During my time as an undergraduate student, I worked part-time at a treatment center for people that had some form of mental illness in combination with ongoing drug addiction. Working there taught me a lot of things. Not at least, that you can learn something interesting from anyone. Unexpectedly, sitting one night talking to one of the patients made me realize, out of all things possible, that Buffett with his famous cigar-butt metaphor had got it all wrong. Telling the story that caused my realization and correcting Buffett’s metaphor delusion will be the focus of this memo.
The cigar-butt metaphor
The first time Buffett mentions the cigar-butt metaphor, that I’m aware of, is in the 1989 Berkshire letter.
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.
In a much later letter, the 2014 letter, Buffett again uses this metaphor with the backdrop of buying Berkshire itself.
I purchased BPL’s (Buffett Partnership Ltd.) first shares of Berkshire in December 1962, anticipating more closings and more repurchases. The stock was then selling for $7.50, a wide discount from per-share working capital of $10.25 and book value of $20.20. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.
Reading the two statements above one gets the impression that although Buffett himself had previously used the cigar-butt approach, he had a few negative things to say about it. Going back to the 1989 letter Buffett explains why this approach is to be considered “foolish”.
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. […] Time is the friend of the wonderful business, the enemy of the mediocre.
While I think there is validity to the “first” and “second” argument that Buffett makes, his overarching conclusion (i.e. this is a foolish approach if you are not a liquidator) is wrong and something worth pushing back on. I will do so with the help of a personal story.
A cigar-butt[s] story
During my time as an undergraduate student, I worked part-time at a treatment center with people that had some form of mental illness in combination with ongoing drug addiction. One evening when I was working the night shift, a patient, let’s call her Agnes for the sake of this story, came into the “office”. Agnes said she was going to smoke a cigarette and wondered if anyone of us would care to join her for a chat. Why not I said and we headed over to one of the smoking rooms. As we sit down opposite each other Agnes takes out a small box and places it in front of her on the table. From the box, she took out four items. Cigarette papers (i.e. rolling papers), cigarette filters, a plastic bag filled with cigarette-butts and a lighter.
With a meditative focus, you could tell that this was not her first time, she started to tear up one cigarette-butt after the other. She collected the tobacco from five or six of the cigarette-butts and then placed it on a line in one of the cigarette papers. She took a filter, placed it in one of the ends of the cigarette paper and started to roll the thing back and forth in her hands. A few seconds later, a whole cigarette was in the corner of her mouth and white smoke had started to climb towards the ceiling. Although I had seen Agnes smoke before I didn’t know that she rolled her own cigarettes. Even more so, I didn’t know that the tobacco that she smoked came from cigarette-butts that she had found and collected from the streets during her daily walkabouts. Collecting cigarette-butts had become a daily routine she later told me.
One should know that Agnes had very little money to spend on anything, and the money that she did have was to a large extent spent on alcohol. I would here make the claim that people with drug addiction are to be considered the most inventive and entrepreneurial people in the world. Unfortunately, though, this ingenuity and entrepreneurship are often focused on things that either hurt themselves or society in general. Or both. This case was no different as we are talking about smoking cigarettes. However, one could also argue that Agnes because of her ingenuity at least didn’t have to take a puff from an “ugly and soggy” cigarette-butt found on the street that had been in the mouth of some unknown person in order for her to have “momentary pleasure”. Rather, because of her ingenuity, she was able to make herself a fresh whole cigarette at almost no cost for her to enjoy at length. Talk about the inverse of the description that Buffett gave us. At that moment I had my realization for where Buffett got it his cigar-butt metaphor all wrong.
Lessons from Buffett’s cigar-butt metaphor delusion
First of all, going back to the quotes earlier, Buffett forgot to mention that you will continue to find cigar-butts all over the place. Using the approach that he is talking about, you are not relying on “one last puff” as to all there is and will ever be. Rather, you are relying on multiple puffs from different cigar-butts. Buffett forgot to mention or even think about that you don’t have to take a puff from the discarded ugly and soggy cigar-butt here and now for your momentary pleasure. Rather, you can find and collect a few of those cigar-butts and then roll yourself a fresh whole cigar from the tobacco that they contain. Just as Agnes did. The difference between these two approaches and their outcomes for the “smoker” (i.e. investor) are paramount for how we think about and apply this investment strategy. Essentially, we should not call the strategy the “cigar-butt” (singular) approach to investing as Buffett labeled it. But rather, the “cigar-butts” (plural) approach to investing. As a side note, this is why my investment writing pseudonym is Cigarrfimpar (cigar-butts in Swedish) and not Cigarrfimp (cigar-butt in Swedish).
I would like to end this memo by claiming that I think Buffett was very much aware of the cigar-butts metaphor that I have tried to put forward. The best evidence of that is found in his 1965 partnership letter:
But more importantly, he was less negative about this strategy than what might first appear. Specifically, Buffett seemed to have realized that he and Berkshire had reached the alpha limits of the cigar-butts strategy. The basis for that argument can be found in the 2014 Berkshire letter where Buffett made the following statement.
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.
[…]
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.
I would also make the claim that the reason Buffett used the cigar-butt metaphor the way he did was that he actually wanted to distance himself from the strategy. Essentially, this was a foolish strategy when trying to get good deals buying control of public and private companies. Selling to a “liquidator” or at least an investor perceived to have a “liquidator mindset” is not something most founders and owners are willing to do. They want to know that their “baby” and/or their ownership is in safe hands going forward. Therefore, you have to profile yourself away from that image and in Buffett’s case, his historical self, if you want to go in the opposite direction. As was the case for him and Munger. The last thing they wanted to be thought of as was short-term focused liquidators. Going back to the 1989 Berkshire letter where the cigar-butt metaphor was first mentioned I think this conscious investor-branding strategy is evident.
I could give you other personal examples of “bargain-purchase” folly but I’m sure you get the picture: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.
An investor that similar to Buffett was from Graham-and-Doddsville but unlike him didn’t go the Munger route of value investing was Walter Schloss. His answer to Buffett on the importance of owning multiple cigar-butts I think will be a perfect way to end and summarise this memo on where Buffett got it wrong with his cigar-butt metaphor.
One of the things we’ve done – Edwin and I –is hold over a hundred companies in our portfolio. Now Warren [Buffett] has said to me that, that is a defense against stupidity. And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work. Now I can’t tell you which ones, so I buy a hundred of them. – W. Schloss
Liquidation Almanack 