridiculously cheap stocks (as opposed to the truly good businesses) is not illogical when you are first starting out.

    Anyway, that’s the way that I try to understand the ‘cigar butts’ vs good businesses dichotomy. Does anyone think I’m crazy?

  4. Thanks Nemo, I added your doc. to this post and re-emailed it. Excelletn addition to the discussion.

  5. Yes, Unfortunately WB is not exactly consistent in his advice and suggestions. You really have to wade through everything he says to come to some sort of conclusion as to what you yourself should do. WB tends to badmouth the classic Graham approach, and net net stocks, but then comes out and says that this is what small investors should do –and what he would do — when investing smaller sums. Case in point:

    http://www.netnethunter.com/how-should-the-small-investor-manage-his-money-heres-warren-buffetts-answer/

    In the end, I think that he’s talking to people managing millions of dollars in capital when he suggests buy and hold forever. I don’t think he’s talking to smaller investors. He also may be trying to justify his own strategy. Whatever the case, the more people who opt for WB’s current strategy, the more opportunities will be open to thoughtful investors using classic graham strategies.

  6. Looks like AUM has a lot to do with the method of style that might be most useful. Although all good investment work for small $, unless activist, larger $ seems limited in scope.

    What signififies a basket of net nets? 5?10?15? What’s the optional number?

  7. Jeremy,

    In my view it totally depends on your level of skill when picking stocks and the quality you demand when selecting net nets. I aim for 10, which is highly concentrated, but I also aim to pick the highest quality stocks. 15-20 is better for someone with less investing experience and wants to leverage the returns of net net stocks as a whole to a greater degree. I don’t think you should really go beyond 20 because you can really increase the quality of your holdings if you just do some simple things and more diversification adds significantly more work without much additional benefit.

    http://www.netnethunter.com/value-investing-diversification/

    Evan

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