Why Cigar Butt Investing and the Magic Formula No Longer Work

TL;DR

• Benjamin Graham's "cigar butt investing" (buying below book value) worked in the tangible-asset-driven old economy but is useless in a modern economy where intangible assets like software, patents, and brands drive value
• Joel Greenblatt's Magic Formula dramatically outperformed the S&P 500 from 1988-2009, but has significantly underperformed over the last 10 years. Popularized strategies self-destruct
• Mechanical formulas suffer from structural limitations: value traps, cyclical sensitivity, and high tax drag from portfolio turnover

Benjamin Graham and the Era of Cigar Butt Investing

Benjamin Graham authored The Intelligent Investor, which Warren Buffett has called the greatest investing book ever written. It contains timeless lessons that every investor should know.

Graham's lessons that still hold:

• Mr. Market: A brilliant metaphor for market behavior—the market is an emotional partner whose panic creates buying opportunities
• The power of behavior: Controlling your own emotions matters more than any analytical skill
• Margin of safety: Only invest when there's a significant cushion protecting your capital

But one lesson from this book needs to die: the idea that the safest way to invest is to buy companies below their net tangible assets or book value.

Warren Buffett called this "cigar butt investing"—like picking up discarded cigar butts from the street to get one last puff. Buy companies trading below their asset value and extract whatever remaining value exists.

Why Cigar Butt Investing Worked in the 1930s-1940s

This strategy genuinely worked during the Great Depression era. Americans were terrified of stocks, and many companies traded below the value of their physical assets. The economy was driven by tangible assets—factories, machinery, real estate, and inventory that you could physically touch. In this environment, book value was a reasonably accurate proxy for intrinsic value.

Why Book Value Has Become Meaningless in the Modern Economy

In today's economy, the source of corporate value has fundamentally shifted from tangible to intangible assets.

Value Source	Old Economy (1930s-60s)	Modern Economy
Core assets	Factories, machines, real estate	Software, patents, brands
Book value accuracy	High	Very low
Representative companies	Steel, auto, oil	Microsoft, Google, Apple

Consider Microsoft. The vast majority of its current value comes from intangible assets—its software ecosystem, cloud infrastructure, and brand power. These intangible assets are barely reflected in book value.

Monitoring Microsoft's book value is essentially tracking a meaningless number. Book value is completely disconnected from the company's actual intrinsic value.

This is why cigar butt investing is completely outdated and should be entirely disregarded by modern investors.

Joel Greenblatt's Magic Formula: Once Truly Magic

Joel Greenblatt's The Little Book That Beats the Market also contains excellent lessons. He popularized the idea of buying great companies at bargain prices, the importance of discipline and patience, and using ROIC (Return on Invested Capital) as a quality metric.

But the Magic Formula itself needs to be retired.

The Magic Formula combined two simple metrics:

1. ROIC: A proxy for company quality—higher is better
2. Earnings Yield: A proxy for cheapness—higher means cheaper

Buy a basket of stocks ranking highest on both metrics, replace them annually, and you would beat the market.

The Rise and Fall of the Magic Formula

To be fair, the Magic Formula truly worked at one point.

According to Stablebread's analysis:

Period	Magic Formula Performance	vs. S&P 500
1988-2009	Dramatically outperformed	Strong outperformance
Last 10 years	Dramatically underperformed	Significant underperformance

So what happened?

Four Reasons the Magic Formula No Longer Works

1. Increased value trap risk The formula targets "cheap and good" companies, but a high earnings yield often signals that the market sees structural problems ahead. Companies are cheap for a reason.

2. Vulnerability to cyclical businesses The formula can lead you to buy cyclical companies at peak earnings and peak ROIC. When the cycle turns, earnings collapse and investors suffer significant losses.

3. High portfolio turnover equals high tax drag Annual portfolio replacement generates realized gains and annual tax bills. This tax cost significantly erodes long-term compounding returns.

4. Popularization leads to self-destruction This is the most fundamental problem. When any simple strategy becomes widely known, other investors pile in, bidding up prices, and the excess returns disappear. The Magic Formula became a victim of its own success.

Investment Implications

• Don't use book value as a primary measure of company worth. Modern corporate value comes from intangible assets
• No simple formula can consistently beat the market. Popularization kills alpha
• Greenblatt's ROIC concept remains valuable—just don't apply it mechanically. Combine it with qualitative business analysis
• Graham's Mr. Market metaphor, margin of safety concept, and emphasis on emotional control are timeless

FAQ

Q: Is book value completely meaningless? A: It still has reference value in financial sectors (banks, insurance) and tangible-asset-heavy industries (real estate, utilities). But for tech, SaaS, and platform companies, it's essentially meaningless.

Q: Is Greenblatt's ROIC concept still useful? A: ROIC itself is an excellent quality metric. The problem is using it as part of a mechanical formula. Use ROIC as a supplementary tool within qualitative analysis.

Q: Why do popularized strategies lose their edge? A: When many investors follow the same strategy, demand for target stocks increases and prices rise. Higher prices mean lower expected returns, and eventually the excess returns vanish. This is known as "alpha decay."

Q: What parts of Benjamin Graham's book should you still read? A: The Mr. Market metaphor, the margin of safety concept, and the lesson that emotional control matters more than analytical skill remain eternally valid.

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Reference: Analysis based on Benjamin Graham's The Intelligent Investor and Joel Greenblatt's The Little Book That Beats the Market, reinterpreted for modern investing.