Ben Graham's 'Cigar Butt' Investing System

Benjamin Graham, the man who would become known as the father of modern security analysis, was an intellectual at heart. He spoke seven languages and could quote classic authors in their native French, German, or ancient Greek. He was also famously absent-minded, known for inventing a new slide rule while also showing up to work in mismatched shoes. After graduating from Columbia in just two and a half years, he turned down teaching positions in math, English, and philosophy to support his family, choosing the one field with the highest earning potential: finance.

The Wall Street Graham entered in 1914 was less an institution and more of a casino. Traders in brightly colored hats literally shouted orders from the curb on Broad Street. His first boss at Newburger, Henderson & Loeb, Alfred Newburger, gave him a stark warning on day one: “If you speculate, you’ll lose your money.” But speculation was the lifeblood of the firm. One of Graham’s first jobs was acting as a bookie for bets on the 1916 presidential election and chalking up stock prices for gamblers in the “customers’ room.” This environment made feel more like a trip to the racetrack than a serious financial endeavor.

Despite the warning, Graham got swept up in the speculative fever. He lost his own money, and his friends’, on a bankrupt railroad and a fraudulent tire company IPO. After confronting the man behind the tire scheme, he only managed to get back 33 cents on the dollar, realizing the legal system offered little protection. By 1920, with a new family to support, Graham knew he needed a reliable way to make money—a method that went beyond pure guesswork. He needed to understand , not just gambling.

A New Way of Thinking

The timing was perfect. After World War I, American industrial companies were on more solid footing and began releasing more financial data. Graham, who once tabulated trucking statistics to get through college, now had concrete numbers to analyze. He started noticing patterns. In 1915, he studied the financial statements of Guggenheim Exploration and saw a glaring disconnect: the company’s stock was trading for less than $69 a share, but the assets it held were worth over $76 a share. Buying the stock and waiting for the company to liquidate its holdings would lock in a near-guaranteed 10% return. This wasn’t speculation; it was analysis. This was the beginning of a real that would eventually become his life's work.

He and his firm made money on the Guggenheim trade, but his partners weren’t interested in his other data-driven ideas. They preferred the high-volume trading of speculative stocks because that’s what the customers in the betting parlor wanted to see. Frustrated, Graham left in 1923 at age twenty-nine to start his own firm. He knew he had an edge. As he later wrote, being a newcomer allowed him to see things “with a clearer eye and better judgment than many of my seniors, whose intelligence had been corrupted by their experience.”

The Pipeline That Built a Reputation

In 1926, Graham found the company that would make his career. While reviewing documents at the Interstate Commerce Commission, he discovered Northern Pipe Line, a small offshoot of Rockefeller’s Standard Oil. The company’s stock was trading for $65 a share, yet it owned $95 per share in high-grade railroad bonds. The profitable pipeline itself was essentially free.

Graham met with the brothers who ran the company and proposed a simple idea: distribute the excess cash from the bonds to the shareholders. They refused, claiming they might need the money for future expansion. At the company’s annual meeting in Oil City, Pennsylvania, Graham was the only outsider among eight attendees. The management team swiftly approved a non-existent annual report and adjourned the meeting before he could present his case.

The next year, Graham returned with four lawyers and enough shareholder votes to elect two directors to the board. Weeks later, the company’s management summoned him to their New York office and agreed to a plan that distributed $70 per share in cash and securities. Graham’s initial $65 investment nearly doubled, cementing his reputation and his bank account. It was a clear example of how with a focus on underlying value could yield incredible results, a lesson crucial for anyone .

Value 1.0 and Its Limits

Graham’s asset-based approach was working so well that he began using borrowed money to leverage his bets, a strategy that backfired spectacularly during the Crash of 1929. His fund lost 70% of its value. Undeterred, he doubled down on his discipline, refining his method to be even more conservative. He began looking for companies trading for less than their “net current asset value”—valuing cash at 100%, receivables at 80%, and inventory at 50%, then subtracting all liabilities. He called these “net nets.” In the depths of the Great Depression, he found hundreds of them, creating the foundation of what became known as value investing.

This system, which we can call Value 1.0, was codified in his classic books and . He introduced timeless concepts like buying with a “margin of safety” and treating the market like a manic-depressive business partner named “Mr. Market.” His approach was rigorous and repeatable, and it’s estimated he earned 20% annually, double the market average, until his retirement. This method was one of the original blueprints for .

However, the system had significant flaws. It was a short-term strategy often called “cigar butt investing”—finding a discarded cigar on the street that has one good puff left in it. It required constantly finding and selling these cheap stocks, leading to high transaction costs and taxes. More importantly, its rigid focus on assets meant it completely missed great businesses with intangible value. Graham famously passed on Haloid, the company that would become Xerox, because it wasn’t “cheap enough.” This strict approach, while creating a potential , also had a massive opportunity cost.

The Ultimate Confession

Years later, in the final edition of , Graham made a quiet confession. Writing in the third person, he told the story of a single investment his partnership made in 1948. The stock was cheap, but he and his partner were also “impressed by the company’s possibilities.”

That one stock went on to make them 200 times their initial investment. Graham concluded that the profit from this single decision “far exceed the sum of all the others realized through 20 years of wide-ranging operations.” In other words, one great business made him more money than a lifetime of picking up cigar butts.

The company was GEICO. He called it a “lucky break,” but he knew better. He knew that identifying great businesses could be a system, not just luck. In fact, his own star pupil from Columbia—the only one to ever earn an A+ from him—was already proving it. His work was one of the first , but his biggest success came from breaking his own rules.