If Ben Graham bought 'cigar butt' stocks in India... - Views on News from Equitymaster

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If Ben Graham bought 'cigar butt' stocks in India...

Nov 16, 2011

The legendry father of value investing, Benjamin Graham died in 1976, at the age of 82. Unfortunately unlike Buffett he never took any interest in non-US listed stocks during his lifetime. His famous 'cigar butt' theory of buying dirt cheap stocks irrespective of fundamentals therefore remains untested in Indian markets. But if Graham were to shop for stocks in India a decade back, what would his 'cigar butt' theory yield?

Firstly let's understand what the theory professes. Graham backed his cigar butt theory with the analogy that cigar butts that are thrown on the ground are always good for a few puffs. Similarly investors should look for discarded companies possessing good turnaround prospects. Graham advised that investors should buy companies when the current situation is unfavorable. Hence the near term prospects would be poor and the low prices would fully reflect the short term pessimism. Going by this logic, if he were to buy the cheapest 10 stocks listed on the BSE in 2001, following would be the result.

Four of the ten stocks went on to become multi-baggers by 2011. In fact, the stock of Gujarat NRE Coke multiplied 77 times in the past 10 years. Also, two of the ten got delisted due to poor fortunes and one lost more than 90% of its value. Nevertheless, with an investment of Rs 100 in each of the 10 stocks in September 2001, Graham would have pocketed a staggering Rs 12,152 in September 2011!

The magic of cigar butts...
Stocks P/E* P/BV*Returns (%)
Envair Electrodyne Ltd. 1.82 0.23 1,474
Faze Three Ltd. 1.68 0.13 129
Gujarat NRE Coke Ltd. 1.51 0.32 7,600
Laffans Petrochemicals Ltd. 1.16 0.16 159
Phillips Carbon Black Ltd. 3.14 0.12 1,079
S Kumars Nationwide Ltd. 5.12 0.31 646
Shree Rama Multi-Tech Ltd. 4.78 0.38 -90
Voith Paper Fabrics India Ltd 3.33 0.40 354
Returns calculated on stock prices from 30th Sept 2001 to 30th Sept 2011
* As on 30th Sept 2001
Source: Ace Equity

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 the stock for a profit. Nevertheless the chances of the cigar butt stocks turning out to be terrible businesses in the long run are unreasonably high. For this reason, as far as we can remember, Graham never mentioned about building a concentrated portfolio of 8-10 stocks using this strategy. What he advocated instead was to have a portfolio of 25-30 stocks so that even few of these turn bankrupt, the gains on the rest would more than make up for the same.

Graham's favourite disciple Warren Buffett however moved on to a slightly different version of value investing we believe. In his 1989 letter to the shareholders of Berkshire Hathaway Buffett cited that the fundamental problems for the dirt cheap stocks may be never ending. Again he backed it up with the analogy "never is there just one cockroach in the kitchen". Also the benefit of cheap valuations will be undone by the destruction of shareholder wealth by the business.

Hence without writing off the benefits of buying stocks at cheap valuations, we find the cigar butt theory slightly risky for investors to follow unless they build a large portfolio of around 25-30 stocks and not allocate too much money in any one stock. To put it straight, for larger allocations rather stick to good businesses with reasonable valuations rather than poor ones with dirt cheap valuations.

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