Long Duration Investments

There are various strategies and approaches that investors can adopt to achieve their financial goals. Two such strategies are the “coffee can” portfolio and the concept of “cigar butts.” Understanding these terms and their characteristics can help investors make informed decisions when it comes to long and short duration equity investments.

In this article, we will discuss the differences between a coffee can portfolio and a cigar butt portfolio. We will also explore the similarities in the analysis process for each of these distinct investment styles. Understanding the nuances of each strategy enables investors to benefit from pattern recognition, helping them identify whether a potential investment aligns with a short-duration or long-duration strategy.

The Coffee Can Portfolio

The term “coffee can portfolio” was coined by Robert Kirby, a renowned investment advisor. It refers to a long-term investment strategy where investors buy shares of high-quality companies and hold onto them for an extended period, often decades. The name originates from the idea that once the shares are purchased, they can be metaphorically put into a coffee can and forgotten about.

Investments suitable for a coffee can portfolio are distinctively characterized by their constant growth, significant free cash flow generation, and longevity.

Constant growth is a vital attribute, as the strategy favors companies showing a consistent upward trajectory in their performance. These firms typically have a robust competitive edge and a resilient business model, enabling them to deliver continuous growth and maintain their market position over time.

The importance of free cash flow generation cannot be overstated in this context. Companies that generate substantial free cash flows are particularly attractive for long-term investment, as this indicates their ability to sustain operations, invest in growth opportunities, and weather economic fluctuations without relying heavily on external financing.

Additionally, longevity is crucial; the ideal candidates for a coffee can portfolio are those that have proven their capacity to adapt effectively to changing market conditions and have a strategic, long-term vision for expansion. This combination of attributes ensures that the investments remain strong and potentially profitable over a long horizon, in line with the long-term holding principle of the coffee can investment approach.

Furthermore, companies fitting the coffee can portfolio criteria must demonstrate strong corporate governance. The core concept of a coffee can portfolio is to “set it and forget it,” making it crucial to evaluate management’s past decisions, compensation, and their vision for the company’s future.

Analyzing the board members is also vital. Insider ownership plays a key role in assessing the ownership mindset of the company’s leadership. When management and board members own significant portions of the company, it aligns the interests of shareholders with those responsible for the company’s operations. This alignment ensures that both groups are incentivized to benefit from the long-term appreciation of the stock.

When assessing the potential attractiveness of long-duration stock investments, industry and market analysis play crucial roles. These analyses help in understanding the broader context in which a company operates and its position relative to industry trends and economic cycles.

Innovation and the ability to adapt in various economic conditions are key factors in selecting long-duration investments suitable for a coffee can portfolio. Companies that consistently innovate and pivot according to market demands are more likely to sustain growth over long periods.

However, it’s also important to recognize that industries undergoing rapid change, such as the information technology sector, require extra caution in evaluating the attractiveness of their stocks. The dynamism of these sectors can often lead to significant uncertainties and volatility.

When analyzing a company within a highly competitive and transformative industry, it’s vital to avoid being overly influenced by potential growth narratives. Such narratives may be easily eroded by fierce competition, or they may rely so heavily on future technology that the potential implications become too uncertain to accurately assess. Therefore, a balanced and thorough analysis is essential to discern genuine long-term potential from mere speculative opportunities.

Durability might be the most important factor when analyzing a stock that could fit into the coffee can portfolio. The Lindy Effect, a concept often used in the context of technology and ideas, can also be applied to the stock analysis process. It refers to the idea that the future life expectancy of certain non-perishable things is proportional to their current age. This translates to the notion that companies with a longer past are more likely to have a longer future. Although this isn’t always the case, as numerous instances show new technology displacing incumbent participants who have held substantial market share in a specific industry for a long time, it remains an important exercise when analyzing a company’s ability to survive over the long term.

One approach to assess the potential of the Lindy Effect is to examine companies that are decades old, sometimes even over a hundred years. This process allows you to study the various industries that have risen and fallen throughout history, understand how companies have adapted and survived during hardships, and observe how management has made changes or implemented new forms of technology to stay relevant in the evolving business landscape.

Incorporating the Lindy Effect into stock analysis is crucial because it forces the analyst to focus on companies that have proven their ability to remain in business for extended periods. This historical perspective is invaluable in evaluating a company’s durability and its potential to be a successful long-term investment.

One-way companies experience extended lifecycles is by exercising dominance in the niche they operate in. A key form of this dominance can be a local competitive advantage. This relates to a company’s strong foothold in a specific geographic region, often due to a deep understanding of local consumer preferences, regulatory environments, or logistical advantages. Industries that typically exhibit strong local competitive advantages include agriculture in regions with unique climates, tourism in areas with distinct natural or cultural attractions, resource extraction in resource-rich locations, financial services in global financial hubs, tech and innovation in specialized clusters, specialized manufacturing in areas with historic expertise, creative industries in cultural capitals, and renewable energy in regions with abundant natural resources.

Another form of niche dominance is supply chain control. This can be related to importers and exporters of important raw materials used in manufacturing, as well as the ability to transport goods from the supplier to the manufacturer. By being an essential actor in the manufacturing and raw materials industries, these companies have the ability to maintain consistent pricing power and can exercise control over the supply and demand of the products or services in which they operate.

Industries that have competitive advantages through supply chain control include oil and gas, with their hold on reserves and refining; mining and metals, controlling key resources; automotive manufacturers, managing everything from raw materials to parts production; electronics and semiconductor firms, dominating essential component production; pharmaceuticals, leveraging drug manufacturing processes; agricultural companies, influencing the seed and fertilizer markets; chemical producers, who are pivotal in basic materials; textile and apparel businesses, overseeing the journey from material to garment creation; aerospace and defense firms, controlling critical technology production; and consumer goods and retail giants, managing end-to-end product supply chains.

Additionally, brand recognition and customer loyalty can be the strongest niche factors that keep a customer engaged with a business for extended periods of time. While brand recognition and customer loyalty are intangible in nature, if properly realized, they should lead to tangible value generation. Being a recognized brand allows a company to benefit greatly from meaningful advertisement, fostering an emotional response in customers who are satisfied with the operations.

Similarly, continuously providing a good value proposition for the customer fosters customer loyalty, either through membership programs or high switching costs associated with changing providers. High switching costs tend to be a powerful form of niche dominance due to locking in customers for recurring revenue. However, an even more powerful form of niche dominance is when customers voluntarily return for services or products because of their previous satisfactory experiences, creating a combination of customer loyalty and brand recognition.

Industries that typically benefit from competitive advantages like brand recognition, customer loyalty, and high switching costs include luxury goods where brand prestige drives sales; technology and software firms where customer familiarity and ecosystem integration create loyalty; financial services where trust and complexity discourage switching; telecommunications with long-term contracts and network reliance; the automotive industry where brand loyalty influences repeat purchases; consumer electronics where brand ecosystems create high switching costs; pharmaceuticals where trusted brands dominate; retail and fast food chains with strong brand identities; and airlines where frequent flyer programs foster loyalty. These sectors leverage their established reputations and customer habits to maintain market dominance and deter switching to competitors.

By analyzing companies with a long-term time horizon, analysts can disregard temporary price fluctuations and focus on the underlying economics of the company. Evaluating the management, understanding the operational aspects of the business, and having reasonable expectations about the future enable shareholders to benefit from the success of the business operations over a complete business cycle. Additionally, the tax efficiency of this low turnover strategy, along with the implications of meaningful dividend increases or other sound capital allocation decisions, compound benefits for the shareholders. This approach becomes logical when one recognizes the benefits of investing in businesses that conduct their operations with ease. The discipline becomes evident once an analyst realizes the challenge in discerning what constitutes a good business and determining the right price for that business.

The coffee can portfolio strategy is based on the belief that by holding onto high-quality stocks for an extended period, investors can benefit from the compounding effect of long-term returns. This approach requires patience and discipline, as it involves resisting the temptation to constantly buy and sell stocks based on short-term market fluctuations.

Cigar Butts

On the other end of the spectrum, the concept of “cigar butts” refers to a short-term investment strategy where investors seek out undervalued stocks that have the potential to provide quick profits. The term was popularized by Warren Buffett, who described these investments as companies that are “so cheap that they are selling for less than the value of their assets minus their liabilities.”

Cigar butt investments are characterized by their undervaluation in the market, offering investors the chance to buy these stocks at a bargain price. The primary objective of this investment strategy is to capitalize on short-term price movements, with investors aiming for a ‘value realization event’—the point at which the stock reaches its fair value and is then sold to secure the gains. Unlike the coffee can portfolio strategy, cigar butt investments entail a more significant level of risk. This risk, however, is often mitigated by a quantifiable margin of safety. The undervaluation of these stocks may stem from temporary market conditions, and there’s always the risk that the market may not fully recognize the stock’s true value.

A quantifiable margin of safety is often paramount in cigar butt investing, as the companies fitting this strategy are usually considered inferior. Their business performance can be mundane or even negative, often leaving previous shareholders dissatisfied and further diminishing the appeal of the shares. It’s crucial to understand the psychological differences between this strategy and the coffee can approach.

In the coffee can strategy, considerable time is spent comprehending the future of the business. Confidence in this analysis often stems from examining the long-term profit history, analyzing various earnings metrics from EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to net income and free cash flow, and making predictions about future earnings based on current capital allocation decisions. However, this approach is not suitable for analyzing cigar butts. Deep analysis to make predictions based on earnings is a mistake for these companies.

The cigar butt strategy focuses on asset analysis, whereas the coffee can strategy is more earnings-based. The goal in cigar butt investing is to purchase a company at a discount to its worth, hypothetically in a liquidation scenario where assets are liquidated, and liabilities paid off. The remaining value is what is due to the shareholder, serving as the analyst’s margin of safety. The desired outcome is to buy these shares at a price significantly lower than this calculated value.

Once becoming a shareholder, the objective is to either have the market recognize the value of the shares, have the company purchased by a larger entity at a fairer price, or see the excess capital returned to shareholders through dividends or full liquidations.

Another distinction between the cigar butt and coffee can strategies lies in the active involvement required in cigar butt investing. Shareholders of companies trading at a discount often have more concerns about operations than those invested in fairly valued companies. In such cases, it can be beneficial for shareholders to voice these concerns to management and board members, particularly if they possess unique insights or expertise on the relevant issues.

Frequently, the accounting procedures of certain companies can be problematic, whether due to ignorance or intent. Unprofitable business lines may continue to operate, draining value from the organization, or there might be insufficient capital allocation for future operations. These issues can prompt shareholders to express their concerns to management, with the hope that the management will listen and take necessary actions. The ultimate goal of these interventions is to aid in achieving the fabled value realization event, where the true worth of the company is recognized in the market.

Reality often deviates from the simplistic notion of a letter to management causing a significant change in the organization’s top executives. In most cases, management is already aware of operational problems, either having unsuccessfully attempted to resolve them or lacking the necessary incentive alignment to make the required changes. An astute investor must either persistently assert to management that changes are needed or exhibit patience, holding shares of the discounted firm until an unforeseen event leads to a fairer value assessment or a liquidation that returns excess capital.

Patience is crucial in this strategy as these situations take time to unfold. However, it can also be risky; the longer an investor holds a discounted asset, the less impactful the realization event becomes. Worse still, if the company’s capital allocation decisions are poor, they might erode the firm’s value, further diminishing the impact of a value realization event.

Active management is vital in the cigar butt strategy. It’s essential to assess the capabilities and intentions of management, the value within the company, and the potential for realization in the market. If the situation doesn’t seem favorable, it’s logical to cut losses and move on to a more attractive opportunity. Staying locked into an unsuccessful investment increases opportunity costs. Therefore, an investor using the cigar butt strategy must be diligent in searching for opportunities, always weighing options, and ready to sell one position to invest in another. This active approach does result in higher share turnover, incurring more taxes and requiring more time spent on idea generation.

The question then arises: why would anyone choose the cigar butt strategy over the coffee can strategy? The answer lies in the potential returns. Properly implemented, the cigar butt strategy offers compelling returns, making it an excellent way to generate outsized returns early in one’s career. Moving from one successful value realization event to another has a compounding effect, similar to that seen in the coffee can strategy, but with the investor actively directing capital flow to the most attractive opportunities. In contrast, the coffee can portfolio relies entirely on the continuing operations of selected firms. Both strategies can yield outsized returns if properly executed, but generally, the successful cigar butt investor is compensated for the strategy’s active nature.

While the coffee can portfolio focuses on long-term wealth accumulation, cigar butt investing aims to generate quick profits. It requires a keen eye for undervalued opportunities and the ability to make timely investment decisions.

Benefiting from Both Strategies

Investors can benefit from incorporating elements of both the coffee can portfolio and cigar butt strategies into their investment approach. By diversifying their portfolio with a mix of long and short duration investments, investors can potentially achieve a balance between steady long-term growth and short-term gains.

By assessing each opportunity individually, an investor can benefit from both the coffee can and cigar butt strategies. Understanding that both approaches have their benefits and faults is crucial for long-term investment success. Recognizing patterns indicative of a situation likely to succeed under either the coffee can, or cigar butt strategy allows an investor to tailor their analysis accordingly. This helps in determining whether an opportunity is attractive.

Both strategies can produce winners and losers based on similar analyses. It’s the investor’s responsibility to identify which opportunities are most likely to succeed within each strategy and to weigh the most attractive options at any given time. This discerning approach is key to navigating the complex landscape of investment strategies effectively.

It’s interesting to note that some characteristics are universally important in both the coffee can and cigar butt strategies. For example, share dilution is viewed negatively in both approaches. Conversely, share buybacks are favorable as they help increase the earnings per share value for consistent earners and also enhance the value per share of discounted assets.

Furthermore, returns on capital are positive indicators in both strategies. While the coffee can approach favors consistent returns on capital with a potential for growth, even modestly positive returns can significantly enhance the appeal of discounted assets in the cigar butt strategy.

Price discipline is a cornerstone of proper execution in both strategies, as is consistent idea generation and successful position sizing. These factors are essential regardless of the strategy being employed when assessing potential opportunities available.

It is important to note that the success of any investment strategy depends on thorough research, analysis, and understanding of the individual investor’s risk tolerance and financial goals. It’s worth mentioning that psychological aversions can sometimes hinder investors from effectively implementing one of the strategies due to various reasons.

In conclusion, the coffee can portfolio and cigar butt strategies offer investors different approaches to long and short duration investments. While the coffee can portfolio emphasizes stability, longevity, and long-term wealth accumulation, cigar butt investing focuses on undervalued opportunities and short-term profits. By incorporating elements of both strategies, investors can tailor their investment approach to suit their individual goals and risk appetite.