Psychological and social factors complicate "cigar butt" investing
“I’ve heard Warren say since very early in his life that the difference between a good business and a bad business is usually the good business just throws up one easy decision after another, whereas the bad business gives you a horrible choice where the decision is hard to make and, is this really going to work? And is it worth the money?
If you want a system for determining which is a good business and which is a bad business, just see which one is throwing the management bloopers time after time after time. Easy decisions. It’s not very hard for us to decide to open a new See’s store in a new shopping center in California that’s obviously going to succeed. It’s a blooper.
On the other hand, there are plenty of businesses where the decisions that come across your desk are just awful. And those businesses, by and large, don’t work very well.”
— Charlie Munger, Berkshire Hathaway Annual Meeting, May 4, 1998
“So, what do you do?”
Chances are that you will be asked what you do for a living within a few minutes of meeting someone for the first time. In response, most people want to say something impressive.1 If you are a software engineer at a cocktail party in Palo Alto, you want to say that you’re working for an exciting company with a bright future that’s giving you a lot of equity. The same goes for a CEO at the country club. No one wants to say they are associated with a company that is in obvious terminal decline.
There is nothing inherently shameful about working for a business that is in decline assuming that you are faithfully doing your job. A CEO who manages a bad situation in a responsible manner is doing honorable work that has to be done by someone. But this is not a level of nuance easily understood in superficial social interactions.
In a capitalist society, it is perfectly natural for entire industries and individual businesses to go through a lifecycle that includes eventual decline. This is often brought about by technological upheaval but can also be driven by changes in comparative advantages due to trade, shifts in government regulation, changing consumer preferences, and a whole array of other factors.
Cigar Butt Strewn Minefields
Most value investors have studied Benjamin Graham and his approach for investing in “cigar butt” situations where a company in obvious decline is selling for so little that it should have at least a few “puffs” left in it before it shuts down for good. Warren Buffett is well known for focusing on cigar butts during the 1950s and 1960s before turning to better businesses starting in the 1970s due to his own searing experiences with cigar butts as well as the influence of Charlie Munger and Phil Fisher.
Benjamin Graham understood that cigar butt situations often have balance sheets that are inflated by obsolete assets. If a declining business purchased physical plant assets in the past that are being depreciated over several decades but are already functionally obsolete, book value will far exceed actual liquidation value.
Graham’s concept of net current asset value stocks, or “net-nets” accounts for this by looking for companies trading for less than the current assets on the balance sheet less all liabilities. In theory, if you have a business in terminal decline that is available for less than net current asset value, you could shut it down and make a quick profit.
Of course, theory and practice are not the same thing at all. For one thing, unless you are in a position to acquire control of the business and operate it yourself, you are not in an immediate position to realize the value that you see on paper. As a minority investor, you would need to convince a majority of shareholders to adopt your plan.
You might have difficulties convincing other shareholders to agree to your plan of liquidation, especially if there are shareholders who have long histories with the company or have other emotional attachments. If you are dealing with a company where blocks of stock are held by descendants of the founder, they might view a plan to accept reality and liquidate the business to be sacrilege and an affront to the memory of a family patriarch. Indeed, such individuals might prefer burning up capital to liquidation, in effect burning money as a homage to a long deceased founder.
Even if you are able to convince a majority of shareholders, unless you are an operator yourself it will be necessary for managers to implement your plan, and now we have potential agency problems to deal with.
In addition to the social stigma associated with running a company in decline, it usually isn’t great for future career prospects. But let’s say the top manager’s mindset is congruent with owners. If a graceful decline and winding down of the business will take time, lower level managers and rank-and-file employees will also have to cooperate. The lower down the organizational chart, the less likely employees will put in their full effort, at least not without financial incentives to do so.
Then there are questions of social responsibility, and I am not referring to trendy movements in “ESG” that are now in vogue and seem to require page after page of glossy full color marketing materials in annual reports. I am referring to normal human decency and awareness of the toll business failure can take on employees with few transferable skills and communities where a major employer is failing and must inevitably shut down. There is a reason that Warren Buffett operated textile mills until 1985, decades after it was obvious that they should be shut down.
When you take into account the psychological and social factors involved, it is easy to see how a company that is trading well below net current asset value could still end up being a disaster if the time required to wind the business down extends for several years and the current assets melt away before they can be distributed to owners of the business. There might be nothing whatsoever left at the end.
Michael Porter on Declining Industries
Michael Porter’s Competitive Strategy: Techniques for Analyzing Industries and Competitors is a book that I’ve owned for nearly thirty years and one of the very few texts from college that I still refer to frequently. Of course, this book is a classic and one of the few that I found extremely useful as a manager. His framework for thinking about competition, particularly the need for a competitor intelligence system, was of great help when I was directly responsible for deciding on the feature set for products.
Although managers are the intended audience of the book, I find it equally useful as an investor, especially if I am trying to learn about an industry that I am unfamiliar with. If you want to think clearly about how an industry is structured and how individual players are fitting in, Porter’s frameworks are tremendously useful.2
Chapter 12 of Competitive Strategy is about navigating an industry in decline. Porter emphasizes that his approach is for industries that “have experienced an absolute decline in unit sales over a sustained period” rather than merely a temporary decline due to business cycle fluctuations, labor disruptions, or supply shocks. Here are a few of the highlights I took away from a recent re-reading of the chapter:
The speed of demand destruction is important, both in terms of actual observed declines and what competitors believe about future decline. Hope springs eternal, especially when the psychological and social factors discussed previously come into play. If competitors believe that demand will decline gradually, or might even recover, competition is likely to be greater than if there is widespread pessimism. Slow decline is more likely to give managers a reason to be optimistic while a rapid freewill will make the true situation impossible to deny.
Exit barriers can keep the level of competition in an industry high even when companies are earning poor returns on equity on the balance sheet. The most obvious exit barriers are specialized assets that serve no other useful purposes and have little or no resale value. Such assets are likely carried on the balance sheet at a value far in excess of salvage value. Porter points out that if the liquidation value of assets is low, it can make economic sense to remain in the business even while earning a book loss due to depreciation charges.
Fixed costs of exit such as labor settlements and breaking contracts with suppliers can erode remaining current assets, especially in jurisdictions where government makes it difficult to eliminate jobs. Porter also points out that a hidden cost of exit is that once a decision to close up shop is known, employee productivity could decline, remaining customers are likely to disappear, and suppliers might be reluctant to fulfill their obligations. A downward spiral.
Managerial or emotional barriers of the type I described earlier must be taken into account. A declining business can be a “blow to pride”, be perceived as “giving up”, and be looked upon as a “sign of failure which reduces job mobility.” In many cases, such barriers can only be overcome by removing recalcitrant managers and hiring managers will less emotional attachment — no doubt a wrenching process in itself.
Diversified competitors may remain in the business for broader strategic reasons, including maintaining a sense of history or overall reputation. A company in a single line of business that is declining might face tremendous competition from a diversified firm that is viewing the declining business as just one of a basket of interrelated enterprises.
Porter goes on to discuss strategic alternatives in decline. Traditionally, quick divestment or a “harvesting” strategy has been seen as the optimal approach, but depending on the various forces at play, it can make sense to attempt to be the “last man standing” — what Porter refers to as the leadership strategy. There are situations where remaining firms in a declining industry could temporarily achieve above average profitability as weaker competitors exit the field. Once in a leadership position, such a firm can shift to harvesting what remains of industry sales.
Harvesting is a process of seeking to optimize and maximize remaining cash flow from the business prior to eventual exit. This is a form of prolonged, or “controlled” liquidation that Porter believes is very difficult to manage in practice due to employee morale issues, supplier and customer confidence problems, and potential agency problems with top executives.
Is it worthwhile to get involved in declining industries when it looks like the last few “puffs” could provide attractive returns? Not without a great deal of caution and probably not without taking a highly diversified approach. From the outside looking in, it is very difficult to understand the internal dynamics of an industry or a company operating under duress. This is the situation investors in the stock market find themselves in. Just because a company “screens” well doesn't mean that the current assets will be there when you try to reach for them.
The point is somewhat academic in today’s environment where there are few situations of the type that Warren Buffett found profitable in his early days as a professional investor. He could not “screen” for potential investments other than by going through the Moody’s manual page by page. Through that process, he found opportunities that had large margins of safety and were unknown to the market at large. Today, anyone with an internet connection can screen for such stocks.
Although the social stigma associated with decline seems wrong to me, I think it is mostly logical to seek out opportunities for growth rather than to spend much time thinking about how to extract the last few puffs of a troubled business.
If you can find a business with a long runway of growth ahead and invest at a reasonable price, it is possible to harness years or decades of tax deferred compounding. The experience is likely to also be more pleasant and uplifting than eking out returns from dying businesses, paying taxes on each gain (if there is a gain), and then trying to find the next cigar butt and repeating the process all over again.
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Asking “what do you do” is natural enough when you are trying to break the ice and lack other ideas to start a conversation. But I think that it is a mistake to try to impress people who you are meeting in a social setting. I say that I am a writer, not an investor. Saying “investor” or, even worse, “private investor”, brings up images of hedge fund billionaires (which I am not, and do not aspire to be) and attracts the wrong type of attention.