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Stepan Lavrouk
Stepan Lavrouk
Articles (292) 

The Dangers of Cigar-Butt Investing

3 issues that aspiring cigar-butt investors need to be aware of

September 17, 2019

"Cigar-butt" investing is perhaps the "purest" form of value investing. The core principle behind the strategy, as practiced by Benjamin Graham and David Dodd, is to search for businesses that are trading at bargain-basement valuations due to some sort of structural issues. They may be on their last leg and have many problems, but they are so cheap that it still makes sense to invest. The analogy comes from the idea of picking up discarded cigars and taking the last few puffs out of them - quite unappetizing, but still technically good value. As such, I want to discuss three pitfalls cigar-butt investors have to contend with.

Dying industries

Cigar butts are often defined as companies that are trading below book value (though there are other definitions). Where are companies like this most likely to be found? In declining industries. This presents a problem for the cigar-butt investor. The fundamental logic behind a cigar-butt strategy like Graham’s famous "net-net" - equity trading below two-thirds of net current asset value, or total current assets minus total liabilities - is that the stock has one last bounce left in it, or one last puff of smoke.

The issue is that in a declining industry (for instance, print newspapers), the time horizon for that last puff is always shrinking. You may correctly identify a newspaper business that is trading at a good discount to its NCAV, but it may never recover enough for you to realize a profit.

Turnarounds are difficult

Not all cigar butts are hopeless businesses, however (this is where the cigar analogy breaks down somewhat). Some cigar butts are actually turnaround candidates - albeit ones where the probability of success is quite low. Therein lies the second problem for the aspiring cigar-butt investor. It is generally not possible to improve the fortunes of a struggling net-net business by simply executing its core functions better.

A turnaround for a business of this sort requires a fundamental strategic reorganization of the company, which often requires refocusing its attention on a completely different market. While this is difficult for a management team to achieve; it is even more difficult for an outside investor to accurately predict whether the efforts of said team will be successful.

No correlation with industry

Usually, it is possible to make investments on a sector-wide basis. For instance, you may believe that banks or retail will do well in the next few years based on your assessment of interest rates, inventory levels or some other important sector variable. In these cases, you can look at what the sector in question is doing on average, and then pick the best investment options from that pool.

The fortunes of cigar butts rarely correlate with those of the wider industry around them, unless, of course, we are talking about an industry that is declining more generally, as discussed above. Assuming that the stock's sector is healthy, it’s pretty rare that the rising tide will lift the most depressed boats. In fact, sector growth could work against the cigar butt as competitors consolidate control of the market. For this reason, you should be wary of drawing inferences about your net-net from the performance of its peers.

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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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