Investing in cigar butts is a form of investing in distressed assets. With this strategy, you buy cheap shares of troubled companies that should be worth more than their current share price. They let the stock go up and then sell it for a quick profit. This should not be confused with value investing, which is making long-term investments in companies that the market has undervalued. Investing in cigar butts is a short-term approach to buying into generally weak companies. You can work with a financial advisor if you're unsure if it's a good fit for your portfolio, or read on to learn more.
What is the cigar butt theory?
“Investing in cigar butts” is a term coined by famed investor Warren Buffet. In a letter to Berkshire Hathaway shareholders in 1989, he detailed the theory as a way to quickly extract value from ailing companies. In his letter it says:
“If you buy a stock at a low enough price, there will typically be a setback in the business, giving you the opportunity to exit for a decent profit, even though the company's long-term performance can be terrible.” I name the “cigar butt” approach to investing. A cigar butt found on the street with only one puff left might not offer much smoke, but the ‘bargain purchase' makes that puff a pure win.”
For example, let's say you find a troubled company whose stock price has fallen to $0.75 per share. This company is still in operation or it wouldn't be trading, but it's either weak or failing and the market has started betting against it.
In such a situation, the company may well experience a last-minute increase in value. Late investors may be interested in betting on cheap stocks, or the company may be looking for someone to buy them. In most cases, simply winding up and liquidating all of the company's assets results in an injection of cash that drives the stock price higher. That price may not be higher than $1 per share, but the additional $0.25 is pure gain for a lagging investor.
If someone finds a smoldering cigar on the street, what they found is 90% garbage. But they can still get the last 10% smoke out for free. The same goes for investing in cigar butts. The stock may be a bad investment in general, but it can still yield last-minute gains.
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How to recognize cigar butt companies?
The general way to determine an investment in a cigar butt is what is called a company's Net Current Asset Value (NCAV). The formula is:
In other words, you start with the total value of all of the company's assets. Then you subtract the company's debt and any debt it owes to preferred shareholders (since they get paid first). Here's how much the company would be worth if it were fully liquidated and all debts were paid off.
Then divide that by the number of common shares outstanding. What you're left with is how much each shareholder would get if the company went into liquidation tomorrow, paid off all the debt, and distributed the rest to its shareholders.
If this number is higher than the stock's current trading price, the company may be a cigar butt investment. Even if the company is doing poorly, a worst-case scenario of a final liquidation would return more to shareholders than the company is currently selling. This makes it a potentially profitable short-term investment.
Pros and cons of investing in cigar butts
It is important to understand that investing in cigar butts is not a value investment. They're not looking for a long-term investment in good companies that are trading below their true value. Instead, look for weak companies that are likely to see a final boost in value. Unlike value investing, this is a short-term strategy.
The advantage of this approach is that it can provide you with a good source of quick income. Cigar butt companies are a way to make quick profits with relatively small investments. Although the profit margin is usually relatively small, you can make many of these investments given their chances of success.
But don't be fooled by the lure of a quick buck. There are many very real downsides to investing in cigar butts, which is pretty much always the case with investment strategies that focus on market timing. As Buffett explained in the letter to shareholders cited above:
“Unless you're an insolvency practitioner, such an approach to buying companies is foolish. First, the original “bargain” price probably won't turn out to be a bargain after all. In a tough business, no problem is ever solved when another surface pops up—there's never just one cockroach in the kitchen. Second, any initial benefit you secure is quickly wiped out by the small rate of return the company is making.
For example, if you buy a company for $8 million that can be sold or liquidated for $10 million and take either path immediately, you can make a great return. But the investment will disappoint if the company sells for $10 million ten years from now and is only earning and paying out a few percent of the cost annually in the meantime. Time is the friend of the wonderful business, the enemy of the mediocre.”
In other words, out of the many points here, two are crucial: First, any other investor can also calculate the NCAV. So if the entire market thinks this stock is only worth $1 when the NCAV formula says the company could be liquidated for $1.50, it's worth asking why. The answer usually has to do with problems in the underlying business, problems that mean your increase in profits won't happen easily – if at all.
Even if that is the case, there is no telling in what time frame. People work hard to save even failing companies. There's absolutely no guarantee this company will hiccup, and if it does, then there's no guarantee it will anytime soon. You may be stuck for years holding on to this floating stock. Even if you finally make that $0.25 per share profit, the opportunity cost of investing long-term will be significant.
Investing in cigar butts is an interesting approach, and one that Warren Buffett credits with making his first million. However, there's a reason he's now warning investors about it, and it carries the same risk profile as any other strategy that promises to time the market.
Cigar butt investing is a short-term investment strategy where you buy undervalued stocks of companies that are experiencing trouble. If it works, you can get one last benefit from short-term trading. This is one of many investment strategies you might consider for your own portfolio.
There are many smart ways to trade and invest. However, if you are unsure of which direction to take, consider working with a financial advisor. A professional can help you develop an investment strategy that meets your long-term goals. Finding a financial advisor doesn't have to be difficult. SmartAsset's free tool matches you with up to three verified financial advisors operating in your area, and you can interview the appropriate advisors for free to decide which one is right for you. When you are ready to find an advisor who can help you achieve your financial goalsGet started now.
It's probably not a good idea to time the market as not knowing what you're doing can be a huge pain and even pros can lose their shirts.
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