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Christopher Browne: Finding the Silver Lining When Markets Dip

- By Robert Abbott

The Santa Claus for value investors is not a person, but a dip in the markets. It's what Christopher Browne called "things that go bump in the market" in chapter nine of "The Little Book of Value Investing."

He was referring to periods when the stock market, or one of its sectors, took a dip or deep dive and sent unprepared investors to the exits in a rush. He listed the most prominent of them:

  • 1972 to 1974 bear market.
  • Crash of 1987.
  • Minicrash of 1989.
  • Asian flu in 1998.
  • Dot-com bust of 2001-02.

Since the book was published in 2006, the 2008 financial crisis was not included in this list.

These pullbacks were precipitated by different drivers, but Browne wrote they had one thing in common:

"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."

He did not elaborate directly on the last sentence in the quotation, but it is worth noting his idea that your greatest risk is not in which stock you pick, but at what price you pay. There is a large community of stock-picking commentators recommending stock X over stock Y; just turn on a business channel or go to any high-profile business or investment site.

There are far fewer places where prices are considered as important, or more important, than the stock selected (this website, GuruFocus, is one of them). Browne has forcefully argued throughout his book that you must always buy with a strong margin of safety. Following Benjamin Graham, he recommended paying two-thirds or less of intrinsic value (defined as what a knowledgeable buyer would pay for the whole company at an open auction).

If you have done that, you have little to fear. The author wrote, "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." He added that studies dating back to 1932 show good companies always recover in a reasonable amount of time.

Further, Browne said the studies show that fortunes can reverse. The stocks that are the "darlings of the day" underperform in the future, while the worst stocks today become the darlings of tomorrow. He cited the situation of the 1973 to 1975 bear market, noting that the highly popular Nifty Fifty collapsed when the market dipped.

One investor who appreciated the opportunities afforded by that crisis was Warren Buffett (Trades, Portfolio) of Berkshire Hathaway (BRK-A)(BRK-B). He reported himself thrilled with all the bargains then available. Other professionals were licking their wounds; Buffett was trying to figure out which of the many bargains he would buy.

In the 1980s, several major electric utilities became pariahs after the nuclear accident at Three Mile Island, and some had to file for bankruptcy. Most investors couldn't get away fast enough. "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," Browne wrote. (Gulf State Utilities is now Entergy Texas (NYSE:EDT).)

The savings and loans crisis also began in the 1980s, after the collapse of Drexel Burnham, implosion of the high-yield debt market and lower real estate prices. While smaller lenders were the problem, it also affected big banks like Bank of America (BAC) and Chase Manhattan (now JPMorgan Chase (JPM)).

One of the hardest hit was Wells Fargo (WFC) because of its exposure to California real estate. But, the author wrote, "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."

Then, there were the great bargains in pharmaceuticals that emerged after Bill Clinton was elected president in 1992. When his health care reform proposals faded away, pharma stock prices shot up again. Browne observed that Johnson & Johnson (JNJ) was one of the stocks that was burned, despite also being a consumer products company.

He wrote, "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."

Shares of American Express (AXP) slumped after 9/11 because many investors thought the company depended too much on air travel. Browne pointed out the company also had a huge book of business at gas stations, supermarkets and more. Still, it was selling at just 12 times earnings and "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."

Browne concluded his paean to underpriced stocks this way: "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."

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.