Cigarette Butts – Why you should be wary of turnaround stories!

Cigarette Butts – Why you should be wary of turnaround stories!

By Ray Chipendo, JOHANNESBURG, June 23 (The Source) – In the early part of his investing career Warren Buffett thrived on cigar-butt style of investing, which describes the buying of a company at a sufficiently low price and then waiting for a favourable “hiccup” in its fortunes to sell the stock at a profit. He likened the style to a cigar butt picked on the street and has only one puff left in it. The puff might not offer much of a smoke, but its very bargain price makes that puff profitable.

Later in his career, Buffett confessed that he realised it was much better to buy good businesses at fair prices instead of just cheap ones. He cautioned against falling for turnaround stories. Later, he would also remind bargain hunters that time is the friend of a good business, but the enemy of a mediocre one. He himself had learnt the harsh lesson when he acquired Berkshire textiles, which operated in a declining textile industry. Though the business came at a nickel and dime, its declining prospects saw it losing money by the fistful. In the end, Buffett almost gave it away for free – easy come, easy go.

Personal Testimony

When I started my investing journey, I made the same mistakes too.  It was in 2011/12, when I first invested in a JSE listed company -1time airline. A heavily undervalued stock by most valuation metrics, 1time was such a seductive stock for a novice. The airline company was one of a few budget airlines serving South African domestic routes. Troubled by an ageing fleet that guzzled fuel amid rising oil prices, 1time was slipping behind badly and needed some new funding – both to get new wings and to refinance loans falling due. At some instance the share price dropped by 60 percent, at which point I snapped a handful of shares. Buying at a 60 percent discount, what could go wrong? I assured myself.

Nothing excites the mind of an underdog than to imagine that everyone else is missing the point but him. Parading as a contrarian, I could see clearly in my mind how this airline’s temporary afflictions would fade away and give rise to a share price comeback. At the height of this “temporary” affliction (financial distress) management executives, in a bid to shore up confidence, came out in the media telling the world they had put their personal assets down as collateral for the business. What more proof would one need that these guys were here to stay? But I did not need any proof because 1time was a visibly ailing business operating in an ICU industry – the airline industry.

The rest of 1time’s regrettable story is there on Google for everyone to read. In the end, I wrote off my investment as part of my fees to the school of investing. That is because 1time turned into a money pit – it filed for liquidation. This Cigar-butt had burnt my fingers; sadly without giving me even a little puff.

Unfortunately, I am not the last gullible guy around, and nor are we done with 1Timers. Even the ZSE market has its fair share of Cigar-butts – those that give incessant excuses and tell you how a new turnaround plan will suddenly change fortunes. You ought to be mindful of them.

How to avoid a Loser?

As Buffett once said- “Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them”. As an investor you have little control over how the business is run, save for an annual general meeting. So, here are my few thoughts on picking the tell-tale signs of a bad business. It is more like dating advice on how to avoid marrying a loser:

Below cost of capital return on investment – A business that issues debt and equity at a cost of 10 percent  but is recording total returns of less than 10% is destroying value. Generally, businesses that on average generate returns of more than 15percent are less likely to lose money.

Avoid industries with poor economics – Industries that are capital intensive; selling commodities; and heavily regulated usually yield little returns. Examples include: mining, airline industry and utilities. As Buffett once said- “Good jockeys will do well on good horses, but not on broken-down nags.” Even maverick management teams cannot pull miracles in poor industries.

Book value growth -The market price of a share can sometimes be irrational, but its net book value is most times a good measure of how management is managing the business. A company that is steadily growing its book value is a sign of a quality business. Without paying dividends, businesses with stagnant or declining book value are indicative of value destruction.

High leverage and thin interest cover ratio – High leverage and high interest rate repayments are dangerous for any business. Slight decreases in turnover or pressure on margins can lead to defaults similar to what happened to 1time airline. By all means, avoid heavily indebted companies.

Apart from losing money, my debacle with 1time had positive effects on my investment philosophy. Instead of being obsessed with valuations, our new stock evaluation criteria have become more balanced – encompassing not only valuation assessment of a stock but quality of the business and growth opportunities.

So the next time you look for good stock investment; remember your job is not to fix businesses or bet, but to avoid bad ones. But if you do decide to get yourself a cigarette butt, get a long one. And don’t wait to get a second puff. Sell it.

Ray Chipendo is Head of Research at Emergent Research. He is contactable on rayc@emergentcapital.co.za, @ray_chipendo