The second kind of situation that presents a buying opportunity is an industry-wide recession. In this case an entire industry suffers a financial setback. These situations vary in their intensity and depth. An industry recession can lead to serious losses or it can mean nothing more than mild reduction in per share earnings. Recovery time from this type of situation can be considerable, one to four years, but it does present excellent buying opportunities. In severe examples, a business may even end up in bankruptcy. Don't be fooled by too cheap a selling price. Stay with a well-capitalized leader, one that was very profitable before the recession.
Capital Cities/ABC Inc. fell victim to this weird manic-depressive stock market behaviour in 1990. Because of a business recession, avertising revenues started to drop, and Capital Cities reported that its net profit for 1990 would be approximately the same as in 1989. The stock market, used to Capital Cities growing its per share earnings at approximately 27% a year, reacted violently to this news and in the space of six months drove the price of its stock down from $63.30 a share to $38 a share. Thus, Capital Cities lost 40% of its per share price, all because it projected that things were going to be the same as they were last year. (In 1995, Capital Cities and the Walt Disney Company agreed to merge. This caused the market-revalued Capital Cities to upward of $125 a share. If you bought it in 1990 for $38 a share and sold it in 1995 for $125 a share, your pretax annual compounding rate of return would be approximately 26%, with a per share profit of $87.)
Warren Buffett used the banking industry recession in 1990 as the impetus for investing in Wells Fargo, an investment that brought him enormous rewards. Remember, in an industry-wide recession, everyone gets hurt. But the strong survive and the weak are removed from the economic landscape. Wells Fargo is one of the most conservative, well run, and financially strong of the key money center banks on the West Coast, and the seventh-largest bank in the nation.
Wells Fargo, in 1990 and 1991, responding to a nationwide recession in the real estate market, set aside for potential loan losses a little over $1.3 billion, or approximately $25 a share of its $55 a share in net worth. When a bank sets aside funds for potential losses it is merely designating part of its net worth as a reserve for potential future losses. It doesn't mean that losses have happened, nor does it mean they will happen. What it means is that there is potential for the losses to occur and that the bank is prepared to meet them.
This means that if Well Fargo lost every penny it had set aside for potential losses, $25 a share, it would still have $28 a share left in net worth. Losses did eventually occur, but they weren't as bad as Well Fargo prepared for. In 1991, they wiped out most of Wells Fargo's earnings. But the bank was still very solvent and still reported in 1991 a small net profit of $21 million, or $0.04 a share.
Wall Street reacted as if Wells Fargo was a regional savings and loan on the brink of insolvency, and in the space of four months hammered Wells Fargo's stock price from $86 a share to $41.30 a share. Wells Fargo lost 52% of its per share market price because it essentially was not going to make any money in 1991. Warren Buffett responded by buying 10% of the company - or 5 million shares - for an average price of $57.80 a share.
What Warren Buffett saw in Wells Fargo was one of the best managed and profitable money-center banks in the country, selling in the stock market for a price that was considerably less than what comparable banks were selling for in the private market. Although all banks compete with each other, as we said, money-center banks like Wells Fargo have a kind of toll brideg monopoly on financial transactions. If you are going to function in society, be it as an individual, a mom and pop business, or a billion-dollar corporation, you need a bank account, a business loan, a car loan, or a mortgage. And with every bank account, business loan, car loan, or mortgage comes the banker charging you fees for the myriad services he provides. California, by the way, has a lot of people, thousands of businesses, and a lot of small and medium size banks, and Wells Fargo is there to serve them all - for a fee.
The loan losses that Well Fargo anticipated never reached the magnitude expected, and nine years later, in 2000, if you wanted to buy a share of Wells Fargo you would have to have paid approximately $270 a share. Warren Buffett ended up with a pretax annual compounding rate of return of approximately 18.6% on his 1991 invetment. For Warren Buffett there is no business like the banking business.
In the cases of both Capital Cities and Wells Fargo, there was a dramatic drop in their share prices because of an industry-wide recession, which created the opportunity for Warren Buffett to make serious investments at bargain prices.
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