CIGAR BUTT INVESTMENT

Cigar butt investment is a technique where you find stocks of businesses which are nearly terrible with their performance but you can still purchase it at a very low price to book the profit one last time. The whole idea is that the value of a declining business might be deteriorating, but the price is so low that buying the stock is likely to produce a one-time return as the gap between price and value closes. After that, there is no point to continue to own the stock. The view is that even when the business is not growing there is an expectation that it will appreciate due to other business news and the investor can realize its profit.

Warren Buffet used this investment method in the initial phase of its career. He learned this technique from his guru Ben Graham. The word ‘cigar butt’ was used out of an analogy with using up a mostly smoked cigar that has one or two puffs left. It’s kind of disgusting but free. That’s the catch. Ben Graham used to refer generally undervalued companies (book value above share price) as cigarette butts. He would buy the shares of these companies and hold till they reach their intrinsic value and then sell them for a neat profit with minimum risk.

 

If the company didn't make any movement in positive direction the other way to make money is to keep on purchasing as many shares as possible until you get sufficient share in the company and liquidate it. After paying out the liabilities the will be the profits.

However later, Buffet changed his view on investing. Instead of cigar butts, he started looking for extreme potential businesses with durable competitive advantages, even if they were not as cheap as those cigar butts. Warren Buffet calculated the working capital of the Cigar Butts as

Cigar Butt or Net Net Working Capital = Cash and short-term investments + (75% x Accounts Receivable) + (50% x Total Inventory ) – Total Liabilities

“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.” – Warren Buffett, Berkshire Hathaway 2014 Shareholder Letter