Chapter Nine
Things That Go Bump in the Market
Falling prices can be a
double-edged sword.
WHEN CHILDREN HEAR STRANGE NOISES in the night, they tend to imagine all sorts of scary things—ghosts, monsters, and frightening creatures lurking under the cloak of darkness. Bumps in the night send children running down the hall in search of the comfort of their parents’ bedroom. The monsters may be imaginary, but they seem all too real to a child. The child’s fears are not rational and the panicky flight down the hall is a gross overreaction. Amazingly enough, adult investors, both individuals and so-called professionals, act the same way when things go bump in the market. We have seen markets fall time and again because of some political or economic announcement. Likewise, individual stocks and sectors often fall on weaker than expected earnings or unforeseen events. As prices fall, at exactly the time investors should be sharpening their pencils to select stocks to buy at lower prices, they join the panic and run down the hall for the unreasonable security of a cash position. Risk is more often in the price you pay than the stock itself.
I have seen many market sell-offs over the span of my career, including major declines such as the 1972 to 1974 bear market caused by higher oil prices and a stagflated economy, the crash of 1987, the minicrash of 1989 and the high-yield bond debacle that followed, the Asian flu culminating in a brief panic in the United States in 1998, and the 2001 to 2002 market implosion. In each case, the rapid decline of prices brought bargain issues that an investor could buy for a lot less than their precollapse price. As others around you are selling in reaction to news reports, you can load up the shelves of your store with value opportunities that can benefit from the subsequent price recoveries. It is important to understand that the prices of solid companies with strong balance sheets and earnings usually recover. In my experience, if the fundamentals are sound, they always have and they always will.
As with the other characteristics that are sources of value opportunities for the shelves of our store, there has been an enormous amount of research into the results achieved by buying markets, stocks, countries, and sectors that have gone bump in the night. From 1932 to nearly the present, the studies confirm that when bad things happen to good companies, they recover—and usually quite nicely in a reasonable amount of time. It has also been shown that high performance seems to beget lower returns, and low performance leads to higher returns in nearly all markets from the United States and Canada to Japan and Europe (see “Don’t Take My Word for It”). Today’s worst stocks become tomorrow’s best stocks, and the darlings of the day turn into tomorrow’s spinsters.
There is danger in trying to catch a falling knife, as the saying goes on Wall Street, but even when stocks dropped 60 percent in one year, and bankruptcy and failure rates jumped fourfold, opportunities abounded. Remember that one of the chief tenets of the value investing approach is to always maintain a margin of safety. You can lessen the chances of buying a failure and increase your portfolio performance if you stick to the principle of margin of safety. Don’t try to catch an overpriced, cheaply made falling knife.
The studies, by esteemed scholars and secretaries of the U.S. Treasury, are consistent with my experiences in the investment business. On the one hand, when stock prices fell on average some 60 percent after the bear market of 1973 to 1975 and the former market darlings—the Nifty Fifty as they were called—had collapsed even further, many investors were decimated. Warren Buffett, on the other hand, was thrilled with all the bargains he found as a result of the collapse. In an interview with Forbes in the November 1, 1974, issue, he described himself as feeling like an “oversexed guy in a harem” and finished the interview by saying that now was the time to invest in stocks and get rich. The average investor and many professionals, having suffered through a bear market, wanted nothing to do with stocks and missed out on the chance to load up on inventory at the lowest prices in 20 years.
During the 1980s, I saw some of the large public utilities overcommit to nuclear power with disastrous financial results. Some of the largest electric utility companies in the United States fell into financial difficulty. Many of them even had to file for bankruptcy to work out their difficulties. After the Three Mile Island accident, world interest in U.S. nuclear power practically ground to a halt. Few portfolio managers or individuals wanted to invest in these companies. But those brave few who invested in concerns like Public Service New Hampshire, Gulf States Utilities, and New Mexico Power ended up with enormous returns over the balance of the decade as the companies worked out their problems and returned to profitability.
In the late 1980s and early 1990s, the fall of Drexel Burnham, the junk bond powerhouse, and the implosion of the high-yield debt market, along with collapsing real estate prices, caused what is now known as the savings and loans crisis. This crisis spread from the smaller S&Ls to the largest banks in the country. Venerable institutions such as Bank of America and Chase Manhattan Bank fell to prices at or below their book value and had price-to-earnings ratios in the single digits. Wells Fargo was hit particularly hard because it appeared to have significant exposure to a rapidly declining California real estate market. Investors who did their homework and invested in banks during this time earned enormous returns over the decade that followed as the industry went though a merger boom that generously rewarded shareholders. You just had to catch the babies being thrown out with the bathwater.
After Bill Clinton took office in 1992, he appointed his wife Hillary to head a committee on health care reform that proposed a drastic program that would have dramatically curtailed the profits of the pharmaceutical industry. All the leading drug company stocks declined sharply. Companies like Johnson & Johnson, which not only makes prescription drugs but also consumer products such as Band-Aids and Tylenol, fell to a level of just 12 times earnings. Most investors shied away from the industry. Investors who saw the opportunity in Johnson & Johnson realized that the stock was selling for the equivalent value of the consumer products side of the business. You got the prescription pharmaceutical part of J&J for free. Once Hillary care was a dead issue, the stock of J&J and the other pharmaceutical companies brought outsized gains to investors willing to take the plunge.
American Express is another example of how catching the right falling knife can sharpen returns with high-quality inventory at low prices. After the disaster of 9/11, the company was viewed as being too dependent on air travel, and its shares fell from the previous year’s high of $55 to as low as $25. While travel is a big part of its business, an astute investor realized that the American Express card is also used at gas stations, supermarkets, and even Wal-Mart. Prior to the events of September 11, card issuance had been rising, and the company had undertaken significant cost-cutting measures. Although American Express may have been facing some travel-related struggles, it was an enormously profitable company that sold at just 12 times earnings. Investors who realized that companies of this quality are rarely this cheap and that the income stream from the credit card business offered a margin of safety have been amply rewarded in the years since.
In the halls of academia, under the eyeshades of researchers, and in the rough-and-tumble world of Wall Street, buying stocks that have fallen in price and yet still offer a margin of safety has resulted in successful investments. Although the public at large and most institutional portfolio managers find it difficult to leave their comfort zone and buy stocks that have fallen, those of us buying cheap inventory realize that the bargains are found in the sales flyers and the new low lists, not in highfliers and $12 per pound Delmonico steaks.
