In the middle of August I received a frantic call from my mother-in-law. She wanted to know what was happening to the stock market and why was it down so much. Like many investors, she had been watching CNBC, listening to Bloomberg radio and reading the business section of her local newspaper. A stock market panic involving businesses in home building and sub-prime lending was taking place. Multibillion-dollar companies that had no exposure to home building or sub prime lending were taking it on the chin, falling hard and fast.
When she called, I happened to be in the middle of reading the latest annual report of a U.S. Bank on my target list. Although it had about 3 percent of its loan portfolio exposed to the sub prime market, that didn’t help, since its stock price had fallen close to 10 percent over the past few weeks as fear reigned supreme. After trying to calm her down by telling her to take a long-term view (to no avail), I ended the conversation by saying that instead of being nervous and scared, now was an excellent time to buy. There was silence on the other end of the phone. I guess she thought I had finally lost it. It seemed that no matter how much I tried to assure her that five years from now this panic would be a distant memory and many stocks, especially in the banking sector, were dirt cheap, I could not alleviate her fears. My mother-in-law’s response was in fact typical of most investors, especially institutional and professional ones. In the face of falling prices, the most common reaction is to panic and sell at any price. For the investor who keeps his head while others around him are losing theirs, panics turn out to be excellent buying opportunities. In addition to doing their homework, value investors also need to have conviction and courage. It takes both to be able to buy in the face of what appear to be doomsday scenarios constantly being played up by “market experts”and the media.
I would be willing to bet dollars to donuts that five years from now the summer of 2007 will be looked on as an excellent buying opportunity. Unfortunately, only a handful of investors will be able to make the claim that they actually bought when prices where sharply lower. During market panics, I have observed that investors fall into two groups when it comes to buying stocks: those who are waiting for the market to settle down before making a purchase and those who buy because their research and analysis tell them that they are making an investment in an undervalued security.
Ring The Bell
The first group, those who are waiting for the all clear signs, usually buy high and sell low. The future is always an unknown and, by definition, never clear. By the time the stock market “settles down,” companies that were bargains are no longer selling at discounted prices. If one invested only when things looked great, odds are they paid a very dear price for their stock. Nobody rings a bell at the bottom to let you know that now is the time to buy. That has to come from your research and how you value a business. Courage comes into play when actually making the buy, and conviction enters when you watch your recent buy head sharply lower. Just because you made a purchase at a low price doesn’t mean it can’t go lower.
There have been several times when I thought I got a bargain price only to see the stock price fall another 30 percent. What keeps me centered during those times are two questions I ask myself: Is the company I just bought going to be selling more goods or services five years from now? And does the price I paid factor in a margin of safety? If the answer is yes to both questions, I am assured of a good night’s sleep.
I wanted to see, given the clarity of hindsight, how effective it was to buy a great company during a time of market upheaval. Over the past 20 years I have highlighted two periods of time that were great buying opportunities yet were full of fear and panic when they occurred. The periods I selected were the crash of 1987 and LongTerm Capital Management’s implosion in the summer of 1998. I selected three big multinational stocks that were in easy-tounderstand businesses, had historically good management and had good business fundamentals. These big companies were out there for everyone to see. I didn’t even do a value analysis on them. Warren Buffett said that time is the friend of a good business, and I wanted to see if that held true.
To find three companies that I could understand, I looked at the Fortune 500 list of 1986. I went down the list and skipped companies that were in a cyclical or commodity business (e.g. oil,gas, chemical) since they have very little competitive advantage, or in a business with lousy economics (e.g., autos, heavy machinery,etc.). I selected Procter & Gamble (PG), ranked number 22; Pepsico (PEP), ranked 41; and Johnson & Johnson (JNJ), ranked 59; and my hypothetical rational long-term investor would buy shares in each company.
Panic #1: Crash Of 1987
The first test of buying great companies during a market panic occurred in 1987. The stock market fell more than 22 percent on October 19,1987, the largest percentage drop ever in a single day. For the next several weeks the stock market was open on an abbreviated schedule and trading curbs were placed to limit program trading. Wild gyrations were the order of the day. For a time it seemed as if the stock market was going to collapse. The market finally bottomed out the first week of December. Not one to pick a bottom, our hypothetical long-term investor bought PG, PEP and JNJ on the last trading day of 1987. How did he fare over the next five, 10, 19-plus years? Quite well.
|Stock||5 Years||10 Years||19.7 Years|
During each period, our hypothetical investor’s stocks handily beat the S&P 500 index by doing nothing. All he had to do was make two decisions-select the company and make the purchase. The fundamentals of the company took care of the rest. Over time, each of his holdings outperformed the S&P 500 by a wide margin (3.5 percent to 3.8 percent). The difference in dollar terms of 3.7 percent over 19.7 years is huge. Investing $100,000 in PG, which returned 16 percent, versus an S&P 500 index fund, which returned 16 percent, versus an S&P 500 index fund, which returned 12.3 percent, over 19.7 years. In dollar terms that difference comes out to over $878,000!
Panic #2: 1998 LTCM
LongTerm Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, the former vice chairman and head of bond trading at Salomon Brothers. On its board of directors were Myron Scholes and Robert C.Merton, who shared the 1997 Nobel Memorial Prize in Economics. Initially enormously successful, with annualized returns of over 40 percent in its first years. Such losses were accentuated by the Russian financial crises in August and September of 1998, when the Russian government defaulted on its government bonds. Panicked investors sold Japanese and European bonds to buy U.S. Treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital. The fear was that there would be a chain reaction as the company liquidated its securities to cover its debt, leading to a drop in prices, which would force other companies to liquidate their debt, creating a vicious cycle.
Eventually several investment banks bailed them out and the crisis was over. At its lowest point in October, the S&P 500 fell close to 14 percent (July 31 to October 18, 1998). However, that only masked the fear of how real the global meltdown was.
|Stock||5 Years||8.9 Years|
How did our hypothetical investor do when he bought those same stocks? Very well. -- Each of the holdings outperformed the S&P 500 over the 5- and 8.9-year periods (from .90 percent to 5.4 percent CAR).
What About Now?
The most recent panic, which we are still living through, will pass over time, yet time will continue to be a friend to the good business. Besides investment banks, which hold much of these sub prime instruments, other companies have seen their share prices fall sharply. The two companies that rated most of these instruments have seen their share prices plummet since May 31, 2007. Moody’s Corp. (-39.6 percent) and The McGraw-Hill Companies (-30.2 percent) have been really beaten up by traders and are selling at valuations not seen in many years. Most likely traders and investors have overreacted once again, and these two companies will probably do very well over the next five to 10 years.
While Warren Buffett was speaking to MBA students at the University of Florida in 1998, a question was asked on how the Asian crisis of 1998 would affect Coca-Cola, a long-term Buffett holding. Buffett replied that Coke would go through “a tough period for who knows, three months or three years–but it won’t be tough for 20 years.” He ended his remarks with the following:
The wonderful business – you can figure what will happen, you can’t figure out when it will happen. You don’t want to focus too much on when, but you want to focus on what. If you are right about what, you don’t have to worry about when very much.
THE LAST WORD: The Dangers of Leverage
One piece of advice that Warren Buffett has repeatedly offered to young people fresh out of college is to stay out of debt. If the debt one is taking on is for consumption–car, clothes, vacations, etc. - that’s just plain silly. If one is taking on debt in order to juice returns by using margins, that could be devastating. The example he gives on the dangers of using leverage, which in essence is borrowed money, is the debacle at Long Term Capital Management (LTCM) in 1998. LTCM was making trades where the differences in value were small, but when leverage was applied made nice profits. At the start of 1998, LTCM had $4.7 billion in equity yet had borrowed more than $120 billion! Just before the summer, two hedge funds managed by Bear Stearns used leverage as high as 15 to 1 in order to increase returns.
Eventually both LTCM and the two hedge funds run by Bear Stearns lost the majority of their assets. They were both engaged in what Nassim Taleb, author of The Black Swan, said was a strategy of “picking up pennies in front of a steamroller.”
Each cycle will produce its own panic and market meltdown. It is best to buy only what you can afford and get rich slowly. The risks of losing everything by using leverage just aren’t worth it.