Why did Warren Buffett eventually almost completely abandon the Graham-style 'Cigar Butt' investing strategy? Is this strategy still applicable in today's market?

Why Did Warren Buffett Ultimately Almost Completely Abandon Benjamin Graham's "Cigar Butt" Investment Strategy?

The "cigar butt" strategy, a core investment philosophy of Benjamin Graham, refers to seeking stocks severely undervalued by the market—akin to picking up a discarded cigar butt for one last puff at no cost (i.e., capturing residual value). This approach emphasizes buying assets priced far below intrinsic value, diversifying to mitigate risk, and waiting for market corrections. Buffett, deeply influenced by Graham early on, achieved significant success with this strategy in the 1950s-60s, such as through investments in undervalued assets like the textile company Berkshire Hathaway.

However, Buffett eventually abandoned this strategy almost entirely for the following reasons:

1. Shift to Quality Businesses Under Charlie Munger’s Influence: Inspired by Charlie Munger, Buffett realized the "cigar butt" strategy often led to investments in mediocre or declining businesses. While cheap in the short term, these companies offered limited long-term growth potential. Munger advocated "buying wonderful companies at fair prices" rather than "mediocre companies at cheap prices." Buffett shifted in the late 1970s, investing in premium brands like Coca-Cola and Gillette—companies with strong economic moats and sustainable competitive advantages.

2. Scale Effects and Capital Management Challenges: As Berkshire Hathaway’s assets grew exponentially (from millions to hundreds of billions of dollars), Buffett managed increasingly large sums. The "cigar butt" strategy relied on small-cap or obscure undervalued opportunities, which couldn’t accommodate massive capital. Conversely, investing in large, high-quality enterprises allowed efficient deployment of capital and delivered steadier long-term returns.

3. Changing Market Dynamics: Mid-20th-century markets featured significant information asymmetry, creating abundant undervalued opportunities. As market efficiency improved, Buffett observed diminishing marginal returns from the "cigar butt" approach. In shareholder letters, he noted that "cigar butts" became scarcer over time, while compounding growth from exceptional businesses proved more reliable.

4. Evolution of Personal Investment Philosophy: Buffett reflected that Graham’s strategy prioritized margin of safety and short-term arbitrage, whereas he sought long-term ownership of quality assets for compound growth. In his 1989 shareholder letter, he stated: "Time is the friend of the wonderful business, the enemy of the mediocre." This marked his transition from "value hunter" to "business owner."

In essence, Buffett’s shift wasn’t a rejection of Graham but an evolution—integrating Munger’s quality-focused approach into a value-investing framework emphasizing intrinsic business strength.

Is This Strategy Still Effective in Today’s Market?

The "cigar butt" strategy isn’t entirely obsolete today, but its effectiveness has significantly declined, with limited applicability. Analysis below:

Effectiveness Analysis

• Remaining Viability:

  • Small-Cap and Emerging Markets: In illiquid small-cap stocks or emerging markets (e.g., certain developing economies), information asymmetry persists, occasionally creating undervalued assets. Patient investors may uncover these "butts" through deep research—e.g., buying undervalued cyclical stocks during recessions for post-recovery gains.
  • Value Investing Foundation: The core principle—buying below intrinsic value—remains fundamental to value investing. Some hedge funds and value investors (e.g., Seth Klarman) still employ similar methods, capturing excess returns during market panics (e.g., 2008 financial crisis, 2020 pandemic).
  • Risk Diversification: For retail investors or small capital, diversification under this strategy reduces single-stock risk, making it suitable for beginners.

• Diminished Viability:

  • Heightened Market Efficiency: Modern markets are highly transparent, with rapid information dissemination. Algorithmic trading, quant funds, and institutional investors quickly arbitrage away undervalued opportunities. Graham-era advantages of manual analysis have vanished, drastically reducing the probability of finding "cigar butts."
  • Intense Competition: Global capital inflows accelerate value-stock mean reversion, but quality growth stocks (e.g., tech) often deliver higher returns. Data shows growth investing (e.g., FAANG stocks) has outperformed pure value strategies over the past 20 years.
  • Macroeconomic Shifts: In a low-rate, inflationary environment, mediocre "cigar butts" may permanently decline rather than rebound. For instance, many cheap traditional industrial stocks face digital disruption and lack long-term appreciation potential.
  • Scale Limitations: Large funds struggle to deploy this strategy effectively, facing liquidity issues or market impact costs.

Recommendations

Today, the "cigar butt" strategy is better suited as a supplementary tool rather than a core approach. Investors should combine Graham’s margin of safety with Buffett’s quality focus—e.g., using quantitative screens for low P/B stocks but prioritizing competitive advantages and growth potential. Overall, it performs better in high-volatility bear markets but underperforms compounders (high-quality compound-growth businesses) in bull or efficient markets. During systemic undervaluation (e.g., geopolitical crises), the strategy retains potential but demands extreme discipline and research rigor.