"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 relative and absolute investment performance," Warren Buffett (Trades, Portfolio) said.
So why did he give it up if the strategy worked so well? And what does he even mean when he says "cigar butts?"
Understanding the cigar butt investment methodology
Early in his career, Warren Buffett (Trades, Portfolio) made millions utilizing a strategy known colloquially on Wall Street as the "cigar butt" approach. As the name suggests, this involves picking up shares of companies with almost no value left - akin to finding a smoked cigar with one last free puff left.
While unglamorous, this strategy can be lucrative on a small scale. During the 1950s, Warren Buffett (Trades, Portfolio) made a fortune buying shares of near-defunct companies for less than their net working capital. This allowed him to profit from selling or liquidating them even if the underlying businesses were mediocre.
However, this bargain-hunting strategy contains an inherent flaw that limits the upside. Once Buffett's capital base grew large enough, cigar butt investing was no longer feasible. Beyond a certain scale, he needed to shift from maximizing the return of capital to maximizing the return on capital.
This inflection point arrived in the mid-1960s after a series of mistakes in buying cigar butts. The final wake-up call was Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), a struggling textile manufacturer he purchased in 1965. Attracted by its cheapness, Buffett accumulated a majority stake. But he soon realized owning such a bad business with bleak prospects was a mistake just because it was statistically inexpensive.
The cost of the cigar butt strategy
Buffett got stuck running this deteriorating textile operation for 20 years before finally shutting it down. He called it "the dumbest stock I ever bought" and estimated it cost him and his partners over $200 billion in lost opportunity costs.
This debacle revealed the underlying weakness of the cigar butt strategy. It led Buffett to rethink his investing principles under the influence of Charlie Munger (Trades, Portfolio) .
Flaws in the cigar butt approach
In hindsight, there were several gaps in Buffett's original cigar butt strategy:
- It focused solely on statistical cheapness without enough weight on business quality, industry dynamics, and future economics.
- There was no margin of safety if he paid too much relative to a company's earning power. Asset values could erode quickly in struggling businesses.
- Psychological biases like loss aversion caused doubling down on mistakes instead of cutting losses.
- It was only scalable up to a point due to the limited size of each bargain investment.
Munger's influence on Buffett
Munger heavily influenced Buffett's shift away from cigar butts. Their fateful meeting and subsequent friendship in the late 1950s marked a turning point in Buffett's investment philosophy.
Munger stressed to Buffett the advantages of buying high-quality companies with robust economics versus mediocre companies simply because they were cheap statistically. This new viewpoint opened Buffett's eyes to the merits of focusing on genuinely excellent businesses even if their shares were not as inexpensively priced.
As Munger put it: "A great business at a fair price is superior to a fair business at a great price. (…) We've really made the money out of high-quality businesses. (…) But when you analyze what happened, the big money's been made in the high-quality businesses."
Transformation of Buffett's investment strategy
This simple but profound insight transformed Buffett's investment strategy into the value-centric approach he practices today. He credits Munger with nudging him toward higher-quality investments that allowed Berkshire Hathaway to scale up in a way that would have otherwise been impossible.
Seeking wonderful businesses at fair prices
Buffett's evolved investment doctrine can be summed up in a few words: "I would rather buy a wonderful business at a fair price than a fair business at a wonderful price."
This means targeting extremely high-quality companies with durable competitive advantages. Buffett is willing to pay a reasonable price for them regarding ratios like price-to-earnings. He does not insist on statistically cheap bargain valuations if it means compromising on business fundamentals.
This discipline opened up a much broader universe for Buffett to allocate Berkshire's capital without size limitations. He could make significant bets on companies with virtually unlimited runways for growth, like Coca-Cola Co. (KO, Financial), Apple Inc. (AAPL, Financial) and American Express Co. (AXP, Financial).
Examples of Buffett 's high-quality investments
Coca-Cola is a prime example of a wonderful business Buffett targeted at a fair price. When he bought in during the late 1980s, Coke already had unrivaled brand equity, an unassailable distribution network, and tremendous pricing power. Though not ultra-cheap statistically, it met Buffett's criteria for a robust franchise built to last. His patience has been richly rewarded, as his $1.3 billion investment is now worth almost $25 billion.
Another more recent instance is Apple. Though historically Buffett shied away from tech companies, the durable competitive strengths of Apple's ecosystem convinced him it was a high-quality business. So when Apple shares corrected in early 2016, he seized the opportunity and established a position despite the stock trading around a price-earnings ratio of 12.
Since then, Apple has returned over 1,100% thanks to its strong free cash flows and growing dividends. This example showcases Buffett's flexibility - even an old dog can learn new tricks and expand his circle of competence.
American Express is also a long-term Berkshire holding where Buffett appreciated the company's brand power, data assets, and network effects as an early mover in payments. Buffett ensures his capital compounds for years and decades by targeting best-of-breed companies.
Buffet still demands a margin of safety
Notably, while emphasizing quality, Buffett still insists on a margin of safety when paying for a business. He wants to buy stocks at a significant discount to his conservative estimate of intrinsic value. This provides downside protection in case his projections are too optimistic.
However, the margin of safety concept has evolved to become more about the quality of the underlying business rather than just its statistical cheapness. In a mediocre business, intrinsic value can erode quickly. But in a high-quality enterprise, value often accrues over time.
This distinction is why Buffett is willing to pay fair prices for terrific companies like Coca-Cola or Apple. Their durable moats act as the true margin of safety by widening the gap between the price paid and the intrinsic value realized.
Applying Buffett ’s lessons
For individual investors, the key implications of Buffett’s evolution away from cigar butts include:
- Don’t compromise on business quality just because a stock looks statistically cheap based on metrics like price-earnings or price-book ratios.
- Take the time to understand what makes a business truly wonderful – strong brands, pricing power, wide moats. Identify companies that prosper decade after decade.
- Conduct in-depth research on a company’s economics rather than just hunting for low prices and falling knives. Assess long-term earning potential.
- Focus more on the future economics and competitive dynamics of a business rather than just current valuation multiples or asset values. The future is more important than the present.
- Be willing to pay a fair price for shares of quality companies rather than holding out for ultra-bargain bin valuations and deep value plays.
- Have a long-term mindset and allow great companies the runway to compound value over years or decades. Don’t overtrade or make impulsive moves.
From cigar butts to high-quality compounders
By shifting from cigar butts to high-quality compounders, Buffett turbocharged Berkshire Hathaway's returns over the past 50-plus years. He continues to evolve by embracing companies like Apple that blur the line between value and growth investing.
Rather than rigidly adhere to the same tactics that worked when he managed small sums, Buffett focuses on the underlying principles: calibrating risk through quality, judging value via long-term cash generation and letting winners ride.
Munger opened Buffett's eyes to this superior mindset of favoring wonderful businesses, even at the cost of overcoming his cigar butt habits. The billionaire duo's insatiable learning, mental flexibility and decision to maximize return on capital rather than of capital all lie at the heart of Berkshire Hathaway's ascendance.
