Looking for Re-rating Stocks? Here's How to Spot Them

There are many interesting stories around the successful investments made by the legendary investor Warren Buffett.

One that remains my favorite is his investment in Amex in the early 1960s.

AmEx was a big beneficiary of the first wave of consumer credit that began in the 1960s. But it was the fall out of a scandal that led Buffett owning a meaningful stake in the company.

Here's what happened...

De Angelis, a former commodity broker, was the owner of Allied Crude Vegetable Oil company. The company used to avail loans using its oil inventory as collateral.

Amex, in those days had a field warehousing division that offered loans to businesses on this basis. Inspectors would check ships full of salad oil, issue Amex certified warehousing receipts, and millions of dollars would be released as loan to the company.

Now there is nothing wrong with availing loans based on such collateral.

But the inventory used as collateral was mostly water, with a layer of oil floating above it, just deep enough to pull wool over the eyes of the inspectors.

This went on for a good amount of time. One fine day, the whistle was blown. Only US$ 6 m of inventory was found against a claim of US$ 150 m of oil.

Of the many casualties of this big expose, Amex was one. The market was concerned that it would have to pay Allied's bill. Amex's stock fell 50%.

It was at that point that Warren Buffett smelled an opportunity. He bought 5% of AmEx for roughly US$ 20 m.

His logic was simple. The crisis and panic were short term in nature.

Buffett was highly keen on having a stake in the company's credit card and travelers checks business, a long-term trend, untouched by the salad oil scandal.

And a 50% correction was too good for him to ignore.

His Amex purchase was completed in 1995 for US$ 1.3 bn.

As shared in one of his annual letters, the annual dividends received from this investment have grown from US$ 41 m to US$ 302 m. Remember, his initial investment was US$ 20 m.

The last I checked, Warren Buffett owns 20.4% stake in Amex. It's worth 7.36% of Berkshire's portfolio, valued at US$ 24.5 bn.

This is a great example of second order thinking on Buffett's part. When the entire market was panicking about the oil scandal, he had the wisdom to look beyond short term pain, and the conviction to invest .

Howard Marks, in his book 'The Most Important Thing' captures it the best:

• First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in "The outlook for the company is favorable, meaning the stock will go up."

Second-level thinking is deep, complex, and convoluted. It's a way of seeing things the way most people don't and perform better because of it.

I believe that my latest recommendation on a food stock that earns most of its income from export markets is such an example.

You see, a lot has been written in investment books about how getting the industry right is critical to successful stock picking.

The niche that my latest recommendation belongs to is not perceived to be the 'right' industry.

It's a mature, commoditised, and cyclical industry, with little control over raw material or finished product price, leading to unpredictable margins.

The regulated nature of industry casts a shadow on raw material procurement price and exports.

The industry's history is full of companies that have gone bankrupt amid such challenges.

Let me now come to the reasons why we believe it's a strong contender for a re-rating.

Over four decades, it has not only survived but thrived. It has a resilient business model that some of the industry leaders lack.

To grow profitably and with a stronger balance sheet in such a tough industry is something to appreciate.

While the financials are comforting despite challenging industry dynamics, it's more important to dig into the reasons for such performance.

I think if I had to list one reason, it would be management's focus on survival and profitability, over revenue growth.

• "All I want to know is where I'm going to die, so I'll never go there." - Charlie Munger

It seems like the management takes this quote very seriously. It has avoided the temptation to go for a growth strategy that compromises survival. It sounds obvious but takes strong discipline, that even some market leaders lack.

The company has chosen to work on an asset light and debt light strategy. As such, it does not have to put up proportionate capacities for the volumes it sells. This helps it grow business without huge investment in capital.

As far as valuations go, the stock trades at a considerable discount to its peers.

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For more such investing insights, stay tuned.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)