An 11-year old boy bought 6 shares of Cities Service (an oil company now known as CITGO) at $38 per share. Soon after, the stock price began to fall and dipped to $27. When it finally recovered to $40, he exited the stock. The story does not end there. The stock price went up to $200 over the next 24 months. The young lad could not benefit from this rise. His impatience to get out of the stock too quickly turned out to be a costly lesson.
That was Warren Buffett’s first experience at stock picking. And one which taught him an invaluable principle - that patience is the cornerstone of value investing. Holding on to a stock when the market is punishing it may be painful, but worth it in the end.
(“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant”.)
Now the poster boy for value investing, his pronouncements electrify faithful adherents of the value philosophy. He once said that “most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” He practiced this principle time and time again. An early investment which lucidly explains how he extracts value from companies which are out of favour is his bet on American Express.
In 1963, the company's shares were clobbered due to its involvement with Allied Crude Vegetable Oil which was owned by small-time businessman Tino De Angelis. He would borrow money from a bank via a line of credit, buy shiploads of vegetable oil and store it in container ships, sell the oil and then pay back the line of credit. The oil in the tanks was inspected regularly and pledged as collateral for the line of credit. Amex provided credit to the company based upon the inventory of the company’s soybean-based salad oil. The inventory was kept on container ships thought to be full of salad oil. De Angelis ingeniously thought of a way to outsmart the banks. He would fill the containers with water and had only a few feet of salad oil on top. Since the oil floated on top of the water, it appeared to inspectors that these ships were loaded with oil. Meanwhile, De Angelis used this as collateral for taking more credit.
In Trade like Warren Buffett, James Altucher claims that De Angelis obtained $175 million in financing on the basis of $60 million worth of vegetable oil as collateral. He used the money to speculate on vegetable oil futures (where he eventually lost all the money). In 1963, the entire operation blew up when it was discovered that the company could not account for the absence of more than $175 million in salad oil.
When Amex did an audit to recover their collateral, they discovered that instead of $60 million worth of oil, there was just $6 million. A cruel reality check! This con job, dubbed as the “Salad Oil Scandal”, resulted in Amex losing nearly $58 million wiping out most of its equity base as its shares went into a free fall. Though Amex instantly made good on the hundreds of millions of dollars in potential liabilities, there were fears that the company would go bankrupt. Investors panicked.
Enter 33-year old Buffet.
- He was impressed by Amex's instant response to the losses, taking the hit and indemnifying many of the third-party victims.
- He also saw that Amex’s competitive advantage and cash-flow generating capabilities were intact and believed that fears over the eventual liability were overblown.
- Most importantly, he recognised that this scandal had nothing to do with Amex's core businesses - credit cards and travellers cheques, in which the company was a distinct market leader with excellent brand recognition. Before arriving at this conclusion, he spent an evening with the cashier at Ross's Steak House in Omaha. He noted that the scandal did not stop people from using their green cards. Amex's intangible qualities (trust and reliability) were intact.
Based on his inference that the Amex brand was still strong along with the underlying business, and the scandal was just a one-time hit against earnings, he began picking up Amex shares which had dropped from $60 to $35 over 60 days. As Wall Street bailed for the exits, he bet 40% of his investment partnership’s capital on Amex. According to Fortune, he bought 5% of the company for $13 million and reaped millions by way of profits.
(“Be fearful when others are greedy and greedy when others are fearful”).
Though he never vocalised it at that time, he believed in Amex’s moat, a term he often used after collaborating with Charlie Munger. When looking at companies, he looks for “economic castles protected by unbreachable moats”. The castle being a metaphor for a company, and the moat being a durable competitive advantage it possesses. Assessing that advantage involves understanding what kind of defense, or competitive barrier, the company has been able to build for itself in its industry, which could take various forms such as being a low-cost producer or owning a world-wide brand or in possession of a patent.
