Be careful when you pick up dirt cheap shares.
Ben Graham, the father of value investing, recommended buying extremely cheap shares using strict quantitative guidelines.
Graham argued that if a company is trading below two thirds of its net current asset value per share, it is probably worth investing in. In any case, the downside would be limited because you bought so cheaply.
In practice, this 'cigar butt' strategy can often work out. The main reason being that there usually occurs some perceived improvement in the fortunes of the business that enables you to sell it for a profit although in the long term it is probably going to be a terrible business.
As Warren Buffett has noted: "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."
What's the risk?
However, it shouldn't be assumed that this approach is risk free. What you are essentially doing is buying into a failing company in the hope that you can either offload it, the market will reappraise its prospects or that should it fail you'll get something back.
Still, the great strength of Graham's approach was the emphasis placed on minimising risk, buying cheap and making sure you had a 'margin of safety', given the tendency of earnings to fluctuate.
If you put aside the fact that companies meeting the criteria laid out by Ben Graham for investment are hard to come by, there are other issues that make this strategy of investing in ultra cheap companies or 'cigar butts' problematic.
Buffett cited two problems in his 1989 letter to Berkshire Hathaway shareholders:
1) The bargain price may not turn out to have been so cheap, since as soon as one problem is solved others will appear.
2) The benefits of buying cheap will be eroded by the poor returns of the business. This is particularly true if the business can't be quickly sold as it continues to deteriorate.
In addition, I'd add that there are three further problems:
1) It only takes account of quantitative factors not qualitative in assessing a business. For example, it ignores important factors such as the quality of management.
2) If you adopt this strategy you need to be very hard headed and possess a strong temperament. The worry being that if you've miscalculated or the company goes into liquidation, you'll make a large loss.
3) Tying up your cash in a business that is failing has an opportunity cost.
One cigar butt I missed
Recently, I was tracking French Connection (LSE: FCCN), which I'd examined in detail and felt sure was attractively priced at about 32p. I fully expected it to head a little lower and was then going to buy this 'cigar butt' when it was trading below the value of its net current assets.
However, I was away the day it hit 28p and missed the opportunity to buy. Its full-year results were predictably poor, as I expected. However, news that it was going to restructure helped it leap up to around 45p. Congratulations to those who picked up this cigar butt at or below 32p. It has risen and I presume the smart money has now moved on.
If you're still holding it, wouldn't you rather be holding Tesco (LSE: TSCO)? For those who answer no, I'm going to have to quote that man Buffett again, who famously, advised: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
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Chris holds shares in Tesco.