If you do any real investing, which I do, invariably someone (usually a family member or ex-wife) will ask whether they should be buying now that stocks are so cheap. Of course, the counter is, what stocks? Some are not so cheap and others have literally had their bottoms drop on the sidewalk.

My answer usually invokes Warren Buffett's "cigar butt" philosophy. Frankly, I like Buffett and I admire what he has done, or not done, as the case may be. So consider this:

If you buy a stock at a really low price, you stand a chance to unload at a decent profit, even though the long-term performance of the business may be dreadful. Buffett calls this the cigar butt approach to investing. "A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the bargain purchase will make that puff all profit."

However, don't be misled here. Buffett is no fool. He tempers what he says with the consideration of the type of investor you are. For example, unless you like rapid turnover (sort of putting you in the liquidator mode), that kind of approach to buying businesses is not too swift. First, the original so-called "bargain" price may not be such a steal. In a difficult business, no sooner is one problem solved than another crops up. You might say there is never just one cockroach in the kitchen.

Second, consider that the initial advantage you once obtained will quickly erode by the low return of the business. For instance, if you buy a company for $8 million (we should all only have $8 million, right?), that can be sold for $10 million, we can realize a high return. But the investment will obviously disappoint if the company sells for $10 million ten years down the road and in the interim has annually earned and distributed only a few percent on cost. "Time is the friend of the wonderful business," says Buffett, "the enemy of the mediocre."

You might think this principle is obvious. It's not. Take a case in point. Buffett once acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with his own Berkshire. He bought at a substantial discount from book value. The people were first-class, and the deal included some extras such as unrecorded real estate values and a significant LIFO inventory cushion. So, you can quickly ask, how could he miss? Three years later he was fortunate to unload the business for about the price he had originally paid for it.

I did that once with a certain stock. And afterwards, I had memories like those of the husband in the country song, "My Wife Ran Away With My Best Friend and I Still Miss Him a Lot."

What this all comes down to, in my opinion, is this. It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access