Thursday, May 24, 2012

Stay cool: learn from the master


In 1963, American Express, the world's largest credit-card company, was involved in a huge financial scandal. The company, previously synonymous with integrity and trust, became wrapped up in a $175 million fraud.

As news of the scandal broke, the company's share price halved. Investors were caught up in a huge panic that, they believed, threatened the company.

After wearing out some shoe leather, an unknown 33-year-old fund manager came to the opposite view. Warren Buffett poured most of his cash into this single stock and made a killing.

Although Amex had a well-known banking division, the majority of its profits came from its traveller's cheque and credit-card divisions.

Nobody paid much attention to a fourth subsidiary - warehousing operations - that assessed the value of a company's inventories. The certificates issued could then be used as bank collateral.

The scam was based on a simple fact: when salad oil was poured on water, it rose to the top and formed a film. By filling tanks with water then adding a little salad oil, Anthony de Angelis, a commodities trader, fooled Amex into thinking the value of what he owned was $175 million in soy-based oil rather than contaminated, worthless water.

De Angelis may have been a crook but he was not without ambition. Instead of making his way to Rio with a few million in the bank, he used the proceeds of the scam to buy soybean-oil futures, hoping to corner the market. Problems only began when a few inquisitive souls began to wonder how the oil supposedly stored in de Angelis's tanks contained more soybeans than the output of the entire industry.

In November 1963, de Angelis and his company, the Allied Crude Vegetable Oil Refining Corporation, filed for bankruptcy. Amex was now on the hook for millions. The stock plummeted but Buffett kept his cool and followed three simple processes from which all investors can learn.



Independent research is vital

Buffett reasoned that the cheque and credit-card businesses were worth enormous amounts of money before the scandal. So why should the actions of an unrelated entity change the value of the entire business after it?

Buffett set out to establish whether the scandal really would affect the entire business. ''The traveller's-cheque business had 60 per cent market share around the world, while selling cheques at a higher price than [the other] banks,'' Buffett explained. And the credit-card business was also a distinct market leader. It enjoyed the highest customer-retention rate and was able to raise prices every year.

After conducting his own research, Buffett noticed customers hadn't stopped using Amex products and, in all likelihood, the brand would survive unharmed.

Make uncertainty work

No one knew the size of the payout that Amex would have to make to settle the scandal, a nasty and uncertain fact that caused most investors to simply flee.

Buffett realised that regardless of the extent of the litigation payout, the size of the company's market share would be unchanged. ''I just took the attitude that they had declared a large dividend, sent it out and it had gotten lost in the mail,'' Buffett explained. ''Would that have caused panic - somebody else gets your dividend but you don't?''

American Express made money not from tangible accounting numbers, Buffett understood, but from intangible qualities, such as trust and reliability. And these would remain intact despite the scandal.

Uncertainty tends to cause most investors to sell first and ask questions later. Buffett knew that was how the opportunity arose.

The power of conviction

Buffett wrote to his investors and explained that stock pickers ''have to work extremely hard to find just a few attractive investment situations'', and because such opportunities are rare, why just nibble at them?

Buffett was no nibbler; he put 40 per cent of his partnership's assets into Amex because there was ''an extremely high probability that our facts and reasoning are correct, with a very low probability that anything could drastically change the underlying value of the investment''. His attitude paid off - within a year the stock price rose more than 40 per cent and compounded at high rates thereafter.

So-called efficient markets suffer from regular outbreaks of inefficiency. Over the past two years, News Corp, Cochlear, QBE Insurance and Cabcharge have all offered attractive investment opportunities due to temporary factors. Buffett's three simple rules show us how to take advantage of them.


Related Books

The Essays of Warren Buffett: Lessons for Corporate America, Second Edition

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor

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