Cigar Butts and the Advantage of Investing Small Sums

In any lecture or interview about investing, Warren Buffett often says that you should buy great businesses at fair prices. The idea being that as long as you purchase a great business at a reasonable price, the firm will generate higher earnings in the future than it does now, increasing potential future dividends while using retained earnings to increase the asset base and further improve earnings. If you buy into a business with a durable competitive advantage, or a wide moat as Buffett likes to say, then you can be sure of the quality of your investment for years to come without having to worry about stock prices. Such is the life of a successful entrepreneur or owner of a great business. This can be compared to private ownership of a business- one would never care how others valued their company, they only care about the cash flows of the firm and potential for future dividends. If you own a great company, it frankly wouldn't matter if the stock was removed from the stock exchange for a few years- or ever for that matter.

This leads many novice and aspiring investors to go out seeking the best companies at reasonable prices and attempt to generate the 20% returns that Berkshire Hathaway has attained since it was formed. While these are the ideal qualities of proper investment and some can be successful following them, in my opinion the vast majority of investors will not. There are many reasons, but a few important ones are listed here:

1.       The best firms are covered by all the best Wall Street investment firms and institutional investment companies.

2.      This coverage of the top 500 or so firms makes it harder to buy in at reasonable prices. From what I have noticed, surprisingly the fluctuations of these top firms can be frequent and dramatic, so I have come to believe that analyst coverage may not be the most important factor (due to Wall Street's obsession with short-term performance and inability to see themselves as owners for the long-run), but regardless a stock is more likely to be properly priced the more coverage it has.

3.      When valuing good companies, the investor must not only examine current performance, but also forecast the future of the business and the growth rate of future earnings and cash flows.

4.      Many of the top businesses are in highly volatile industries subject to rapid technological change and disruption, making it very difficult to predict future growth rates and earnings. Since competitive advantage can be fleeting in highly technological firms, sometimes one's estimate of the leading companies in the future may be completely false due to these changes in the nature of business in the industry.

5.      Even if you purchase a great business at fair prices, many of the top businesses experience lower growth than smaller firms, leading to lower returns for investors than what otherwise could be made.

6. It can be difficult to understand competitive advantage, and even more difficult to predict how long that competitive advantage will grant the firm in question excess returns on capital. Competitive advantage is a form of market failure in my opinion- ideally all industries would be perfectly competitive for the benefit of the consumer. Competitive advantage is therefore the postponement of perfectly competitive conditions for as long as the firm can manage in order to achieve abnormal profits. As Joseph Schumpeter once explained, creative destruction is the norm in capitalism and the companies that can postpone competition for significant periods of time are few and far between.

These factors lead academics and others to conclude that the market is highly efficient and that it is near impossible or essentially luck to be a successful investor. The best way to summarize this effect in the top firms is how Aswath Damodaran, a professor of finance and valuation obsessive at NYU did:

"The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes."

Now of course, I would disagree as there have been many, many investors who have beat the market over long periods of time- but for the largest asset managers who mainly invest in the components of the S&P 500 it is generally true.

Further, by investing in the largest and most successful businesses, the small investor is wasting their sole advantage- their size. There are over 9,000 stocks on public U.S. exchanges alone, and the vast majority of them are lacking in coverage due to their size. Many of them are too small for Wall Street firms and other investment companies to invest in, as they have hundreds of millions or billions in Assets Under Management (AUM). Good news is that you don't. The small and nimble investor can gain enormously by finding the ignored and depressed stocks.

Despite what is frequently said in news articles and what Warren Buffett himself says about proper investing, his best returns were made by investing in small, poorly managed, undervalued, and ignored companies. From 1957-1969, Buffett ran his own investment partnership and invested a significant percentage of his assets in mediocre but cheap companies (cheap relative to assets, earnings or cash flows). Below are his returns from using this strategy.


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Over the 12 year period, he averaged 30% a year (before removing his take of the management fees) while the Dow generated a measly 7.4% annually. Even better, Buffett has discussed his investment results through the 1950's in the Berkshire Hathaway 2014 Annual Report:


"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."

"The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access."

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

For those who have not heard the term 'cigar butt' used in the context of investing before, it is essentially when you purchase a mediocre company at a very cheap price relative to fair value. As explained in my last post, you can ride the stock up to fair value, and thereafter you will receive returns equal to that of the growth of the company's earnings, and so you must sell. This jump to fair value is the last puff of the cigar butt.

In a lecture-type event to university students, someone asked him how he would invest if he were a small investor again and answered:

"Yeah, if I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low PEs and maybe below working capital and all that. Although -- and incidentally I would do far better percentage wise if I were working with small sums -- there are just way more opportunities. If you're working with a small sum you have thousands and thousands of potential opportunities and when we work with large sums, we just -- we have relatively few possibilities in the investment world which can make a real difference in our net worth. So, you have a huge advantage over me if you're working with very little money."

Maybe it's just me, but his advice to the mainstream and what he would actually do if he were in our position seem quite contradictory. Of course, he can't tell the masses to go looking for undervalued businesses as they would surely hurt themselves doing so- which is why he advises to invest in low cost S&P 500 index funds or go for the best companies. At Berkshire Hathaway's size it is impossible for him to invest in these types of companies, leaving them all for us.

Investing in larger and better companies from 1965 to 2014 led to returns of 19.4% annually for Berkshire Hathaway which is market dominating performance, yet still it pales in comparison to the returns he achieved when he was young and going for deep-value stocks.