Bad news. No one likes to hear it—unless they are value investors such as Warren Buffett (Trades, Portfolio). As we have seen in previous chapters, Buffett is a man who plays other market players, looking for opportunities when fair weather investors flee the market, selling their stocks at a steep discount.
In chapter 10 of “The New Buffettology,” authors Mary Buffett and David Clark delineated four types of bad news environments which Buffett would like:
- Industry recessions.
- Individual calamities.
- Structural changes.
- War.
What these conditions have in common is a “negative impact” on stock prices, regardless of their underlying economics. If they occur in combination, they can have a devastating effect on prices, creating fine buying opportunities.
Industry recessions
In these cases, not just one or a few companies are affected, but whole industries. The authors said recovery can be slow, between one and four years normally. They tell the story of Capital Cities/ABC (now part of Disney (DIS, Financial)), which saw its revenues drop because of a business recession in 1990. Investors, used to earnings growth of some 27% per year, fled the stock, driving it down from $63.30 to $38 per share, a drop of 40%. Five years later, in 1995, it was selling for $125 per share.
Buffett used the 1990 banking recession to get started in Wells Fargo (WFC, Financial). As he has pointed out, everyone gets hurt in an industry-wide recession, but the strong survive while the weak go under. Within that context, Wells Fargo was considered the most conservative, well-managed and financially strong of money-center banks on the West Coast. In 1991, it made provisions for future loan losses because of a recession in the real estate market; the set-aside amounted to approximately $25 per share of the company’s then current price of $55 per share. As the authors put it, “Wall Street reacted as though Wells Fargo were a regional savings and loan on the brink of insolvency and in four months hammered its stock price from $86 down to $41.30 a share.”
Not surprisingly, Buffett was watching and waiting. He bought 10% of the company at an average price of $57.80 per share. A decade later, those shares were worth approximately $270 per share. Incidentally, loan losses did not explode as expected, helping fuel a rebound in the share price.
Individual calamities
Managers make mistake. When the mistakes are big enough, the market promptly sells out in hurry, pushing prices way down. As the authors said, “Your job is to figure out whether this situation is a passing calamity or irreversibly damaging.” Buffett knows that the answer to this question hangs on the existence of a durable competitive advantage.
One example is insurance company Geico (now fully owned by Buffett’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)). For some 40 years it had thrived using the same business model: only preferred drivers (to keep down the cost of claims) and direct-mail marketing (keeping marketing costs down). In the early 1970s, however, management decided to grow the company by relaxing its underwriting standards; the results were predictable: bad drivers drove up the cost of claims and threatened to bankrupt the company. The Geico board of directors brought in Jack Byrne as the new chairman and president. He went to Buffett to ask him to invest. Buffett responded by asking if Byrne would go back to the old business model and was assured the company would. Buffett invested $45.7 million by 1980; 16 years later, as he was about to buy the rest of Geico’s shares, that original investment had ballooned to $2.4 billion, working out to an average annual gain of 28% per year.
Something similar happened with American Express (AXP, Financial), which also contributed to the Buffett legend. In the mid-1960s, the credit card company made a mistake involving $60 million worth of salad oil held in collateral and had to pay out that amount in damages. That almost depleted the company’s equity base, and its stock price took a beating. Buffett, though, saw the company’s credit card and traveler’s check business as remaining solid, and thus did not expect American Express to suffer any long-term damage. He subsequently invested 40% of his capital to buy a 5% stake. When the rest of market recognized what Buffett had seen two years earlier, the price popped up again and he sold his shares for a $20 million profit.
Structural changes
Mergers, restructuring, reorganizing and conversion in corporate form are all ways in which a structural change can occur. Again, we can expect Buffett to be watching and waiting, at least for the companies that have durable competitive advantages.
He picked up shares of Costco (COST, Financial) when it posted negative earnings because of merger and restructuring costs. When Tenneco Offshore (TEN, Financial) and Service Master (SERV, Financial) changed their corporate forms to master partnerships, Buffett was there. That was also the case when Sears (SHLD, Financial) announced plans to spin off Allstate (ALL, Financial), its insurance division.
War
Declarations of war usually elicit intense emotional reactions, especially fear, prompting investors to run from the market. That happened with the 1990 Iraq War and the 2001 Afghanistan War, and especially with the Sept. 11, 2001 attacks.
Travel immediately slowed and all types of travel companies felt immediate pain. That included airlines, car rental agencies, hotels and cruise lines; all began losing money. For an investor like Buffett, it is important to look past the immediate effects and focus on the medium and long term. People soon started traveling again, and the affected companies recovered.
About
Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”Â
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
