be “Fearful when others are greedy and greedy when others are fearful.” This
statement is somewhat of a contrarian view on stock markets and relates
directly to the price of an asset: when others are greedy, prices typically
boil over, and one should be cautious lest they overpay for an asset that
subsequently leads to anaemic returns. When others are fearful, it may present
a good value buying opportunity.
Keep in mind, the price is what you pay and value is what
you get, pay too high a price and returns are decimated. To elaborate on this,
the value of a stock is relative to the amount of earnings it will generate
over the life of its business. In particular, this value is determined by
discounting all future cash flows back to a present value, or an intrinsic
value. Pay too high a price and the return that arises as a stock gravitates
back to its intrinsic value over time will erode. Act greedy when others are
fearful and reap enhanced returns, under the right set of circumstances:
predictability must be present and short term events that create the subsequent
downgrade in prices must not be “moat” eroding.
Cigar Butts and
Coca-Cola
Warren Buffett is not just a contrarian investor. He may be what you might
call a “business-oriented value investor.” Meaning, he does not purchase any
and everything just because it is on sale. That was Ben Graham’s style (and
initially Buffett’s). It is called the “cigar-butt” style of investing in which
one picks up discarded business cigar butts laying on the side of the road,
selling them at deep discounts to book value with one good puff left in them.
Ben Graham looked for “net-nets” or businesses priced below their net current
assets or current assets minus total liabilities.
Although Warren Buffett began his investing career this way,
in the face of anaemic net-net opportunities, he evolved. With the help of
Charlie Munger, he discovered the land of outstanding businesses, the home of
See’s Candy and Coca-Cola (KO), businesses with durable, competitive economics
– the moat – and rational, honest management. He then looks for a good price
and takes advantage of opportunities when others are fearful. As he has said in
the past, it is much better to buy a wonderful business at a good price than a
good business at a wonderful price.
Salad Oil: Don’t
Leave Home Without It
The fear-inducing events that lead to superior investment opportunities can
include short-term shock waves created by macroeconomic events such as
recessions, wars, sector apathy, or short-term, non-moat damaging business
results.
In the 1960s, the value of American Express (AXP) was cut in
half when it was discovered that the collateral it had used to secure millions
of dollars of warehouse receipts did not exist. The collateral in question was
salad oil and it turns out that commodities trader Anthony De Angelis had faked
the inventory levels by filling his tankers with water while leaving small
tubes of salad oil within the tanks for the auditors to find. It is estimated
that the event cost AXP in excess of $50 million in losses.
After reviewing the company’s business model, Buffett
decided that the company’s moat would not be materially impacted by the event,
and he subsequently invested 40% of his partnership’s money in the stock. Over
the course of five years, AXP increased by five-fold.
The Gecko
In 1976, GEICO was teetering on the edge of bankruptcy due in part to a
business model shift in which it extended car insurance policies to risky
drivers. With assurances from the then company CEO John J. Byrne that the
company would revert to its original business model, Buffett invested an
initial sum of $4.1 million in the company, which grew to over $30 million in
five years. GEICO is now a wholly owned subsidiary of Berkshire Hathaway
(BRKB).
Shock-waves such as salad-oil scandal and business model drifts create value and have allowed Warren Buffett to reap substantial returns over the years. To be greedy when others are fearful is a valuable mindset that can reap substantial rewards for the investor.
In Summary
Once the shoeshine boy starts giving out stock tips, then it is time to leave the party. Charlie Munger once likened a frothy stock market to a New Year’s Eve party that has gone on long enough. The bubbly is flowing, everyone is enjoying themselves, the clocks have no arms on them. No one has a clue that it is time to leave, nor do they want to. How about just one more drink? As a business-value investor, it is imperative to know when it is time to leave and to be prepared for that perfect opportunity, to be greedy when others are fearful, yet to be greedy for an investment with long-term durable economics and rational, honest management.
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