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Monday, 30 April 2007

The ugly cigar butt raised his head, United Food's 3Q results in October 2006

Citing rising raw material prices and operating expenses, coupled with pricing pressure to maintain market share, United Food Holdings saw a nearly 50% drop in net earnings.

Such margin squeeze was common with firms who operate in competitive environment without a clear strategy to compete. Thus, I would expected to see a decline in profits in coming quarters.

The fact that it traded substantially below NAV and without impressive performance earn it a place in the category of stocks called Cigar Butts. The latter term was first coined by Benjamin Graham to mean heavily beaten down stocks that might still have a good puff or two, i.e. such beaten down stocks should be so low that the only is up for them should circumstances change for the better.

It might make sense to invest in Cigar Butts with tremendous diversification because a few runaway Cigar Butts that do turn around would be enough to raise the entire portfolio above water. However, I subsequently realised such approach was similar to betting that the stocks would turn around, a risky gamble in essence.

I realised it make more sense to buy good companies at reasonable price (normally the price of good companies stay reasonable only if they were not noticed by general public or fund managers) than buy cigar butts and hope they turn around. The risk for cigar butts to turn around was much higher, though the returns would be proportionately higher too.

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