The street is abuzz with success stories of investors and speculators
who have doubled or tripled their money in select low unit value stocks in the
post Covid stock market rally. Calls from our investors also want to know about
that magical stock which can multiply in days if not months. Work from
home or no work with plenty of time to
spare and suddenly everyone has become “Skilled Investors” and “know it all
master operators” of the Stock market by reading the pink papers, following the
business channels and attending Webinars, all of who are all only promising and
providing fodder to the thought that this “Once in a lifetime rally should not
be missed.”
The more than 40% rally from the March lows has proven lucky for many
first timers but the beginners luck is only being attributed to “Skill” of the
Investor. The more than 18 lakh new D mat accounts opened in this period and
the “Robinhood” investors have all made a killing so far, but for how long will
the market rally support the lucky gains without any fundamental basis,
especially so in the so called Penny stocks is anybody’s guess. The market
veterans have all seen it before and continue to advice caution against
participating in the rally and especially adopting the Cigar Butt investing
strategy but the latest “experts” are loath to listen to the non-supportive
advise.
I am reminded of the advise of Warren Buffet, the legendary investor on
the subject.
"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.” That is Warren Buffett speaking
in the 2014 edition of his annual letter to his company shareholders.
The ‘cigar
butt strategy’ is a colourful and colloquial investment term from Wall
Street which refers to someone picking up the butt of a smoked cigar from a
pavement and then relighting it to get a few free puffs. This is akin to buying
a very cheap, apparently worthless stock that no one is willing to pick up and
somehow getting squeeze gains out of it.
At a certain level, "Cigar-butt"
investing is perhaps the "purest" form of value investing. The core
principle behind the strategy, as practiced by Benjamin Graham and David Dodd,
is to search for businesses that are trading at bargain-basement valuations due
to some sort of structural issues. They may be on their last leg and have many
problems, but they are so cheap that it still makes sense to invest. The
analogy comes from the idea of picking up discarded cigars and taking the last
few puffs out of them - quite unappetizing, but still technically good value.
This
activity is also called 'penny stock investing' and currently in India,
it is called the'Rupee stock investing'. The idea being that stocks that
have fallen to very low prices, pennies in the US or single digit rupees in
India, sometimes jump a lot and rebound on some
positive news. In percentage terms, this jump tends to be larger for
rupee stocks than it would be in an equivalent situation for a higher priced
stock.
This rarely
happens, but it is what is believed by fans and investors of Rupee stocks.
Buffett does say some good things about it, but who is to say whether cigar
butt stocks of the 1950s on Wall Street have any resemblance to rupee stocks of
2020 on Dalal Street? In recent months, as many stocks have tanked and stayed
tanked despite some others rising, the temptation to dabble in Rupee stocks
seems to have stuck a certain sub-section of equity investors. Buffett’s advice
would obviously be, “Don’t.”
However,
in the recent stock market rally, Certain Rupee stocks in India have indeed risen
sharply. Ruchi Soya, Reliance capital,
Vodafone, Sintex, Trident, IFCI, Bajaj Hindustan, Suzlon, Dish TV, Reliance
Infra, Nagarjuna Fertilizers, Zee media and many such names have actually given
more than or close to 100 % gains from its March Lockdown lows.
But, as Buffett
says further in his 2004 letter, “... though marginal businesses purchased
at cheap prices may be attractive as short-term investments, they are the wrong
foundation on which to build a large and enduring enterprise. Selecting a
marriage partner clearly requires more demanding criteria than does dating...
It took
Charlie Munger to break my cigar butt habits; The blueprint he gave me was
simple: “Forget what you know about buying fair businesses at wonderful
prices; instead, buy wonderful businesses at fair prices”.
Buy
wonderful businesses at fair prices. Therelies the secret of investing well.
There are two adjectives in that sentence: ‘wonderful’ and ‘fair’. Note which
one Buffett puts where. He does not say buy fairly good businesses at
wonderfully low prices. He certainly does not say buy any business as long as
the price is very low.
The
market can be irrational most of the times and can give wonderful opportunities
by valuing good business at fairly low price points. Therein lies the
opportunity of buying good businesses with a reasonable “Margin of Safety”
The idea
is very simple and goes to the heart of investing as it should be practiced.
To quote
a famous source, it’s all about “the search for discrepancies between the value
of a business and the price of small pieces of that business in that market.”
Like all those who hunt for good value, whether in stocks or while shopping in
a market, one should get excited when prices fall. However, one should not get
excited at everything whose prices fall.
The issue in Cigar
Butt Investing is that low value stock will most likely belong in a declining
industry or those who have lost their competitive advantage and hence the time
horizon for that last puff will always be shrinking.
As the prices of equity have
fallen and risen over the last few months, there’s a temptation to believe that
because almost all stocks did badly in March and then many recovered smartly
over the next months, therefore most stocks will recover and there will be a
full and broad-based ‘revival.’
However In our
opinion, the question of whether to do “Cigar butt or Rupee StockInvesting” or
not comes down to three main factors and it depends on:
a) The company in question : In other words, you need to objectively look at aspects such as; How likely is the company going to pull through? Does it actually have potential or do the assets still hold value and can deliver value? What was the reason for the company and the stock faltering and is the damage permanent or can the company recover?
b) The specifics of the situation : When it comes to situation specifics, we’re predominantly referring to price points, proposed recovery routes, and the larger market. How is all that looking? Does the big macro picture look worthwhile or even more disconcerting when all is added up?
c) The individual investor wanting to get involved :Perhaps most important, is this factor; the individual investor and the role this investment will play in the portfolio. What does your portfolio look like? How much is it going to hurt if your deep valuebet goes wrong? And do you have the stomach to see it through even more potential volatility and possible loss in case the price corrects substantially from this level?
a) The company in question : In other words, you need to objectively look at aspects such as; How likely is the company going to pull through? Does it actually have potential or do the assets still hold value and can deliver value? What was the reason for the company and the stock faltering and is the damage permanent or can the company recover?
b) The specifics of the situation : When it comes to situation specifics, we’re predominantly referring to price points, proposed recovery routes, and the larger market. How is all that looking? Does the big macro picture look worthwhile or even more disconcerting when all is added up?
c) The individual investor wanting to get involved :Perhaps most important, is this factor; the individual investor and the role this investment will play in the portfolio. What does your portfolio look like? How much is it going to hurt if your deep valuebet goes wrong? And do you have the stomach to see it through even more potential volatility and possible loss in case the price corrects substantially from this level?
There are three critical things
cigar-butt investment strategy needs in order to be successful:
a)
The first is a low
valuation, which may be evident from low valuation metrics like PE, PB, market cap lesser than cash and cash
equivalents in the books etc.
b)
The second is a
collection of core productive assets that have a decent chance of generating
relatively steady cash flow over time, otherwise the low valuation will not
valid.
c)
And finally Those
assets should be long-lasting and with a wide-moat which is still sustainable.
In a Cigar butt strategy or Penny
stock picking, you may have to look at the story behind the pure numbers; the
reasons why the company is where it is and can it recover with the help of its
productive assets and relative strengths.
In most
times and with most stocks, nothing of the sort is likely to happen. In the
Covid times, the probability is still lower what with perfectly sound business
models also faltering due to the demand slowdown or/and supply constraints.
Times
like these are exactly what separates out the good, the bad and the worthless.
Picking up cigar butts and chasing rupee stocks may seem like a good idea but
they could easily turn out to be worthless paisa stocks. And money lost is
money lost, whether in Rupee stock investing or in growth Strategy.
In times
like this Iam reminded of Warren Buffet’s basic Rule of Investing :
Invest
wisely!
Stay Blessed ForeverSandeep Sahni
Note: All information provided in this blog is for educational purposes only and does not constitute any professional advice or service. Readers are requested to consult a financial advisor before investing as investments are subject to Market Risks.
About The author
Sandeep Sahni
Sandeep is an alum of IIM Lucknow with a Post Graduate Degree (MBA class
of 1988). His also an alum of Shri Ram College of Commerce, Delhi
University (B.Com. Hons. Class of 1985.)
Sandeep's investing experience and study of the Financial Markets spans
over 30 years. He is based in Chandigarh and has been advising more than
500 clients across the globe on Financial Planning and Wealth
Management.
He has promoted “Sahayak Gurukul” which is an attempt to share thoughts
and knowledge on aspects related to Personal Finance and Wealth
Management. Sahayak Gurukul provides financial insights into the
markets, economy and Investments. Whether you are new to the personal
finance domain or a professional looking to make your money work for
you, the Sahayak Gurukul blogs and workshops are curated to demystify
investing, simplify complex personal finance topics and help investors
make better decisions about their money.
Alongside, Sandeep conducts regular Investor Awareness Programs and
workshops for Training of Mutual Fund Distributors, and workshops and
seminars on Financial Planning for Corporate groups, Teachers, Doctors
and Other professionals.
Through his interactions and workshops, Sandeep works towards breaking the myths and illusions about money and finance.
He also writes a well read blog;
He has also conducted presentations, workshops and guest lectures at
Management institutes for students on Financial Planning and Wealth
Creation.
He can be reached at:
+91-9888220088, 9814112988
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