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Rupert Hargreaves
Rupert Hargreaves
Articles (1189)  | Author's Website |

Warren Buffett: Why Investors Should Avoid Declining Businesses

Takeaways from the Berkshire Hathaway 2012 annual meeting

May 13, 2020 | About:

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 (NYSE:BRK.A) (NYSE:BRK.B) 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.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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Rating: 4.8/5 (6 votes)

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Comments

Watchdog
Watchdog premium member - 2 weeks ago

Very important lesson this is. However with regard to the last paragraphs I'd like to add that the intrinsic value of a stock cannot really decline (in my view) since it depends on some unknown stream of cashflows in the future which will come anyhow but that we just do not know precisely beforehand. So I'd rather like to think about it that way that the intrinsic value of a business is a given (but unknown) and the intrinsic value of a declining business may be lower than what we think at first sight. Nevertheless in the currrent market I have the impression that the market still heftily overprices growth businesses (due to a collective rush in so-called quality businesses) versus stagnating or declining businesses, in other words the former might have a much less favorable price-to-intrinsic value-relationship than the latter group. In the end it always comes down to the individual investment case. Buffetts paradigm about generally favoring growing businesses is a useful rule of thumb. It's just that many of the good growing businesses in my view aren't available at reasonable prices nowadays. So it can pay off to look elsewhere.

Praveen Chawla
Praveen Chawla premium member - 1 week ago

I think the problem with cigar butt investing is that not only do you have to expend a lot of effort and time to buy these stocks you have a bigger problem is finding the right time to sell them. Apart from time, there is an element of chance and luck involved that you will find the right window of time to buy and sell. There is also the problem of babysitting your cigar butt investments as you have to watch them carefully so see if they are reaching their potential. There is a lot of emotional energy involved here if you are a concentrated investor.

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