This may be the most repulsive of the 50 objects we’ll view in this series. A cigar butt – discarded, maybe thrown into the gutter – can hardly be a pretty sight, or an enticing one. It doesn’t matter whether it started out as a big fat corona – perhaps a Churchill or even a Presidente – or as a little cigarillo; whether it was a famous brand name – a Davidoff or a Montecristo – or whether it was just a plain old Castella. By the time the thing has been smoked down to its tar-enriched butt, it won’t be something to admire.
So why pick up the old stogey and give it a drag? Because it’s all free. The quality of smoke may be awful, but it provides a shot of nicotine at zero cost. What can be so bad about that? Well, clearly it has its limitations, but, if there is something to be said for picking up discarded cigar butts, there is much more to be said about what’s labelled ‘cigar-butt investing’. The principle is similar to cigar-butt smoking. You are buying rubbish, but what you’re getting comes free so there should be some profit, just as that drag on the old cigar is almost all ‘profit’.
Back in the first half of the 20th century cigar-butt investors were a common sight, mostly scouring the sidewalks of Wall Street’s stock lists, especially the over-the-counter issues and the preference shares. If they gave themselves a name it was ‘value investors’ and the most famous of their number was Benjamin Graham.
Graham himself referred not to cigar-butt investing or even to value investing but to searching for ‘bargain issues’. At its vaguest – and according to Graham in his best-known book, The Intelligent Investor – a bargain issue was any sort of security that was worth considerably more than it was selling for in the market. How to assess the gap between price and value was also flexible. Graham did acknowledge that one way was to estimate a company’s future profit then multiply that by “a factor appropriate to the particular issue”. That is much the same as the process that goes on throughout the City’s research houses today – take an estimate of profits for a big company such as Diageo and find an estimate of its value by multiplying those profits by the average profits multiple on which shares in all beverages companies trade.
However, Graham’s preferred method was to value a company as a private owner would. That meant paying much attention to the company’s assets, especially its net current assets (also called its ‘working capital’). Graham had seen how the volatility of stock-market prices meant that when the market got depressed a company’s shares could trade at prices well below the value of the working capital recorded in the company’s accounts, which usually remained fairly stable. His aim was to buy shares for less than the value of their pro-rata working capital alone after deducting everything that the company owed, including its long-term debt. This meant that the company’s fixed assets – its goodwill and, more important, its land, buildings and plant – came for nothing. Adopt that approach, buy a diversified portfolio of such stocks and, said Graham with some understatement, “the results should be quite satisfactory”.
Given that approach, the quality of a company – ‘quality’ being assessed by its ability to maintain or even grow its profits – did not matter much. Graham did not care whether he was buying shares in a company that was more dead than alive so long as its inventory, debtors and cash were worth more than all its liabilities.
But, as Graham’s most famous student, Warren Buffett, was to show years later, that approach had its limitations. When he reviewed the first 25 years’ performance of his investment conglomerate, Berkshire Hathaway, after he had taken charge, Buffett laid into cigar-butt investing, Even buying Berkshire itself, which Buffett did in 1965, was an example of that approach and, said Buffett, it was a mistake.
He explained: “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.
“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. 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 will be quickly eroded by the low return that the business earns.
"For example, if you buy a business for $8m that can be sold or liquidated for $10m and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10m in 10 years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”
That assessment may be a bit harsh. Nowadays pure bargain issues such as Graham defined them are a rarity among quoted securities – intensive research sees to that. However, buying shares in companies that are rich in fixed assets, have net cash and sell for little more than the book value of their net assets usually works out well. Not that Buffett does this nowadays; his operation is much too big for that. Then again, he was never any sort of smoker anyway. Cherry-flavoured Coca-Cola was always his addiction and no one’s going to drop a used cigar butt into his can.
9: A New York subway token: How Buffett learnt his trade
Not just any old subway token. This one is for a very specific journey. Board the subway at Grand Central Station in mid-town Manhattan and take the Flushing line heading west. At Times Square change onto the Broadway (7th Avenue) route and head north, exiting at 116th and Broadway. There, you will see New York’s Ivy League university, Columbia, or – as Martin Amis once put it – Columbia’s “pillared, high-chinned buildings, their chests thrown out in cultural pride” mixing it with “the worst, the biggest, the most desperate ratshit slums in the civilised world”.
It’s where academia meets Harlem’s crumbling concrete and it’s the journey that Benjamin Graham made every week to teach his finance class at Columbia from 1928 to the mid 1950s. From the Chanin Building, an art-deco block on the corner of Lexington and 42nd Street East, where he ran the Graham-Newman Corporation, a highly successful boutique money manager, Graham rode to Columbia, where he introduced students to what was then a fairly new discipline – security analysis.
Chief among those students – and without whom Graham might be just a footnote in the history of finance – was the young Warren Buffett, who took Graham’s course from 1949 to 1951. Buffett, who had been rejected by Harvard, was immediately taken with Graham’s three core ideas, which provide the basis for what we now call ‘value investing’.
First, that, with the rigorous analysis of a company’s accounts, investors can assess the underlying per-share value of a company. Second, that the manic-depressive nature of stock markets means that, from time to time, stocks are offered at prices far below their underlying value. Third, that investors should always insure themselves by applying a ‘margin of safety’ – a wide gap between what they pay for a stock and what they think it is really worth. Do that often enough and – on average and in Graham’s word – the results should be “satisfactory”; that, however, is really just a euphemism for ‘exceptional’.
After graduating from Columbia and spending a frustrating couple of years working for his father’s stock-broking firm in Omaha, Buffett returned to New York where he persuaded Graham to hire him for, as it were, post-graduate education. At Graham-Newman “there were three partners and four of us at ‘peasant’ level,” Buffett once joked. A contemporary at Graham-Newman, Walter Schloss – who also did the Columbia course and became a hugely successful value investor – disputes that. Buffett was always marked out as something special, he has said. After two years of apprenticeship at Graham-Newman – 1954 to 1956 – Buffett was ready to start out on his own. He returned to Omaha where he set up Buffett Associates with $105,000 of family money plus his own pool of $140,000 in another partnership.
The rest, as they say, is history, but what was Benjamin Graham’s finance class at Columbia is still going strong. Nowadays it is part of the Heilbrunn Centre for Value Investing at Columbia Business School, whose web site is well worth a visit – http://www8.gsb.columbia.edu/valueinvesting. You can even find a grainy black-and-white video snippet of Graham taking his famed class.
10: A See’s Candy dish: Value investing Mk 2
At $12.50 plus postage and packing, surely a See’s Candy dish is the must-have item for a chocolate-loving investor? With a six-inch diameter and standing two inches tall, the dishwasher-safe ceramic bowl is big enough for a good helping of See’s candies – that’s ‘chocolates’ to you and me. Fill it with See’s custom mix – $23 a pound – maybe with a bias towards vanilla nut cream and rum nougat. A bowl-full will be enough for an evening pigging out in front of the hopeless little screen. On the lid of the bowl there is a portrait of the firm’s founder, Mary See – looking suspiciously like Agnes Brown of Mrs Brown’s Boys – plus – and this has to be the clincher – portraits of Warren Buffett and Charlie Munger flanked alongside her. If those seem an odd trio, the inscription on the lid offers some explanation. It reads: Berkshire Hathaway 50th Anniversary.
The point is that San Francisco-based See’s is a subsidiary of Berkshire Hathaway, the hugely successful US conglomerate run by Messrs Buffett, the world’s best-known and richest investor, and Munger, his side-kick. But it’s also a very special subsidiary and that’s not just because of the quality of its chocolates (sorry, candies). True enough, 2015 marked the 50th anniversary of the date that Mr Buffett took control of Berkshire when it was still a declining textiles operation based in New England. But, really, the important date in Berkshire’s history is 1972 because that’s when it bought See’s.
Until the acquisition of See’s, Berkshire was involved in what we just labelled ‘cigar-butt’ investing (see above). This approach had served Buffett well; though, as he acknowledged recently: “Cigar-butt investing was scalable only to a point. With large sums it would never work well.” By the early 1970s, Berkshire’s growth meant it had reached that point.
The solution – as advocated by Munger, who became, and still is, Berkshire’s vice-chairman – was to buy top quality firms. Or, as Buffett also said recently: “The blueprint that he (Munger) gave me was simple: forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”
See’s was the first one to meet this criterion. The family owners wanted to sell for $30m, a price recommended by Munger. Buffett could not bring himself to offer more than $25m and even that amount was three times net tangible assets. Luckily for Buffett and for Berkshire, the family accepted. But, actually, $30m would have been a good price to pay. According to Berkshire’s 2014 annual report, since then – and with the addition of just $40m of capital investment – See’s has disgorged $1.9bn of pre-tax profit for Berkshire. Not just that – Buffett also says that “through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to other profitable investments”.
The point is that See’s did not just sell candies, it sold a brand and Buffett came to realise that brands gave a company strength and resilience, what is commonly labelled a ‘business franchise’. In other words, consumers often don’t buy the generic product, they buy the branded one. They don’t buy a carbonated cola-flavoured drink but Coca-Cola; they don’t take their children to an amusement park but to Disneyland; they don’t do the weekly wash with washing powder but with Procter & Gamble’s Ariel or Unilever’s Persil.
This loyalty gives the best brand-name companies the strength to ward off the competition and to dictate prices to customers; in the jargon, they become ‘price makers’ not ‘price takers’. For an investor this translates into above-average chances that profits will grow steadily and without the volatility that characterises the progress of so many companies. This is really important – the absence of major shocks pays off in the long run. It means that the remorseless power of compounding gets to work most effectively.
A similar type of investment much favoured by Buffett is the ‘toll gate’. It may be linked to the strength of a brand name, but effectively it means that customers of the toll-gate company have little choice but to use its facilities and to pay the toll. When Buffett was building Berkshire in the 1970s, newspaper publishers and television-station operators were formidable toll gates. If a firm wanted to advertise its wares it had little choice but to buy space in the newspaper or air time on the TV station, especially if – as was often the case in the US – the two were regional monopolies.
True enough, technology smashed those toll gates, but in the process it built others. Where newspapers and TV stations ceased to be price makers – or sometimes ceased to be anything – their place was taken by newcomers. Thus Microsoft was smart enough to extend its lucky dominance of PC operating software into dominance of various types of applications software. So high, wide and effective was its gate that, for a while, it seemed it would even resist the attempts of governments to bust it. As it happened, technology – again – performed an effective dismantling, only for new toll-gate companies to emerge in the IT industry – Google in search engines, Amazon in on-line retailing.
However, the related question related is: was this forecastable? For a value investor, that’s a vital question and it explains why Buffett has stayed well clear of some sectors where, he reckons, the dynamics mean that companies can’t be well understood. The logic goes like this: if you can’t forecast the future of an industry or companies within it, then you can’t forecast a company’s likely cash flow. Without a sensible stab at that number, you can’t be confident that today’s price is a steal or a rip-off.
And that’s crucial. After all – and despite its extra sophistication – one thing about value investing has not changed since the pre-War days of Benjamin Graham: it is all about buying $1 for 50 cents. Chew on that thought as you munch your See’s candies.
