Tuesday, September 8, 2009

Cigar Butt Picking and S-chips

What are 'cigar butts'?

'Cigar butt' is a termed coined by Warren Buffett, the world's richest man. It refers to listed companies that are good for just "one last puff", and one school of thought in stock investment originating from Benjamin Graham (aka founding father of value investment) is to pick up cigar butts, or stocks that are trading at a net tangible asset value that is higher than its current stock price. That is like equivalent to buying an asset at less than what it costs, with little regards for the profitability or stability in cashflow generation of the company. This is done in the hope that one day, when business turns arounds, the share price will appreciate enough for the investor to sell off at a decent profit - that is the "one last puff" Buffett was referring to, otherwise also termed as a 'net-net' share.

The obsolescence of 'cigar butt' - seeing value beyond apparent value

This philosophy of 'cigar butt' persisted for many years, but this was until Buffett met his good friend Charlie Munger, who is instrumental in shaking up the archaic foundations of value investment philosophy net tangible assets as the premise. Munger, a corporate lawyer, had plenty of experience in corporate law matters and he is the person who brought a brand new investment paradigm by insisting that intangible but real aspects of a business must be taken into valuation. These intangible aspects include the brand value, goodwill with existing suppliers and customers, and the reputation of the company; valuing a business based on net tangible asset (NTA) value paints an unrealistic and obscured picture of the company. It was Munger, who made the frugal Buffett believe that it is worth paying a much higher price for See's Candy that has tangible assets worth less than its current share price.

The risks of cigar butt picking and value investments

I was having an "intellectual sparring" with my younger brother about the philosophy and methodology of investing. My younger brother is a value investor who adopted the idea of "collecting as many cigar butts as possible", whereas I am a person who adopts multi-faceted perspective on the valuation of a company. He shared with me his extensive research into this SGX listed company called Changtian chemicals that is trading at like Price-Earnings Ratio of 2 (i.e. theoretically the company only takes 2 years of pure profits to match its current share price -> this is a ridiculous market valuation because the median of PE ratio is about 10~15 for SGX) with little current liabilities and hoards of cash, trading at 'net-net' price. Changtian Chemicals is a China-based company that is listed in Singapore, market players call them 'S-chips'. PE of 2 and NTA more than price -> Such kind of statistics can give you a very sizable safety margin that Buffett (pre-Munger era) might raise an eyebrow at first glance, but a closer examination and Buffett might just say otherwise.

Why not cigar butt picking for S-chips?

Firstly, the value investor in Singapore is already significantly disadvantaged as compared to counterparts in the United States with a very sluggish market response to good undervalued stocks. Experienced folks will tell you that value investment is for the long haul, requiring a patience of at least 2~3 years before the market re-prices the stock. Even then, there's a very real risk of de-listing, or acquisition by private investors who have the financial muscle to offer the retail investors ridiculously low price offers. There have been so many classic examples, like Pokka (see
here), because the market has persistently shown its disdain for such a boring business, the parent company in Japan has decided to delist.

Secondly, there is a significant number of corporate scandals for S-chips in recent years, including big giants (or so, as touted by the media) Ferrochina to China Aviation Oil. Unless you really understand the company and the industry inside out, there is good reason to doubt the integrity on any S-chip company. Even if the companies like Changtian prove to be honest businesses, the scars of these scandals will overshadow everything else and it is very likely an impossibility for the market to re-price and allow you to encash your investment in the next 5-10 years.

So, cigar butt picking for S-chips? Beware, you may never get that one last puff.