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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

Why Did Warren Buffett Move on From 'Cigar Butt' Investing?

The Oracle of Omaha did well early on by buying cheap businesses, but has since evolved his approach

November 22, 2020 | About:

Warren Buffett (Trades, Portfolio) may be the most accomplished investor in history, but he wasn't born that way. When he began his career back in the mid-20th century, Buffett had to learn his craft, just like any other aspiring investor. The person who had the most influence on Buffett was Benjamin Graham - who is considered to be the father of value investing. Graham, who lived and worked through the Roaring '20s and the Great Depression, was one of the first people to formalize the precepts of value investing.

In a nutshell, Graham's philosophy boiled down to buying companies that were selling at below their book value. Naturally, in many cases, the companies that he invested in were poor businesses, with little chance of growth. Nonetheless, they were still good value, and many investors since have gone on to do very well by adopting this approach. Buffet himself had phenomenal success with this strategy. Between 1957 and 1968, his partnership averaged a 31.6% return annually, in no small part due to his "cigar butt" style, so named because the companies he bought were like cigar butts that had one last puff of value left in them.

After winding down the partnership and buying Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), Buffett gradually changed his investing approach. At the conglomerate's annual shareholder meeting in 1998, Buffett explained to his audience why he decided to break with his mentor.

Cigar butts don't work when you are too big

Size - this is the simple reason why Buffett decided, over time, to move away from buying cheap companies on their last legs and started looking for "wonderful businesses at fair prices" - that is, companies with large moats, excellent cash flows and great managements.

"Where you really want to be is in businesses that are going to be even better ten years from now, and we want to buy them at a reasonable price. Many years ago, we gave up what was labelled the 'cigar butt' approach to investing...There were free puffs in them, but it doesn't work with big money."

Berkshire Hathaway is currently the seventh-largest company in the S&P 500 Index, with a market capitalization of $545 billion and a cash pile of almost $150 billion. With so much capital to deploy, it's simply not worth the trouble for Buffett and his partner, Charlie Munger (Trades, Portfolio), to go looking for small, cheap businesses that have a tiny amount of free money left in them. Being big is good, but it certainly imposes some restrictions.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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