Where Buffett got the cigar-butt metaphor all wrong

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.

1989 Bershire chairman’s letter

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.

2014 Bershire chariman’s letter

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.

1989 Bershire chairman’s letter

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.

2014 Bershire chariman’s letter

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.

1989 Bershire chairman’s letter

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

Consensus is what you pay; the relationship to value determines what you get.

The foundation of “value investing” is built on a narrative that price and value are two distinguishable components. Benjamin Graham, also known as the father of value investing, is often credited as the first author of this narrative. The best evidence for this, if we exclude The Intelligent Investor and Security Analysis, is a quote from one of his famous disciples:

Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. – W. Buffett [2008 Berkshire Shareholder Letter]

The “Price is what you pay; value is what you get” phrase has become one of the most quoted expressions in value investing circles. It has also become one of the most misunderstood and misused quotes in investing. Still, I would argue that it is the most important quote in investing. This is what this post will be about.

We are all value investors, but…

One can make the argument that independent of our investment approach, fundamental analysis, technical analysis, indexing or pure speculation to buy low and sell high, no-one will buy something for more than what they think it is worth (i.e. the basic premise of what constitutes value investing). In other words, all investors have the intention to make money when they buy an asset. The opposite would be paradoxical and although I believe that we humans are not very rational I also believe we are not irrational. My point is, all market participants are inherently value investors.

But let us take a step back and consider this:

Not all successful investors call themselves value-investors and not all investors that call themselves value-investors are successful.

or if I haven’t convinced you with my “we are all value investors” argument:

Not all successful investors call themselves [insert investing philosophy]-investors and not all investors that call themselves [insert investing philosophy]-investors are successful.

First of all, I make the statement above to point out that there exists no need to put investing-labels on ourselves or to fight on Twitter with a purpose to defend our investment-style. Outside of Twitter, the same phenomena exist in books on investing, in blog posts and podcasts on investing etc. I have been there myself and I can honestly say that nothing fruitful come out of these discussions. That is not to say that this phenomenon of labeling ourselves and that we defend our investment-style with nails and claws is not interesting. To the contrary, this is extremely interesting!

What fascinates me is that it seems like we have an inherent urge and need to belong to a certain tribe of investors. An urge and need to subscribe to a certain investing philosophy with the simultaneous exclusion of other approaches although we might share some common ground. As you probably realize, the very same phenomena can be found in discussions about politics, sports, religion etc. In the case of investing though, I would argue that this urge and need makes us blind for the path towards the holy grail of investing. It makes us forget about the only question an investor needs to focus on. That is the question of:

What determines the success of an investor?

The holy grail of investing

I can assure you, answering the question above and you have attained the map to the holy grail of investing. Answering the question and you have almost figured it all out. The answer is “simple but not easy” as Mr. Munger has famously said about investing in general. But let me give you the answer:

The success of an investor is determined by the exploitation of price and value. More specifically, buying assets for less than they are worth

This conclusion goes back to my argument that we are all value investors. With the help of inversion we also realize that; if we buy something for more than it is worth we will be unsuccessful investors. However, this simple answer is not easy to implement successfully. Especially on a reoccurring basis. The reasons for that are multiple. On an overall level though I would argue that it has to do with a basic misunderstanding of the value/worth component as it relates to the price paid for an asset.

The quality-fallacy

The basic misunderstanding is this:

Buying good things ≠ Buying things good

or said differently:

Quality ≠ Value

What I mean with the two statements above is that the quality characteristics of an asset (i.e. good things) are not a substitute for buying assets for less than they are worth (i.e. buying things good). Investors fall for this quality-fallacy all the time. The reason for that is that it’s far easier emotionally to buy and own what is considered to be of quality (good asset) than what is considered non-quality (bad asset). Unfortunately though, in investing the quality of an asset is not a determinant for the value you will get. This is a mistake that people make all the time when investing. This is even true if one isn’t careful to think about what the quote that started this post “Price is what you pay; value is what you get.” really implies. Let me explain.

A simple misunderstanding

What people don’t understand or misinterpret about the quote is that the value component, “what you get”, is a residual. What you get is the difference between the price paid for an asset in relation to the value of that asset. That is the value you will “get” as an investor. Again, I would like to point out that “value” in this quote is not a synonym for the quality of that asset, as some people would like to believe. Making this mistake is not something to be ashamed of considering how the quote was framed by Buffett himself:

Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. – W. Buffett [2008 Berkshire Shareholder Letter]

I know that buying “quality companies” has been key to Buffett and Munger (Berkshire’s) success. However, people forget that they have still bought those companies at a price below their worth (i.e. “when it is marked down”). Too often though I see their philosophy for what constitutes a good investment dwarfed into an argument that a good company equals a good investment (i.e. “I like buying quality merchandise”). Although their methods for determining value were different from those used by Graham they never deviated from the lesson of what determines the success of an investor. That is, buying assets for less than they are worth. Remember that.

Evolving the quote

In order to make what I consider the most important quote in investing a bit clearer and to summarise this post I thought I would wrap things up with an evolved quote. In order to fully understand this evolved quote, I would like to frame it with the help of two favorite quotes of mine. These quotes will help to explain the “price” component and the drivers behind what makes an investor not only successful but more successful than everybody else. Both quotes are from the famous investor H. Marks:

The price of a security at a given time reflects the consensus value. The big gains arise when the consensus turns out to have underestimated reality [value], or to have miss-estimated reality [value]. To be able to take advantage of such situations, you must be able to think in a way that’s away from the consensus. You must think different and you must think better. It’s clear that if you think the same as everybody else, you’ll act the same as everybody else, and have the same results as everybody else. – H. Marks

[value] has been added by me to the original quote.

Note that Mr. Marks is not saying “different and right” in the quote above, he is saying “different and better”Better in the sense that:

Superior performance does not come from being right, but from being more right than the consensus. You can be right about something and perform just average if everyone is right too. Or you can be wrong and outperform if everyone else is more wrong. – H. Marks

Based on what I have concluded in this post and what H. Marks has helped to explain in the two quotes above:

Price is what you pay; value is what you get.

evolves into:

The consensus expectations of value is what you pay today; the realization of those expectations in relation to the value at a future date is what you get.

or as I would like you to remember with the help of fewer words:

Consensus is what you pay; the relationship to value determines what you get.