I harbor no interest in cigars. I know, the stogie cuts a popular image of masculine success and is associated with other manly endeavors like cards and golf.
The cigar has embodied financial triumph for centuries. Remember the robber barons of the gilded age and the cinematic images of smoke-filled meeting rooms where they carve up their economic spoils?
The history of the cigar has deep roots in the Susquehanna Valley. Amish/Mennonite farmers began growing cigar tobacco in the 1830s; York and Lancaster became important cogs in the national cigar manufacturing industry before the Industrial Revolution.
I just don’t like inhaling smoke nor the outrageously bad taste cigars leave in your mouth the next day. Truth be told, I actually don’t mind the smell of second-hand cigar smoke - in moderation. When it comes to bad habits, to each his own and I’ll stick with beer as my main vice.
I mention cigars to set up a metaphor that’s been part of the investment lexicon for a century. Ben Graham, professor and investor, is widely acknowledged as the father of modern investment theory and he first coined the term “cigar butt investing” in the 1930s. Warren Buffet, Graham’s famous student and mentee, used this trading technique in the early days of his investment career.
In its crudest form, Graham’s cigar butt investing is a trading strategy wherein you purchase a distressed company’s stock at a uber-bargain price - well below its book value - with the goal of capitalizing on a future upturn in share price then selling it. Buffet explained the metaphor as akin to finding a cigar butt on the ground with one good puff left in the wrapper and that free last puff will be all profit.
In the depths of the Depression, many companies were trading below their liquidation value, which presented Graham with “cigar butt” opportunities to invest in stocks and bonds at generation-low prices.
Buffet has talked about his own early cigar butt investing days and how his successful value investment approach was informed by this shorter-term trading strategy.
As I scour investment research these days attempting to divine the next big move in global capital markets, this cigar butt metaphor comes to mind. Not in its purest form - which is an arcane and high-risk short-term trading strategy - but more akin to looking for a whole unsmoked Cuban stogie on the sidewalk.
The context is that I foresee once-in-a generation investment opportunities presenting themselves over the next couple of years.
Crazy talk, right? After the hot investment mess of the past two years and ugly current headlines, who in their logical mind is seeing investment opportunities?
To wit, in the wake of the historic interest rate spike, rattled investors are now scorning real estate of all stripes, with real estate stocks experiencing a doozy of a bear market. Many real estate stocks (“REITs”) are trading at cigar butt valuations with market prices representing a fraction of their liquidation value.
For sure, higher interest rates across the curve have caused real damage to real estate valuations - but the stock market overreaction has been stunning to watch. I sense serious value forming in many real estate sectors and the stock pain is not over yet.
As the Fed Reserve tries to stuff its free money toothpaste back into the tube and reverse the toxic inflation it helped foster, strict monetary policy is now a serious economic headwind and has caused real damage to the banking sector as well.
Bank balance sheets are replete with unrealized capital losses on their government bond investments. Combined with horrid deposit market conditions, the banking industry has all but stopped lending money; I bet even a free pen is hard to come by in the lobby these days.
Since banks are loath to lend new money and/or refinance the maturing debt of their commercial borrowers, the population of “cigar butt” credits is starting to swell. The banking crisis has fostered the creation of many new private credit vehicles seeking to capitalize on the wall of distressed credit opportunities forming that is only in the early innings. We’re on board.
A third sector catching our eye is traditional energy. It’s a stretch to refer to oil and natural gas stocks as cigar butts given their healthy current profit levels, but there’s a serious supply problem forming as producers are not drilling at a pace to replace depleting wells.
A 2024 recession could trigger the overselling of energy stocks and create a compelling buying opportunity should crude oil prices uncoil to $100+ per barrel and stay there. Furthermore, online US LNG gas export capacity is set to double within the next two years and gas drillers are not ramping up production, which is a time-tested recipe for materially higher prices and profits.
The key factor that I’m obsessing over is the next major move in US interest rates. The Fed is likely done with rate hikes and they’re allowing bond investors to apply the slow brakes on the economy in the form of a five-percent ten-year Treasury yield. The Fed will keep short-term rates elevated for as long as possible to ensure it has snuffed out inflation. It remains to be seen if they’ll have to cut interest rates and abandon their “QT” program, a fancy term for withdrawing money out of the economy, to soften their manufactured recession.
The big bond management shops are cheerleading that the next move in interest rates is down, which helps their investor fund flows. The tactical credit managers are not sure, concerned that large government deficits are coming home to roost in the form of higher term yields. I’m listening to all sides these days for guidance.
“A crisis is an opportunity riding the dangerous wind” is a Chinese proverb appropriate for these investment times. I’m no Warren Buffet, but I do know deep value when I see it, butts or no butts.
Until next time, be well…Tim
