A reader asked me this question:
…your last article on Gurufocus regarding 50% returns and microcaps…seems (to) have sparked a lot of responses on it. Some are off the mark or just misinterpreting the point of the article. Other comments provide good points. Not sure if you were planning on responding to all the various comments. There is a difference between cigar butt approach and hold forever approach. Personally I think your approach considers the downside based on your checklist…Maybe discussion on margin of safety in the approach should be mentioned...your thoughts?
Regarding the difference between the cigar butt approach and the hold forever approach, Warren Buffett was not using a cigar butt approach to invest in micro caps in the 1950s. He was just focused on decent, dependable, dirt cheap, neglected stocks. The companies Buffett invested in for his own account in the 1950s were not cigar butts. He just didn’t plan to hold them forever. He sold out of one cheap stock whenever he found a cheaper one.
But these weren't low quality businesses.
Let’s take a look at one...
I found some strange things when I was 20 years old. I went through Moody’s Bank and Finance Manual, about 1,000 pages. I went through it twice. The first time I went through, I saw a company called Western Insurance Security Company in Fort Scott, Kansas…Perfectly sound company. I knew people that represented them in Omaha. Earnings per share $20, stock price $16…I ran ads in the Fort Scott, Kansas paper to try and buy that stock – it had only 300 or 400 shareholders. It was selling at one times earnings, it had a first class (management team)…I’d never heard of Western Insurance Services until I turned that page that said Western Insurance Services. It showed earnings per share of $20 and the high was $16. Now that may not turn out to be something you can make a lot of money on, but the odds are good. It’s like a basketball coach seeing a guy 7’3” walk through the door. He may not be able to stay in school, and may be very uncoordinated, but he’s very large. So I went down to the Nebraska Insurance Department, and I got the convention reports on their insurance companies, and I read Best’s. I didn’t have any background in insurance. But I knew I could understand it if I worked at it for a while. And all I was really trying to do was disprove this thing. I was really trying to figure out something that was wrong with this. Only there wasn’t anything wrong. It was a perfectly good insurance company, a better than average underwriter, and you could buy it at one times earnings. I ran ads in the Fort Scott, Kansas paper to buy this stock when it was $20. But it came through turning the pages. No one tells you about it. You get ‘em by looking.
I would put something like Bancinsurance in that class. It was a micro cap. But it was not a cigar butt. It had an average combined ratio of 90 over the last 20 years and was selling at less than 5 times pre-tax earnings after the CEO made his buyout offer. Bancinsurance was no cigar butt. It earned a higher return on capital than most insurers. It was a better underwriter. It was focused. And it was certainly easier to understand than 9 out of 10 insurance companies.
I think the margin of safety and high returns in these stocks are both caused by the same thing: neglect.
These stocks aren’t priced right.
It’s not about some trade-off between risk and return. It’s about the trade-off of paying attention, finding the stock, and then buying into something you’ve never heard anyone else talk about – ever.
A lot of folks don’t like the feel of that.
That’s the trade-off.