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Crisis investing: Company blunders

This series has previously looked at the general principle of investing during a crisis, as well as how you might react to particular headline news events.

But crisis investing is also relevant to particular company stocks.

Companies are hit by media headlines proclaiming ‘crisis’ all the time, whether it’s a crisis in the boardroom, a crisis on the shop floor, or a crisis for the newspaper journalist who has space to fill and nothing better to write about.

A good company-specific crisis can present great opportunities for clear-eyed investors, particularly those of us managing our own money.

Unlike institutional managers, we don’t have to explain to pension funds why we’re holding a stock that “everyone knows” is in trouble because of the BBC headlines. Sometimes this can lead to big profits.

Investing in companies in crisis

A great example of crisis buying was Warren Buffett‘s classic purchase of American Express shares in 1963, as told in The Snowball, his recent biography (alternative US link).

American Express had been hit by a scandal involving one of its clients, and its share price quickly fell from $65 to $35.

But Buffett judged the crisis wouldn’t hurt American Express long-term, and that well-handled it could even boost its fortunes. Deciding the share was being priced irrationally, Buffett put 40% of his funds into the stock.

Buffett’s money tripled over the next two years.

On the other hand, the demise of many companies really does begin with a bad headline. Just consider Chrysler in 2009, or Northern Rock in 2007.

Clearly, the aim then is to distinguish between a true crisis and a bad-but-not-fatal blunder or even a PR mishap. The latter is where the profits lie.

What really kills companies?

In my experience, most companies are not felled overnight by crisis but rather lose their competitiveness or market share over a period of years.

While there are some one-off events that can cripple a company, the most dangerous kinds of crisis will be the fatal manifestation of a long-term deterioration.

Big profit warnings, anything to do with banking covenants or other kinds of threats to the company’s solvency, and substantial legal liabilities are all situations best avoided by crisis investors, as a general rule.

Mega-sized companies can ride out problems

It’s vital to consider scale when judging how badly a crisis will affect a company.

  • A loss of a key patent might cripple a small cap drug maker, but barely scratch a giant with lots of products.
  • On the other hand, a general court ruling in favour of generic drugs could threaten the earnings of even a big pharmaceutical company’s entire range, and so affect its profits and valuation for years to come.

Crisis in the boardroom

Management changes can be tricky to evaluate, whatever the size of the company.

Finance directors suddenly departing may indicate problems with the company’s books, and are often a warning sign of problems further down the line.

On the other hand, management might say lots of nice things publicly about a departing member of their directors’ club, but in reality be happy to see the back of a rubbish manager.

Succession is a fact of life at big companies, but smaller outfits can be crippled by the loss of key founders or other insiders. And even mighty Microsoft has suffered since Bill Gates stepped down, while Apple’s share price fluctuates wildly on news about Steve Jobs’ health.

You also have situations where new managers arrive to solve a crisis; look at the recovery of Marks and Spencers after Stuart Rose arrived.

Judge an incoming or outgoing manager’s importance to the future of a company in crisis correctly, and you could buy shares at bargain prices.

Don’t turn a blunder into a crisis

Very often what the newspapers call a crisis today is just wrapping up paper for the fish and chips tomorrow.

As a very general rule, anything involving a PR gaff but not making an obvious impact on revenues is worth investigating.

The talk in the papers may depress the share price, but the underlying business is probably little changed – and that’s a recipe for cheap shares.

There are always exceptions. When Gerard Ratner jokingly described his eponymous 2,500-store strong jewelry chain’s products as ‘total crap’ in 1991, the uproar caused a £500 million collapse in the company’s valuation and saw the Ratner name disappear from the high street.

But often, PR gaffs are patient investors’ friends. Anything involving the personal life of a director, for instance, is highly unlikely to matter long-term, whatever the papers say.

Even apparently monumental events can fade away from the newspapers and get lost in a successful company’s share price graph.

The Exxon Valdez disaster of 1989 saw one of Exxon’s tankers spill 10 million gallons of crude oil into pristine Alaskan waters, with devastating consequences for wildlife. The tanker was a news staple for years, and legal wranglings from fisherman are only now coming to a conclusion. Yet rightly or wrongly, Exxon’s share price is seven times higher.

Sticking with the oil majors, I bought Shell shares in 2004 on news of a ‘reserves scandal’ that focused on Shell overstating its reserves by 20%.

  • Shell shares plunged
  • The chief executives resigned
  • The company was restructured
  • It has also paid out or set aside hundreds of millions in fines and damages

Throughout I judged the amount of oil in the ground hadn’t really changed, even if its book value had. And oil was still in demand.

Even after a long bear market and the collapse of the commodity bubble, my holding is still worth 10% more today then when I bought during the crisis. In between I could have sold for big profits.

Such is the value of buying when investors over-react to what seems a disaster.

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