UK: SELF INTEREST - EYE FOR THE BEST BUY. - Buying a stock when it is temporarily down may yield high returns, if you're Warren Buffett or Philip Fisher, that is. For the masses pickings may be more modest.

by Alistair Blair.
Last Updated: 31 Aug 2010

Buying a stock when it is temporarily down may yield high returns, if you're Warren Buffett or Philip Fisher, that is. For the masses pickings may be more modest.

Lots of stocks which fall out of orbit don't stop until they hit the ground. But not all. Think what just one of these would have done for you. Next shares were 12p in January 1991 - now they trade at £5.88. Airtours shares were listed at 27p in October 1990 and have risen to £6.73, while Perpetual stock has increased from 38p in October 1990 to £22.55.

Buying a stock when it has been laid low is a technique much exercised by experts. In 1964, young Warren Buffett figured out that in marking down American Express after its involvement in 'the salad oil scandal', Wall Street had not taken due account of the strong profitability of its card and travellers cheque businesses. For $13 million, he bought 5% of the company. Within five years, he had cashed that up into $65 million.

Even more spectacularly, as direct insurer GEICO teetered on the edge of collapse in 1976, Buffett started buying its shares at $2. They had come down from $60. Continuing to buy as it recovered, he eventually owned half of the company at a cost of $47million. Last year he bought the other half. That cost more: $2.3 billion.

Philip Fisher, another legendary stock-picker, was also well aware of the benefits of buying a stock when it is down. Fisher, whose investment career started before the Wall Street crash and continues to this day, is an expert in evaluating technology stocks. He spotted Texas Instruments in the 1950s and is said to hold the original shares still. Dow, Du Pont and IBM were other successful picks.

Fisher's eye has been on growth stocks. But it was not lost on him that they can look deterringly expensive in their early days. The conventional growth investor's answer to this problem is to ignore the expense. So it looks pricey. It won't be in the end. Even if it is, one good selection, returning ten-, twenty-or thirty-fold returns, will pay for several duds.

Long-term investment success, though, means considering the cost of every investment, no matter what its promise. To the great investor, expensive growth stocks don't offer the same value as cheap growth stocks.

Fisher's answer therefore was to buy the growth stocks he wanted as they tripped. In his admirable book, Common Stocks and Uncommon Profits, he describes the formula. 'As word gets out about a spectacular new product ... eager buyers bid up the price of that company's shares.' But it's an expensive, protracted and difficult road, he points out, to turn the prospectively spectacular product into actually spectacular profits. First there's the pilot plant - all expense. Then you have to get the commercial plant going - another round of costs and gremlins. Next follows expensive advertising, maybe a new sales 68e force. Working capital needs have to be funded. '... month after month difficulties crop up ... word spreads that the plant is in trouble ... down goes the price of the stock ...

word passes all through the financial community that the management has blundered. At this point the stock might well prove a sensational buy.'

If only it was that simple. Problem number one is getting in after the low, not before it. US broker Morgan Stanley put Next on its buy list in July 1990 when it was 40p. They and anybody else who shared their view would have needed unusual self-belief to have stuck with it as it halved - and then halved again (Morgan Stanley never wavered and indeed the firm's fund management side made huge returns by buying 10% of Next close to its low).

Self-belief is not sufficient, however. Problem number two is matching Buffett's or Fisher's skill in assessing the intrinsic value of a business, also known as an eye for a good investment. Many stocks fall. A fair fraction recover. But not many pull off a multiplication of their value. The ones most likely to do so are those of supreme quality. For Buffett, the attributes that put a business in this category are high returns on capital, the ability to grow profits without requiring corresponding capital and the possession of a strong franchise - enabling prices to be raised without losing sales to the competition. His classic example is a strong newspaper.

Perhaps, had he been based in the UK, he might have bought into Mirror Group (50p in late 1992, 230p today) but frankly, I'm dubious whether Next, Perpetual or Airtours would have been his bag. Buffett prefers businesses less dependent on the pure skill that it takes to succeed in selling clothes, unit trusts and holidays. Next and Airtours displayed few of the inbuilt advantages he likes, at least when they were at their lows, although Perpetual's ability to grow without needing capital would have appealed to him.

Right now, as at any other time, there are dozens of stocks that are temporarily depressed and will give their shareholders 100% or 300% returns. A few will deliver a 1000%. So not everyone's a Buffett - we knew that already. But there's still lots of fun to be had in trying to be.

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