Warren Buffett's followers are astonished at his ability to buy a business when the prospects seem amazing. They all wonder how he manages.
To get the point you have to remember that Graham considered that most investors were short-oriented market players and thus made their most to understand present results. If a business did not get good results in a particular year, the stock market would push the stock price down, even if the business has been doing well the year before. Graham considered that this “smash on the face” by the stock market was an opportunity to investors. However, Warren has a different idea: The short-term fluctuations provide opportunities to long term-oriented investors.
This volatility that companies may suffer is not limited to consumer monopolies. Even banks have suffered from market reaction. Let's see a few examples of companies that were victims of this strange manic-depressive market response:
· In 1990, a strong recession bringing about a drop in advertising revenues caused Capital Cities to announce that the net results of that year would be similar to the 1989 results. At that time Capital Cities EPS were growing at 27%. However, the announcement didn't sit well with the stock market. It reacted violently beating Cap Cities' stock price way down from nearly $63 to $38. Capital Cities lost 40% of the share price only by saying that profit would stay the same as in 1989.
· Between 1990 and 1991 as a result of the ongoing recession, Wells Fargo (WFC, Financial), also considered a money center bank (one that lends to smaller banks and is allowed to buy US Treasuries to sell them to other banks) decided to create a reserve for contingencies and set aside almost $1.3b or $25 a share of its $55 a share. It decided to keep that amount in case of potential losses as a result of the severe economic situation. Losses did occur but they weren't as serious as they expected. The bank was still very solvent. However Wall Street reacted as if Wells Fargo were about to go bankrupt. What did that reaction bring about? The bank's shares drastically dropped from $86 to nearly $40.
The following example differs from the other two in that the downtrend in stock price was not caused by an external event but by a weird action carried out by the company itself:
· GEICO, one of the companies where Buffett saw a chance and purchased positions, highly benefited insuring preferred drivers by carrying out low-cost operations and operating via direct mail rather through agents between 1936 and 1970. However, in early 1970 management changed as well as the way they did business. The company decided to start selling insurance to just about anyone who knocked on their door and see if they could increase their earnings. What they considered a chance of growth turned out to be a problem because they accepted drivers who were susceptible to having accidents. More accidents meant more money. In 1975 it reported a net loss of $126 million, which placed it on the brink of insolvency. GEICO appointed a new chairman who asked Warren to invest in the company. Warren also wanted to know if they were returning to the old way of insuring. And they did. Warren purchased an important position when things were not so good and was able to make a difference when they returned to the old format.
You are probably asking yourself what is the point of all this. The point my dear reader is to let you understand that downtrends or volatility in the stock price caused by a recession (as in the case of the examples) or by any other rare event are great opportunities for investors who plan in the long term, just like Buffett does.
If you identify a company with a solid management or a consumer monopoly or both, and the economic situation for them is not good, you have to purchase a position in them. With those two features it is likely that the company will survive a recession and probably come out in a better position. You would have bought shares at a much cheaper price than the shares of other companies and the pretax compounding rate of return will end up being high.
To get the point you have to remember that Graham considered that most investors were short-oriented market players and thus made their most to understand present results. If a business did not get good results in a particular year, the stock market would push the stock price down, even if the business has been doing well the year before. Graham considered that this “smash on the face” by the stock market was an opportunity to investors. However, Warren has a different idea: The short-term fluctuations provide opportunities to long term-oriented investors.
This volatility that companies may suffer is not limited to consumer monopolies. Even banks have suffered from market reaction. Let's see a few examples of companies that were victims of this strange manic-depressive market response:
· In 1990, a strong recession bringing about a drop in advertising revenues caused Capital Cities to announce that the net results of that year would be similar to the 1989 results. At that time Capital Cities EPS were growing at 27%. However, the announcement didn't sit well with the stock market. It reacted violently beating Cap Cities' stock price way down from nearly $63 to $38. Capital Cities lost 40% of the share price only by saying that profit would stay the same as in 1989.
· Between 1990 and 1991 as a result of the ongoing recession, Wells Fargo (WFC, Financial), also considered a money center bank (one that lends to smaller banks and is allowed to buy US Treasuries to sell them to other banks) decided to create a reserve for contingencies and set aside almost $1.3b or $25 a share of its $55 a share. It decided to keep that amount in case of potential losses as a result of the severe economic situation. Losses did occur but they weren't as serious as they expected. The bank was still very solvent. However Wall Street reacted as if Wells Fargo were about to go bankrupt. What did that reaction bring about? The bank's shares drastically dropped from $86 to nearly $40.
The following example differs from the other two in that the downtrend in stock price was not caused by an external event but by a weird action carried out by the company itself:
· GEICO, one of the companies where Buffett saw a chance and purchased positions, highly benefited insuring preferred drivers by carrying out low-cost operations and operating via direct mail rather through agents between 1936 and 1970. However, in early 1970 management changed as well as the way they did business. The company decided to start selling insurance to just about anyone who knocked on their door and see if they could increase their earnings. What they considered a chance of growth turned out to be a problem because they accepted drivers who were susceptible to having accidents. More accidents meant more money. In 1975 it reported a net loss of $126 million, which placed it on the brink of insolvency. GEICO appointed a new chairman who asked Warren to invest in the company. Warren also wanted to know if they were returning to the old way of insuring. And they did. Warren purchased an important position when things were not so good and was able to make a difference when they returned to the old format.
You are probably asking yourself what is the point of all this. The point my dear reader is to let you understand that downtrends or volatility in the stock price caused by a recession (as in the case of the examples) or by any other rare event are great opportunities for investors who plan in the long term, just like Buffett does.
If you identify a company with a solid management or a consumer monopoly or both, and the economic situation for them is not good, you have to purchase a position in them. With those two features it is likely that the company will survive a recession and probably come out in a better position. You would have bought shares at a much cheaper price than the shares of other companies and the pretax compounding rate of return will end up being high.
