The “cigar butt” investment approach remains one of the most colourful analogies in value investing, having been inextricably intertwined with Warren Buffett’s formative years. The analogy equates those undervalued companies that possess the possibility of retaining their intrinsic value to a cigar found on the street corner that, to the naked eye, looks unappetizing at first, yet has the potential to provide the final puff at little to no charge to the consumer. By financial management standards, the technique stresses value over narratives that may pertain to enhanced growth.

The intellectual roots of cigar butt stock selection, therefore, are rooted in Benjamin Graham’s net-net stock philosophy, introduced in his publications Security Analysis and The Intelligent Investor. Graham’s philosophy cantered on seeking firms that traded at a fraction of their net current asset value, calculated by subtracting total liabilities from all current assets. In essence, it became possible for an investor to purchase an entire firm for an amount that merely covered its liquidation cost, thereby establishing a vast gulf of ‘margin of safety.’ Buffett applied this approach during the beginning of his investment career, specifically during his Buffett Partnership period, because of his meagre capital and ‘small market.’

From a financial point of view, the attractiveness of the cigar butt investment strategy consists of its focus on the downside rather than making forecasts that are necessarily optimistic. The investor concentrates on what the company already has in its possession: cash, accounts receivable, inventory, and investments, rather than what it might possibly produce in the future. So the strategy does indeed reflect a high level of analysis and its strong roots in accounting reality. The cigar butt period of his investments was a phase that Buffett would look back on in his 1989 Shareholder Letter when he confessed that he was investing in “cheap stocks that had only a few puffs left.”

One of the most important advantages of cigar butt investing is that it creates a margin of safety for the investor. It allows the investor to purchase at a discounted price, and if the underlying business is not doing well, the risk of loss of capital is negligible. It also creates an opportunity for exploiting inefficiencies in the market, and most often, when institutional funds are less likely to enter, this method of investing yields positive results in times of market turmoil. In the Indian context, for instance, in the global crisis of 2008 and 2009, a number of PSUs and cyclically declining manufacturing segments had companies quoting below book value.

Nevertheless, the cigar butt approach faces important structural issues by itself. The most fundamental problem with the cigar butt approach, according to the author, is the lack of a compounding engine. Companies that can be purchased solely based on low price may lack the capability to reinvest earnings in a high-return manner. This point is remarkably validated by the same Buffett, who confessed the same weakness in the cigar butt approach many years later. “A cigar butt,” he observed, “may deliver one excellent smoke, but there will be no follow-up performances.”

The rarity of this investment approach can be exemplified by real-world case studies. At an international level, Buffett’s investment in Sanborn Map Company can be termed a “cigar butt” investment, which can be considered a “textbook” case. The market capitalization of the company was surpassed by the value of its portfolio, which means that shareholders received the company’s business “for free” by leveraging this investment technique, which was chronicled by Roger Lowenstein in “Buffett: The Making of an American Capitalist.” The Indian market does have “deep value” investors applying this investment technique to the shipping, textile, or sugar industry from time to time, although it’s been hampered by structural challenges. 

One of the most important turning points in the evolution of Buffett’s approach to investing occurred through the tutelage of Charlie Munger, who convinced him to think beyond cigar butts and buy superior business franchises at fair valuations. This transition in his approach to investing has been aptly captured by Buffett himself when he said that it is “far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” This transition reveals an important aspect of effective financial management and the creation of long-term wealth. 

Final thoughts

In closing, therefore, the cigar butt investment approach is a relevant investment strategy in particular circumstances but definitely not for all investors and in all markets. As attested to by Buffett’s own investment experience, in fact, the investment approach ought to be used discriminatingly, not as a guiding philosophy for a lifetime. The investment approach is a good schooling in disciplined investment, in intrinsic business value, and in balance sheet analysis but not a suitable strategy for all-round investors.

Dr. Prahlada N.B
MBBS (JJMMC), MS (PGIMER, Chandigarh). 
MBA in Healthcare & Hospital Management (BITS, Pilani), 
Postgraduate Certificate in Technology Leadership and Innovation (MIT, USA)
Executive Programme in Strategic Management (IIM, Lucknow)
Senior Management Programme in Healthcare Management (IIM, Kozhikode)
Advanced Certificate in AI for Digital Health and Imaging Program (IISc, Bengaluru). 

Senior Professor and former Head, 
Department of ENT-Head & Neck Surgery, Skull Base Surgery, Cochlear Implant Surgery. 
Basaveshwara Medical College & Hospital, Chitradurga, Karnataka, India. 

My Vision: I don’t want to be a genius.  I want to be a person with a bundle of experience. 

My Mission: Help others achieve their life’s objectives in my presence or absence!

My Values:  Creating value for others. 

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