When Is It Worth Buying a Cigar Butt Stock?

When Warren Buffett got started, he was heavily influenced by his mentor, Benjamin Graham. Ben was keenly aware of what companies were intrinsically worth. If you could buy an enterprise on sale, surely money would be made when it eventually hit fair value, as it necessarily must over the long-term when cash flows are computed and discounted to the present.

The theory makes a lot of sense when taken at face value. But it lacks a nuance, and that’s where Charlie Munger comes in. He spotted that an arbitrage could be earned by paying for a company on sale and waiting for it to hit its intrinsic net worth. But even more money could be made by buying a great company that wasn’t simply going to trade up to fair value but was going to grow its market capitalization over time by leaps and bounds.

That’s one of the reasons cited as to why Buffett’s Berkshire Hathaway sold IBM a few years ago and purchased Apple. In a sense, Buffett got the best of both worlds scooping up shares of Tim Cook’s firm. Apple was trading at a low P/E ratio and it was a great company.

Munger’s insight to buy great companies at fair prices versus fair companies at great prices has resulted in enormous profits for Berkshire and its shareholders.

But is there ever a time when it is worth buying what Buffett has described as a cigar butt stock, one that has a few final puffs left in it before finally giving up the ghost?

Western Union Case Study

Arguably, some companies deserve a second look even if they appear at first glance to fall into the cigar butt category.

Take Western Union as a prime example. It’s being dis-intermediated on a grand scale by competitors like Revolut and PayPal.

Why will anyone go into a Western Union to send money abroad when they can do so via their mobile phones through an app more quickly? Over time, it’s clear that the Western Union business model has Everest-size challenges to conquer if it is to remain viable.

And yet the company also offers compelling value at this time. For one, the company trades at a very low price-to-earnings ratio of 5.8x. It also pays a very high dividend yield of 7.9%.

Bears would argue, and rightly so, that buying a high dividend yield is not worth the payoff if the share price declines by the same amount or more. And in the case of Western Union that has certainly been true this year as WU share price has fallen by 15.6% year-to-date.

Over the past five years, the returns have been even worse, down 34.6%, a sign that something is structurally very wrong. However, investors already know that and perhaps when the negative news has already been priced in, a cigar butt opportunity arises to buy a stock on sale that has considerable upside potential.

Is Western Union a Cigar Butt Stock?

Western Union has the hallmarks of being a cigar butt stock because its revenues have declined over the past decade from $5.5 billion in 2013 to $4.4 billion in the most recent fiscal year.

But the slowdown and fall in the top line has not translated to an awful bottom line by any means. Western Union continues to report around $1 billion in operating income each year.

And when we turn our attention to a valuation analysis, it’s easy to see where a compelling argument can be made to buy the stock at a discount.

Analysts currently assess fair value at $13.34 per share while a discounted cash flow forecast analysis is much more optimistic and reveals an intrinsic value of $17.19 per share, suggesting 44.6% upside.

A few other noteworthy points include the payout ratio sitting at 47%, meaning that even though the company pays a high 7.9% dividend yield, management has ample room to increase the dividend over time, and it certainly appears to be in no jeopardy.

Similarly, the company has a very impressive return on invested capital of over 23%, suggesting that few competitors can rival the existing model in place. Certainly, the online companies like World Remit are attempting to go around the brick-and-mortar model, but for physical locations globally, WU has a stranglehold.

Indeed, Western Union’s price versus valuation discrepancy has not gone unnoticed by insiders. Last year, management announced a $1 billion share repurchase scheme.

On the one hand, it’s admirable and confidence-inspiring that management would do so because it shows their conviction that the stock is undervalued.

The other side of the coin is, in spite of the buyback scheme, the share price has still fallen by another 15% in the past twelve months.

So the question arises when is it a good idea to buy a stock like Western Union?

When Is It Worth Buying a Cigar Butt Stock?

It’s worth buying a cigar butt stock when the margin of safety and upside to fair value are high. A classic example of when to buy a company that falls into this category is when revenues and profits are predictable for the foreseeable future.

Western Union is a classic example now. While rivals threaten to disrupt the legacy brick-and-mortar business model, the company continues to post billions in revenues and profits. 

Although management has failed to grow sales in the past ten years, the enormous profits of around one billion annually are compelling when contrasted against the market capitalization of $4.3 billion.

The upside to fair value according to both analysts and a discounted cash flow forecast suggest that prospective buyers could earn a handsome return over the medium term.

These are the types of opportunities that open the door to generous returns while at the same time, investors who do buy in should appreciate that sustained growth is unlikely and so, once the valuation arbitrage window closes, so too should another investment opportunity likely be sought.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.