Warren Buffett (Trades, Portfolio) built the foundations of his investment career buying deep value investments.
When he was managing his investment partnerships in the late 1950s and early 1960s, the young investor concentrated on finding what he called cigar butts. This style of investing involves buying a discarded business (aka a "cigar butt") selling at a deep discount to book value. The idea is that these cigar butts have one good puff left in them because the assets are worth more than the business.
Buffett made a considerable amount of money following this strategy and built an excellent reputation at the same time. However, in the 1970s, he started to move away from this style of investing. Rather than focusing on deep value securities, he started buying high-quality businesses trading at reasonable prices.
This was a significant transition for Buffett and undoubtedly helped cement his position as the world's greatest investor over the next few decades. Buffett realized that while deep value stocks could yield a positive return, continually finding new investments was becoming more challenging as time passed, and many of these companies would not make attractive operating businesses because they tended to be businesses in decline. Owning a declining business is not a good way to make money, and an increasing percentage of cigar butts began faling under this category.
At Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) 2012 annual shareholder meeting, Buffett explained why he started avoiding these types of companies:
"Generally speaking, it pays to stay away from declining businesses. It's very hard. You'd be amazed at the offerings of businesses we get where they say,... it's only six times EBITDA, and then they project some future that doesn't have any meaning whatsoever.
If you really think a business is declining, most of the time you should avoid it."
Buffett went on to say that Berkshire did own a selection of declining businesses at the time, including but not limited to the newspaper business, where he admitted, "We will pay a price in that business." These companies were not "where we're going to make the real money," he concluded.
Instead, "the real money" at Berkshire is going to be made in "growing businesses, and that's where the focus should be." Buffett went on to say:
"I would never spend a lot of time trying to value a declining business and think, you know, I'm going to get one free — what I call the cigar butt approach, where you get one free puff out of the cigar butt that you find. It just isn't — the same amount of energy and intelligence brought to other types of businesses is just going to work out better. And so we — our general reaction, unless there's some special case, is to avoid new ones."
This is an essential lesson for value investors. There are plenty of stocks out there on the market at the moment that look cheap in comparison to book value or sales. However, if these companies are suffering from falling growth rates, there's no guarantee they will ever be able to return to previous levels.
Buying these stocks may only lead to losses. If cash flows are declining, the intrinsic value of the business is also declining. If the intrinsic value continues to decline, there's no guarantee that the stock price will return to previous levels as it may only reflect the new, lower intrinsic value.
On the other hand, companies with growing sales and cash flows should see the intrinsic value rise steadily over the long term. If intrinsic value is growing and the company is creating more value for investors, then this should be reflected with a higher stock price one day.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- A Look at the Deep Value Stocks of Kahn Brothers
- Charlie Munger: The Best Defense Against Inflation
- Howard Marks: Investors Need to Be Aware of Bias
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
