1. Buying cigar butts at good prices
2. Buying great companies at great prices
3. Buying great companies at so-so prices.
Mr. Klarman said he is still in the first stage, buying cigar butts at good prices. This is clearly the case from his recent purchase of Targacept (TRGT) after the stock price dropped 60% in one day.
An interesting question here is: What kind of value investors are you? Would you rather buy cigar butts at good prices, or buy great companies at great or so-so prices?
As long-term followers of Warren Buffett, we know that he was cigar butt investor when he was young and was not limited by the size of the capital he had. As Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) grew bigger, he could only buy large chunks in large companies to “move a needle” in his portfolio. Most of us apparently do not have this problem (we wish we did). Even Seth Klarman, with more than $30 billion under management, can buy cigar butts. All of us can invest in cigar butts if we choose to. Do you choose to do it?
A company becomes a cigar butt for a reason, and usually for good reason. In the case of Targacept, it failed in a key drug trial that was expected to be successful. The market cap dropped 60% to $250 million, while the company has net cash of $210 million.
Investing in cigar butts can be hugely profitable, as Ben Graham proved in his long-term investment in net-net situations. (Check out the current list of net-nets in our Net-Net screener and the monthly Net-Net Newsletter.) Seth Klarman also proved that with his great long term track record. By the way, Seth Klarman is on the way to become the Investment Guru of Year 2011, according to the poll on GuruFocus homepage.
If it is that good, why don’t all value investors just invest in cigar butt situations and make huge profits out of them?
Just if it is that simple…
Most of the cigar butts situations are distressed. The companies are going through bad times, and the news about them is rarely good. As shareholders, this distressed situation with the company can make you distressed, too. You will have to go through a lot of frustrations. You may lose patience, lose confidence in the company, and even worry about its survival and become afraid of losing your investment completely. These investment may turn out to be hugely profitable, but the process might hurt. If you never experienced that, just ask Bruce Berkowitz how he feels about Bank of America (NYSE:BAC).
Or you may just want to buy good companies at reasonable prices such as the companies in our Buffett-Munger screener. As Warren Buffett said, “I would rather buy good companies at fair prices than fair companies at good prices.” That should be much less stressful. You will certainly miss some 5-baggers in the short run, but it may well be as rewarding in the long run. The process is much easier and you can have much better night’s sleep.
Which way do you choose? What kind of value investors are you?