Jason's World

Since the turn of the decade, many Wall Street firms have been roiled by retail investors buying stocks that are either distressed or on the road to bankruptcy. The GameStop short squeeze, for example, contributed to the failure of Melvin Capital, costing it nearly $7 billion. Many so-called meme stocks have emerged after this, with examples being AMC (which had a second wave in the past weeks), Bed Bath & Beyond, and more recently Tupperware and Yellow. Bed Bath & Beyond and Yellow have since declared bankruptcy.

While this “meme stock” phenomenon has only made waves in recent years, the underlying concept is nothing new. In “The Snowball”, Warren Buffet’s memoir, it was described that Buffett’s mentor, Ben Graham, had a special name for stocks that were facing bankruptcy that could still be worth investing in: “cigar butts”. Both meme stocks and cigar buts are failing stocks that contained one last profit opportunity, that “one last puff”. They are companies that were failing but had a share price that was below its fair value, or net current asset value (NCAV), which is assets minus liabilities and preferred stock, divided by outstanding common shares. The logic was that even if the company was liquidated tomorrow, the holder of the common stock would profit because he or she would receive a higher amount in payout compared to the price the stock was bought. This strategy was popularized by Warren Buffett until he met Charlie Munger, who shifted Buffett’s focus towards high-quality businesses.

Since 2021, this new “meme stock” phenomenon has emerged, involving distressed stocks just like the concept of cigar butts. GameStop, for example, is a widely shorted company that has been hit hard by the COVID pandemic and the rise of online shopping, with a short interest that used to be as high as 140% of its float. According to Goldman Sachs, there were only 15 occasions in which a stock’s short interest has risen over 100%.

Thus a “cigar butt” opportunity might arise with heavily shorted stocks-when such stocks rise slightly, they could trigger a wave of short covering that appreciates the price further, causing investors, mostly retail, led by online communities such as WallStreetBets, to pour into the stock. This is precisely what happened with GameStop and many other stocks.

Profiting from this kind of phenomena is a very tricky endeavor, as you never know just how high they rise. Most investors are caught flat-footed when they buy these stocks when they are rocketing, often failing to predict just how high they will go. Therefore if you are looking for relatively stable profit opportunities, attempting to buy them would be an exceptionally risky bet. However there is one thing that is certain about these stocks-they fall just as quickly as they rise. The best move may be to purchase put options. Unlike directly shorting the stock, as many institutions and large investors do, it is relatively risk-free-the most you can lose is your investment. But like with all other investments, you should be prepared to be in it for the long run, as the path towards the cooling down of a meme stock is often rocky-the stock went back and forth for a long time before finally lowering below $30 (split adjusted) for good (so far), and it still has yet to retain its pre-boom level in the (split adjusted) single digits. Therefore buying short-term options, while not posing as significant of a risk as shorting, may still prove risky for the same reason. 

In conclusion, while the “meme stock” phenomenon appears to be a modern twist on Benjamin Graham’s “cigar butt” strategy, it comes with additional layers of complexity and risk. Retail investors looking to capitalize on these opportunities should proceed with caution, recognizing the potential for both significant gains and substantial losses. Typically, given the fundamentals of these stocks, most solid profit opportunities come when the fever is cooling down. If these stocks surge higher than what you expected, don’t be afraid to double down on your position-as long as you can lose the money. This is made substantially easier if you are buying puts instead of directly short-selling the stock.