Unloved. Unwanted. Worthless.

To most people (particularly non-smokers), the idea of picking up a cigar butt from the gutter would rank fairly high on the ‘disgusting’ scale. Lighting it up and taking a few puffs - even more so.

After all, there’s a reason people throw things away. Usually, it’s because they’re unloved, unwanted, or worthless. Often all three apply.

Don’t worry, this isn’t a lecture on the evils of smoking. It’s about a style of investing developed nearly a century ago, that Warren Buffett has described as ‘cigar butt investing’.

The concept made Benjamin Graham a legend in the Value Investing fraternity, and despite the passage of nearly a century, it’s still worth considering today.

Cigar butt investing

In his 1989 letter to Berkshire Hathaway shareholders, Buffett wrote this:

“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.”

Buffett has admitted in recent years that he’s no longer a ‘cigar butt investor’. Not because the strategy doesn’t work, simply because the sheer amount of investment capital he has at his disposal means it’s hard to pick up sneaky bargains.

These days, Buffett tends to buy large or controlling stakes in giant companies rather than unloved and unwanted stocks. But don’t forget, his $150 billion fortune started small – delivering newspapers, collecting lost golf balls, and then investing in cigar butt companies.

Billion-dollar butts

Cigar butt stocks aren’t necessary ‘Penny Dreadfuls’ (companies trading at just a few cents with little hope of success). Some of the biggest gains in the history of share markets have come from the insights of investors who’ve bought unloved companies trading at way below their breakup value.

Cast your mind back to the 1980s (or watch the 1987 movie Wall Street) and you’ll find that many, if not most takeovers were on the basis of stripping a company’s assets, and selling the individual components at a profit.

Gordon Gekko, the fictional asset-raider in Wall Street, was a specialist in finding undervalued companies, then buying them at a fraction of their real value.

Which is what Benjamin Graham did in 1926.

Scouring regulatory returns, he found that a company called Northern Pipeline was holding around $95 per share in cash and fixed interest investments that weren’t needed for the ongoing operations of the business. At the time, Northern Pipeline was unloved by the market, trading at $65 per share.

He quietly accumulated 5 per cent of the company’s shares, then launched a publicity offensive aimed at forcing the company to distribute the surplus assets to shareholders.

After initially being ignored as being a young upstart, Northern Pipeline eventually bowed to pressure and distributed $110 per share to shareholders.

Okay, that was a century ago, and we live in a very different world. Greater disclosure of company information, plus the ability to use computer power to analyse data, has made it much easier to find companies trading at below their real value, which means they don’t stay undervalued for long.

But other types of cigar butts still exist.

Finding deep value

There are plenty of great opportunities out there for investors. Companies that are profitable, well-managed, and have every chance of growing earnings for years into the future.

Then there are the others… those with failing business models, incompetent management, and a miserable outlook. Often they are in industry sectors with a clouded future.

This is the happy hunting ground for Deep Value investors.

As humans, we have biases that draw us towards successful businesses, and steer us away from failing companies. But for Deep Value investors with nerves of steel, buying these unwanted cigar butts can be extremely profitable.

Sometimes, failing companies can be quickly turned around. A new management team might be able to restore the company’s fortunes, quickly regaining the support of investors.

Others have managed to pivot from dead and dying industries to new growth sectors. Nokia was a struggling paper manufacturer before switching to telecommunications. Twitter began life as a podcasting platform. And Netflix offered DVD rental – delivered through the mail service.

Most failing companies will eventually collapse, of course. But for investors in the ones that not only survive but thrive, the payoff can be huge.

Those last few puffs

Cigar butt investments, almost by definition, don’t have to be successful companies. They just need to be successful enough to make your investment worthwhile. That can happen when the share price rises to better reflect the underlying value, or by the sale and distribution of the company’s assets.

Either way, cigar butt investing flies in the face of conventional wisdom that investing in shares is a long-term strategy.

In Graham’s day, cigar butt stocks were everywhere, particularly in the aftermath of the Wall Street Crash. Today, although there are plenty of terrible companies at the ugly end of the market, few of them have real potential. Which means investors not only need to understand the risks of investing in shares, but also accept that many of their investments will be not just unloved and unwanted, but may wind up worthless as well.

Disclaimer: This article is prepared by Tom Ellison. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.