Cigar-Butt Investing

Cigar-Butt Investing (also known as 'Net-Net Investing') is a value investing strategy that involves buying stocks in deeply distressed companies that are trading for less than their breakup or liquidation value. The term was famously coined by Warren Buffett to describe the early investment style of his mentor, Benjamin Graham. The analogy is of finding a discarded cigar butt on the street with one last puff of smoke left in it. The butt isn't pretty, and it won't last long, but that last puff is essentially free profit. Similarly, a cigar-butt company may be a poor business in a declining industry, but because its market capitalization is so low relative to its tangible assets, an investor can buy it, wait for the market to realize its minimal value (the “last puff”), and then sell for a quick, modest profit. It is the quintessential strategy of buying a “fair company at a wonderful price.”

Imagine strolling down the street and spotting a discarded cigar. It looks a bit grubby, it's certainly not a premium brand, and it's almost finished. But you notice there’s just enough left for one final, satisfying puff. Best of all, it's completely free. You pick it up, take that puff, and toss it away. That, in a nutshell, is the philosophy behind Cigar-Butt Investing. You're not looking for a great, long-lasting smoke (a wonderful company to own for years). You're hunting for a statistically cheap, often mediocre business that the market has thrown away, but which still has one last puff of value left in it.

Cigar-butt investors are bargain hunters in the truest sense. They use a quantitative approach pioneered by the father of value investing, Benjamin Graham. The most famous method is looking for stocks trading below their net-net working capital (NNWC). The logic is beautifully simple: you're trying to buy a company for less than its walk-away, fire-sale value. A common calculation for this value per share is: (Current Assets - Total Liabilities) / Number of Shares Outstanding = Net Current Asset Value Per Share If you can buy the stock for significantly less than this value (Graham suggested a price of two-thirds or less), you've found a potential cigar-butt. You're effectively buying the company's working capital for a discount and getting its long-term assets, like buildings and machinery, for free. These opportunities are almost always found in ugly, unloved, and ignored corners of the market.

The investment thesis is not based on the company's future earnings or growth prospects. Instead, the profit—the “last puff”—is realized when one of two things happens:

• Market Correction: The market eventually recognizes the extreme gap between the stock price and the underlying asset value, and the price drifts up toward its liquidation value.
• Corporate Action: The company is liquidated, acquired, or taken private, which forces the value of the assets to be paid out to shareholders.

This is a short-term, transactional strategy. Once you get your puff of profit, you sell the stock and look for the next discarded butt. It is the polar opposite of a “buy and hold forever” philosophy.

The single greatest advantage of this strategy is the enormous margin of safety. By buying assets for 50 or 60 cents on the dollar, you create a substantial cushion against errors in judgment or further business deterioration. The price is often so low that it seems there is little further to fall. As Benjamin Graham argued, this quantitative, asset-based approach provides the surest defense against permanent loss of capital.

While the theory is sound, the practice is fraught with challenges. Cigar-butt investing is not for the faint of heart.

• Value Traps: The most significant risk is that you've bought a 'value trap'. These are often terrible businesses for a reason, and their asset value can continue to erode faster than the market realizes. The company could burn through its cash, turning your cheap stock into a worthless one.
• Scarcity: Finding true cigar-butts in modern, efficient markets is incredibly difficult. Most stocks that appear this cheap have serious, often hidden, problems.
• Diversification is Key: You cannot bet your portfolio on a single cigar-butt. The strategy only works reliably when applied across a diversified basket of 15-20 or more such stocks, as some will inevitably fail.
• Psychological Toll: It is mentally taxing to own a portfolio of what the world considers “junk.” These companies are often in the headlines for all the wrong reasons.

Warren Buffett, the strategy's most famous practitioner, eventually abandoned it. With the guidance of his partner Charlie Munger, Buffett shifted his focus from buying “fair companies at a wonderful price” to buying “wonderful companies at a fair price.” He concluded that it was far better to pay a reasonable price for an excellent, growing business you can hold for decades than it was to constantly hunt for cheap, mediocre ones. The size of his firm, Berkshire Hathaway, also made it impossible to deploy billions of dollars into the tiny, obscure companies where cigar-butt opportunities typically reside. For the small, individual investor, however, the strategy may still hold some relevance. Small investors are nimble enough to navigate the micro-cap world where these statistical bargains might still exist. While it's a tough game to play, the core lesson of Cigar-Butt Investing remains a cornerstone of value investing: always insist on a margin of safety.