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How to make investing in Warren Buffett’s cigar ass work for you

investment of cigar butts

Cigar butt investing is a form of investing in problem assets. In this strategy, you buy cheap shares in troubled companies that are expected to be worth more than their current share price. You let the stock rise, then sell it for a quick profit. This should not be confused with value investing, where you make long-term investments in companies that the market has undervalued. Investing in cigar butts is a short-term approach to buying generally weak companies. You can work with a financial advisor if you’re not sure if it’s right for your portfolio or you can read on to find out more.

What is the cigar butt theory?

Cigar butt investing is a term coined by famed investor Warren Buffet. In a letter to Berkshire Hathaway shareholders in 1989, he explained the theory as a way to quickly capture value from weak companies. According to his letter:

“If you buy a stock cheap enough, there will usually be some hiccup in the fortunes of the business that will give you the ability to offload at a decent profit, even though the long-term performance of the business could be terrible. I call the ‘cigar butt’ approach to investing. A cigar butt found on the street with only a puff left may not offer much to smoke, but the ‘bargain buy’ will make that puff pay off” .

For example, suppose you find a struggling company whose stock price has been driven down to $0.75 per share. This company is still in business, otherwise it wouldn’t be trading, but it is weak or failing and the market has started betting against it.

In a situation like this, the company could very well have a last minute surge in value. Late investors may be interested in betting on cheap stocks, or the company may be looking for someone to buy them. More often than not, simply liquidating and liquidating everything the company owns will generate an infusion of cash that will drive up the stock price. That price may not exceed $1 a share, but the extra $0.25 is all profit for a late investor.

If someone finds a smoking cigar on the street, what they found is 90% trash. But they can still get the last 10% of smoke for free. The same goes for investing in cigar butts. The stock can generally be a poor investment, but it can still make a last-minute profit.

How do cigar butt companies identify themselves?

The general way to determine an investment in a cigar butt is through what is known as a company’s current net asset value (NCAV). The formula is:

In other words, it starts with the total value of all assets in the company. Then subtract the company’s debts, liabilities anything it owes preferred shareholders (since they get paid first). This tells you how much the company would be worth if it completely liquidated and paid off all of its debts.

Then you divide that by the number of common shares outstanding. What you are left with is how much each shareholder would receive if the company liquidated tomorrow, paid all its debts, and distributed the rest to its shareholders.

If this number is higher than the stock’s current trading price, the company could be an investment for the cigar butt. Even if the company is doing poorly, in the worst-case scenario a final liquidation would pay shareholders more than the company is currently selling. This makes it a potentially profitable short-term investment.

Pros and cons of investing in the cigar butt

investment of cigar butts

It is vital to understand that investing in your cigar butt is not an investment of value. You are not looking for a long-term investment in good companies that trade below their true value. Instead, you’re looking for weak companies that are likely to experience one last jolt in value. Unlike value investing, this is a short-term strategy.

The benefit of this approach is that it can give you a good source of quick income. Cigar butt companies are a way to make quick profits with relatively small investments. While a given profit margin will usually be quite small, you can make many of these investments given their turnaround.

But don’t let the lure of quick money fool you. There are many very real downsides to investing in cigar ass, which is pretty much always the case with investment strategies that focus on market timing. As Buffet explained in the same letter to shareholders cited above:

“Unless you’re a liquidator, this kind of approach to buying companies is foolish. First, the original ‘bargain’ price probably won’t turn out to be a bargain after all. solved a problem that another surface: there’s never just one cockroach in the kitchen. Second, any head start you secure will quickly be eroded by the low returns the company earns.

For example, if you buy a business for $8 million that can be sold or liquidated for $10 million, and you go about both options promptly, you can make a high return. But the investment will disappoint if the company is sold for $10 million over ten years and has earned and distributed only a small percentage of the costs annually in the meantime. Time is the friend of wonderful business, the enemy of mediocre.”

In other words, of the many issues here, two are key: First, any other investor can calculate NCAV as well. So if the entire market thinks this stock is only worth $1, even though the NCAV formula says the company could liquidate for $1.50, it’s worth asking why. The answer usually has to do with problems in the underlying business, problems that mean your increased profits won’t come easily…if at all.

Even if it does, it is not known in what period of time. People work hard to save even failing businesses. There is absolutely no guarantee that this company will fail and if it does there is no guarantee that it will anytime soon. You could be stuck keeping this stock rolling for years. Even if you end up making that $0.25 per share profit, the opportunity cost of investing over the long term will be substantial.

Cigar butt investing is an interesting approach and one that Warren Buffet credits with making his first million. However, there’s a reason it now warns investors and shares the same risk profile as any other strategy that promises to time the market.

The bottom line

investment of cigar butts

Cigar butt investing is a short-term investment strategy where you buy undervalued shares in troubled companies. When it works, you can get a last gasp of value from short-term trading. It’s one of many investment strategies you may want to consider for your portfolio.

Tips for investing

  • There are many smart ways to trade and invest, but if you’re not sure which direction to take, you may want to consider working with a financial advisor. A professional can help you create an investment strategy that fits your long-term goals. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, get started now.

  • It’s probably not a good idea to try and time the transfer market as it can cause a lot of pain if you don’t know what you’re doing and even the pros can lose their shirts.

Photo credit: ©iStock.com/courtneyk, ©iStock.com/shironosov, ©iStock.com/PeterPhoto

The post Cigar Butt Investing: Warren Buffett Strategy first appeared on the SmartAsset Blog.

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