Warren Buffett, one of the most successful investors of all time, is known for his investment philosophies that have built Berkshire Hathaway into a financial powerhouse. One of his earlier and lesser-known strategies is the “cigar butt” investment approach. This strategy, influenced by his mentor Benjamin Graham, involves investing in companies that are significantly undervalued, akin to picking up a discarded cigar butt with one last puff of value. Here’s an in-depth look at how Warren Buffett made money with this approach.

The Origin of the “Cigar Butt” Strategy

The “cigar butt” investment strategy is a concept that Buffett adopted from Benjamin Graham, the father of value investing. Graham’s philosophy centered around purchasing stocks that were trading for less than their intrinsic value, often found in distressed or neglected companies. The idea is that these companies, despite their troubles, have enough remaining value to provide profitable returns.

Buffett famously described this approach: “If you buy a stock for a cheap enough price, there will usually be some unexpected good news and the stock will recover, providing a nice return.”

Key Principles of the “Cigar Butt” Strategy

1. Intrinsic Value Over Market Price: The core of this strategy is finding stocks priced significantly below their intrinsic value. These stocks might be overlooked, underperforming, or suffering from temporary issues.

2. Margin of Safety: By purchasing stocks at a deep discount, investors create a margin of safety. This minimizes the risk of loss and maximizes potential returns when the market corrects itself or the company’s situation improves.

3. Short-Term Gains: Unlike Buffett’s later emphasis on long-term investments in high-quality businesses, the “cigar butt” strategy is often about capitalizing on short-term mispricings and market inefficiencies.

Successful Implementation of the “Cigar Butt” Strategy

1. American Express (AmEx)

In the 1960s, American Express was embroiled in the “salad oil scandal,” which significantly depressed its stock price. The scandal involved a company called Allied Crude Vegetable Oil, which used false collateral (salad oil tanks filled with water) to secure loans from American Express. When the fraud was uncovered, AmEx’s stock plummeted.

Buffett saw this as a classic “cigar butt” opportunity. He analyzed the company’s core business and concluded that despite the scandal, AmEx’s brand and financial services business were strong. He invested heavily in AmEx, and as the company recovered from the scandal, the stock price surged, yielding substantial returns.

2. Sanborn Map Company

Another classic “cigar butt” investment was the Sanborn Map Company. Sanborn made detailed maps for fire insurance companies, but by the late 1950s, its business had declined. However, Buffett noticed that Sanborn owned a portfolio of marketable securities worth significantly more than the company’s stock price.

Seeing the disparity between the stock price and the intrinsic value of the assets, Buffett purchased a significant stake in Sanborn. He then pushed for a reorganization to unlock the value of the securities portfolio, resulting in a profitable return.

3. Dempster Mill Manufacturing Company

Dempster Mill, a company that manufactured farm equipment, was another undervalued company that Buffett identified in the 1960s. The company was struggling, but Buffett saw value in its inventory and real estate.

Buffett’s approach here was hands-on. He installed new management to improve operations and eventually sold off parts of the company to realize the intrinsic value of its assets. This intervention turned a struggling company into a profitable venture.

Transition from “Cigar Butt” to Quality Investing

While the “cigar butt” strategy yielded significant returns in Buffett’s early career, he eventually shifted his focus. The main reason for this transition was the realization that buying great companies at a fair price was better than buying fair companies at a great price. This evolution in his investment philosophy was significantly influenced by Charlie Munger, his longtime business partner.

Munger advocated for investing in high-quality businesses with strong competitive advantages, even if they were not as deeply discounted. This approach led to Buffett’s investments in companies like Coca-Cola, Gillette, and See’s Candies, which offered sustained long-term growth and consistent returns.

Conclusion

Warren Buffett’s “cigar butt” strategy was instrumental in building his early fortune. By identifying deeply undervalued companies and capitalizing on the intrinsic value that the market had overlooked, Buffett was able to achieve substantial returns. However, as his investment philosophy matured, he moved towards investing in higher-quality companies with enduring competitive advantages, leading to even greater success.

The “cigar butt” strategy, while effective in certain market conditions, requires a keen eye for value and a willingness to delve into companies that others might avoid. Buffett’s ability to discern such opportunities and his subsequent evolution as an investor highlight the importance of adaptability and continuous learning in the world of investing.