The Cigar Butt Approach, The Bane Of The Common Investor

by: Aaron Leow

Benjamin Graham has often been hailed as the founder of security analysis. His approach to stocks has its place in history as being one of the rare fund managers who beat the S&P500 over a 20 year period.

Many investors themselves, successful in their own right, preach the approach which Graham took. One of his cornerstones of value analysis was to ensure a proper margin of safety before the investor could take the plunge. This limited his losses if the company went into liquidation.

There are, however, pitfalls with his approach towards a common investor. Even Graham himself, in the last chapter of The Intelligent Investor, stated that the safest way in which common investors should go about investing was to simply buy bonds for the long term.

This article aims to depict the several issues in which a common investor is faced when approaching the cigar butt.

1. Time is the Enemy

Most cigar butts, are exposed to several problems. Some examples might include companies which have an outstanding litigation's, declining margins and failing business models. Businesses trading at cigar butt prices often find themselves in a bottom of the ocean with loads of problems. The number of companies which emerge and turn from their problems is so incredibly low that for most cases, the easier way out would be to go into liquidation. As such, time is often the enemy of businesses which are on the brink of death. Margin of safety, defined as;

"Buying businesses whose tangible assets minus all liabilities (including all debt) below the market capitalization"

is often used to lower the risk of losing significant capital.

Hypothetically, suppose an investor bought a stock at $60 when its net tangible assets value is at $100, his margin of safety is $40.

Suppose that the stock rises to $90 reflect the temporary disconnect between value and price, these are the compounded returns recorded year on year as per time frame;

  • 1 Year : 50%
  • 2 Years: 22.48%
  • 3 Years: 14.47%
  • 4 Years: 10.67%
  • 5 Years: 8.45%

The above shows diminishing returns when the investor has to wait 5 years for his money to appreciate to a proper price point. The above illustration is without further issues which often plagues a failing business; quarterly losses, write-downs, creditor claims and issues of stock.

In most cases above, the investor faces reinvestment risk the longer time passes.

2. Return on Time

The cigar butt approach to portfolio creation is often created with a big basket of stocks. Often, the number exceeds 100. The investor is often not acquainted deeply with each and every company which he invests. One of the main problems cigar butt investing brings is the amount of time one has to spend screening, selecting, monitoring and rethinking each and every stock. It is intensive work, but the investor with due diligence is rewarded handsomely. Benjamin Graham, Warren Buffett, David Dreman have all managed to outrun the S&P500 through using cigar butts in some point of their careers.

The problem, however, is that most common investors do not have the same 80-100 hour weeks to focus on stocks. Your author will emphasize again, this does not apply to full-time fund managers but the common investor.

The cigar-butt approach requires investors to spend a massive amount of time for it to work. While the work might be simplified in recent times due to advanced software, practitioners of the cigar-butt approach will still require more time than other approaches of investing(Indexing). While the results may justify, only a small handful of investors would be able to focus that intensively. If they could, they would be working in a fund management firm.

3. Alternative Investing

Much has happened since Benjamin Graham's book. Today, investors are spoiled with overflow of information arriving at the fingertips. It only takes seconds to search and get the SEC filings of whatever company one wishes to enquire. The same has come for alternatives for investors. Unlike the 1960's, much of the secretive fund management industry has progressed towards a transparent playing field. The common investor no longer has to depend solely on himself to form quantitative decisions from scratch. Instead, capital can be allocated and outsourced towards fund managers of highest integrity with above average track records. Should a common investor not be able to enter such a fund, he could simply go towards an indexing approach. Common investors are faced with several key decisions when deciding on capital allocation.

  1. Do-it-yourself
  2. Outsource

Often, common investors who "do-it-yourself" rarely have the time required to perform the cigar-butt approach. For those who can, they are often investment professionals themselves. Instead, a common investor would be apt to choose several businesses in which he knows, from observation and careful study that has consistently returned to shareholders an above average performance.

While outsourcing may be the solution for some people, the odds of managers outperforming the benchmark are stacked so overwhelmingly against their favor that they would do better by simply buying the index.

Key Takeaways

In no way your author is suggesting that the cigar butt does not work. Your author is emphasizing that the challenges in which common investors who do not have the required time might find it challenging to approach stocks as mentioned above. The diminishing return on investment when stocks are held longer and high time expenditure often stops most common investors from following in the footsteps of cigar-butt funds.

However, there are two key takeaways in which the cigar-butt approach brings of tremendous value to the common investor;

  1. The Margin of Safety
  2. Never bet the farm

The margin of safety concept can be applied in almost any investment decision. Be it a business of growth, special situations or arbitrage. Common investors will do well to takeaway the key towards a successful investment is to ensure with high probability that there is a cushion for the investment to succeed.

Graham has advocated in wide diversification to prevent significant losses. While this has much controversy depending on the approach to portfolio allocation, the key concept would be to avoid spectacular losses from concentrating on a single business.

Business owners, operators and self-employed owners understand the problematic fundamentals of concentrating on one product, client or service for revenue generation. Should that one product, service or client cease to exist, the company will fail.

Kevin O'Leary, an investor in Shark Tank puts it best when he quoted, "In business, poo-poo happens."

Like a game of poker and bridge, common investors should always avoid putting everything into a single bet. Unless the stock has wide diversification such as Berkshire Hathaway or the index S&P500, they would sleep better with a group of holdings.

Sometimes, the smartest thing to do in the world of investing is to claim stupidity and buy an index.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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