The Salad Oil Swindle

What’s a stock investor to do during the "greatest bear market in a generation"? Do as Buffett would do, writes Extreme Value’s Dan Ferris…and keep an eye on the "equity risk premium".

The Salad Oil King finally got caught in November of 1963, and was led from his two-story red brick home in the Bronx to face criminal charges in Newark.

Never heard of the Salad Oil King? I don’t doubt it.

Still, the fall-out from this relatively obscure episode in U.S. financial history leads directly to one of the greatest investing fortunes the world has ever seen. And the lessons you can pull from it are essential to posting returns when the most difficult bear market in a generation resumes.

Here’s what happened. Anthony DeAngelis, a former New Jersey meatpacker, ran a company called Allied Crude Vegetable Oil Refining. Allied regularly delivered shipments of vegetable oil to large vats in a warehouse in Bayonne, New Jersey. For each shipment, warehouse receipts were issued, indicating the amount of oil that had been stored.

By November 1963, DeAngelis was holding warehouse receipts legally verifying the existence of $60 million worth of salad oil. Allied used the warehouse receipts as collateral for $175 million in loans. DeAngelis used the loans to speculate on vegetable oil futures in the commodities market.

In 1962, when vegetable oil prices plunged, DeAngelis didn’t get at all what he expected. Rather, he got what he deserved: he lost the money he’d borrowed, and Allied went bankrupt. His loans reverted to the company that issued the receipts – American Express – which now found itself the proud owner of a warehouse full of vegetable oil.

American Express quickly discovered that the oil tanks contained mostly seawater. It was later found that DeAngelis had his henchmen follow an auditing team through the confusing, labyrinthine rows of oil tanks. His men changed the numbers on the tanks that did contain oil, so the auditors would count the same oil twice. In other tanks, DeAngelis put enough oil to float on top of the seawater. Anyone looking in from the top would be fooled.

In the wake of the scandal, American Express’s stock fell 45%, from $60 a share down to $35 a share by early 1964.

Warren Buffett: American Express

At that time, Warren Buffett was running a small investment partnership he’d started 8 years before with $105,000 he’d raised from friends and family. As Buffet’s mentor, the original value investor, Benjamin Graham, was watching with great interest as the Salad Oil Swindle unfolded. Buffett researched the situation, bought shares, and even testified on behalf of American Express management, which had remained honest and forthright throughout the ordeal.

Buffett put 40% of his available capital into American Express, buying 5% of its stock. Two years later, he was sitting on a $20 million profit.

Buffett made similar coups buying GEICO, the insurance company, which had run itself to the brink of insolvency by insuring any and all drivers. Today, he owns the entire company. Shortly after October 19, 1987, the single worst day in stock market history, Buffett bought Coca-Cola. In the late 1990s, when people talked as though California real estate was going permanently out of style, Buffett bought shares in Wells Fargo bank. He also bought American Express shares again, and still holds all four of these stocks today.

Buffett has bought businesses on the brink of bankruptcy, including Berkshire Hathaway, Inc., the beleaguered textile maker that became the holding company he runs today. He bought bankrupt Fruit of the Loom in 2001 for $835 million. By running his company as though it were a value-oriented mutual fund, and investing in valuable businesses and assets when no one else wanted to buy them, Warren Buffett has turned every $10,000 invested in 1965 into $14 million today.

Warren Buffett: Buffett’s Strategy

Unfortunately, it’s too late in Buffett’s career for us to expect to ride along with him and make a fortune. Buffett himself admits that his company is currently overpriced!

But Buffett’s strategy – buying beleagured-yet- fundamentally sound companies at depressed prices – still holds inveterate lessons for the investor with a would-be growing net worth.

In a study of price to book value ratios from 1963-1990, researchers Eugene Fama and Ken French found that the cheapest 10% of the market garnered the highest return with the least amount of risk. The safest, cheapest and most profitable stocks, they found, are one and the same. And among these, those stocks with a sound business behind them – the ones Buffett sought after – are the stocks to concentrate on.

This is all well and good…but what about the economic environment surrounding stocks? For example, during the greatest bear market in a generation? How much of a stock’s price reflects the machinations of the company that owns it…and how is due to the greater market forces that be? Therein lies the rub.

The academic-turned-$5-billion-hedge-fund-manager Cliff Asness expressed doubts about current future returns for most stocks. Both French and Asness watch a number called the "equity risk premium."

Warren Buffett: The Risk Premium

Says French, "If anything exercises a gravitational pull on stocks, it’s the risk premium."

The risk premium is the extra return investors require to justify an investment in stocks, leaving behind the (perceived) safety of bonds. The equity risk premium is roughly equal to the expected total return on stocks minus the yield on bonds.

Asness calculates about 6.5% expected growth in the S&P 500. Using my own method of simply adding the S&P 500’s earnings yield (4.3%) to its current dividend yield (2.2%), I get the same number, 6.5%. Technically, that’s what you can expect to make from most stocks over the next several years.

Subtracting the 10-year Treasury bond yield of 4.3% from the expected return on the S&P 500, we get: 6.5% – 4.3% = 2.2%. That’s the risk premium right now, 2.2%. You can expect to collect 2.2% more on your stock portfolio than you would on 10-year Treasury bonds bought today and held.

The risk premium was zero just before the 1929 crash, meaning there was zero benefit for risking money in stocks…possibly the greatest understatement of that entire century.

Warren Buffett: The Horns of a Dilemma

By contrast, in 1972, the risk premium was 3%. From 1970- 1979, stocks hardly budged, while the dollar lost 28% of its purchasing power. The risk premium was negative in early 2000…and we know what followed after.

Following the meticulously researched common sense of Mssrs. Fama, French and Asness, an intelligent investor finds him/herself on the horns of a dilemma. The bond bubble is finally bursting. Stocks are either on their way to the formation of another bubble, or they’re about to fall.

But the dismal outlook for stocks is not necessarily a time to despair. Rather, it’s an ideal time to be an investor in search of stocks trading at extreme lows in price. Stocks are easier to ignore when they’re so expensive.

If you follow Buffet’s lead and investigate the cheapest stocks in the market, you can reasonably expect to earn the safest and highest returns. The superior returns available from buying cheap stocks exist whether the broad indexes are overvalued or not.

Regards,

Dan Ferris
For the Daily Reckoning

August 19, 2003

Dan Ferris is the Editor of Extreme Value, an investment advisory service that uncovers the safest, cheapest stocks in the market. Dan has recently published an 80-page analysis on his latest discovery – a way to own some of the most valuable real estate in the world, at a 99% discount, through a handful of companies listed on the NYSE.

Today, we stand back and ask ourselves:

Are we completely wrong?

We have asked the same question each year for the last 4 years.

For each year, we think we see the End-of-the-World coming. And each year, about this time of year, we find ourselves still in the middle of it.

One by one, nearly every conceit of the New Era has been demolished. The Peace Dividend, the Federal Surplus, the Magic of Technology, the End of Business Cycle, the Elimination of Bear Markets and so on.

All that remains is the Productivity Miracle and an apparently unshakeable faith in American capitalism. In the minds of most economists and investors, a recovery is always just ahead…and stocks are always going up. And the bubbles continue.

Yesterday, the Dow hit a new high for the year. Economists raised their estimates for GDP growth. And home prices hit new records. We can almost hear the cheerful chorus of lumpeninvestoriat: If this is the end of the world, let’s have more of it!

And yet, we grumps have no reason to complain, either. Our gold is up 40% since April of 2001. And we’ve lost nothing in stocks.

Will these sunny days of late summer ever end, dear reader?

If we just look at the day’s weather, we might think nothing else. Even looking at the trend for the last 6 months, we see nothing to contradict it. But we know from experience that in the complete cycle of the seasons is bad weather as well as good. Likewise, we know from history – if not from personal experience – that no bubble lasts forever…no paper money ever survives…and there is no boom that is not followed by a bust.

We are not guessing about the end of the Dollar Standard boom. It has lasted for more than 3 decades. But its end will come, as sure as death, and bring the End-of-the-World as we have known it. We are only guessing about when. Today, it looks as though the Fed has done the trick; it has succeeded in pumping up yet more bubbles…and keeping the system alive. Another summer seems to be passing with no End-of-the-World in sight.

But each year, it gets later in the Dollar Standard season. Even the major media is beginning to see it:

"We Americans are buying vast amounts of foreign-made pots and pans, cars, CD and DVD players, bicycles, clocks, umbrellas, socks and shoes," writes Paul Samuelson in Newsweek. "In 1996, the United States imported $1.31 of goods for every $1 it exported; now, the import figure is approaching $2 (it’s $1.79 so far in 2003)."

Samuelson goes on to estimate that the U.S. trade deficit must continue to grow by $50 to $100 billion per year in order to keep the world trade system in business. This, he reckons, is unlikely…maybe impossible.

And so, the biggest bubble of all – the Dollar Bubble – will blow up, too, eventually. We came early enough to get a front-row seat. For the last 4 years, we have been munching our popcorn waiting for the climactic scene.

That it will come, we have no doubt. That it will come soon, we have plenty of doubts. In the meantime, we are afraid even to get up to go to the bathroom – for fear we might miss it.

And now, over to Eric…

————-

Eric Fry in the Big Apple…

– The U.S. stock market is as indomitable as the American Spirit itself. Sure, it suffers a setback now and again, or even a major defeat from time to time. But it always battles back, to the shame and chagrin of naysayers and doomsdayers.

– Yesterday, our hero soared to fresh one-year highs, as the Dow climbed 91 points to 9,412 and the Nasdaq surged 2.2% to 1,739. In the currency market, the dollar soared one percent versus the euro to reach $1.11, a three-month high for the resurgent greenback.

– Technology stocks led the charge on Wall Street yesterday, thanks to cheery remarks from research firm Gartner, predicting stronger information technology spending in the second half of the year and beyond. The University of Michigan joined the cavalcade of positive prognostications by revealing that its annual economic forecast anticipates "robust growth" in the second half of 2003 and throughout 2004. Specifically, the University expects GDP to increase 4% in the second half of 2003 and 4.5% next year.

– Adding to the economic "high fives," Lowes and Home Depot both posted better-than-expected earnings results, in the process demonstrating that Americans still possess a Nietzsche-esque Will to Spend. Mortgage refinancings and job growth be damned! Americans will spend without the help of these allies. The Home-Depot-shopping American consumers will not be denied their Weber grills, Whirlpool air conditioners and Henckels kitchen knives.

– For the moment, Greenspan emerges the heroic economist once again. The bond market may be smoldering somewhere on a sacrificial alter, but isn’t that a small price to pay for the salvation of American consumption?

– "It has now reached the point," says the Prudent Bear’s Doug Noland, "where we can recognize the Fed’s latest reliquification as having orchestrated one more fateful Boom – The Post-Boom Boom…Note the following: record July sales for Lexus (up 16% y-o-y), the third-best month on record for Acura, BMW sales up 16% y-o-y, Mercedes up 26%, Infinity up 38% and Porsche up 9%. Surging luxury auto sales provide evidence that a large number of individuals are enjoying Boom-time conditions. Furthermore…we are in the midst of extraordinary home sales. Existing home sales are set for new records over the next month or two, with average prices already having surged to a new record ($224,900)."

– Yessiree, the Post-Boom Boom is well underway. And it is almost as much fun as the original Boom…except for bond investors.

– While in San Francisco last week, your New York editor refrained from putting flowers in his hair (what’s left of it), but he did not hesitate to "share the love" with his fellow bond bears. "What a long, strange trip it’s been," the bond bears said to one another, recalling the 22-year bull market in bonds that – perhaps – has ended. But now it’s time for yields to get high…really high, the bond bears believe.

– "The bull market was born in 1981 when the bond market was in tatters," the Santa Cruz County Sentinel relates. "Bond investors, who thought rates of 8 percent looked attractive in 1978 were sitting on losses of 40 to 50 percent. Although inflation peaked at 13.5 percent in 1980 and had declined to 10.5 percent in 1981, the bond market remained spooked by predictions of 20 percent interest rates. Business Week magazine proclaimed the death of bonds. As a result, the benchmark 30-year Treasury bond issued in November 1981 sported a record high 14 percent coupon. Investors brave enough to purchase bonds during those dark days were handsomely rewarded. The 14 percent treasuries of 2011 are still outstanding and trade at a 36 percent premium to face value. Before taking compound returns into effect, this represents a return of 15.4 percent per year in cash and appreciation. This is a cumulative total return of 1,336 percent."

– We cannot say for certain, of course, but we’d guess that today’s buyers of 30-year bonds – yielding all of 5.35% – won’t be relishing 1,300% returns 22 years from now.

– "Contrast the dark days of 1981 with the situation a few short weeks ago," the Sentinel continues. "Ten-year Treasury bonds were yielding about 3 percent. Thirty-year Treasuries were paying just higher than 4 percent…Signs of a speculative peak were everywhere. Mutual fund investors, who poured record amounts into stock funds around the time of the 2000 peak, were shoveling record amounts into bond funds. The leading mutual fund of the day was the Pimco Total Return bond fund."

– Prediction: the Pimco Total Return bond fund will not be the leading mutual fund in 2025.

————-

Bill Bonner, back in Ouzilly…

*** Insiders are selling heavily, reports the Wall Street Journal. In July, they sold more than $32 worth of stock for every dollar’s worth they bought. You should sell, too, dear reader.

*** Half of all manufactured goods sold in the U.S. now come from overseas.

*** Italy is in recession. Germany is in recession. So is the Netherlands. The euro is down to $1.11. Buy it.

*** Gold lost $4.80 yesterday. It is below $360. We hope it falls below $350 – so we can buy more.

*** Personal bankruptcies continue to soar, says an Associated Press headline. Meanwhile, Chrysler is offering 72-month 0% financing if you want to buy their cars.

*** Record worldwide indebtedness…the trade deficit…the Japanese bubble…the Asian Crisis…bubbles in mortgage refinancing, bonds and real estate…in the U.S….the rapid rise of China as a manufacturing center…all of these things can be traced to a single event that occurred in August of 1971. President Richard Nixon set in motion a series of booms and busts…and the biggest of them is still ahead…

*** More vile bodies: It has been a good few days for obituaries. Several brought a smile to our face. First, the adorable Diana Mitford Mosley expired in Paris…and now, from Saudi Arabia comes news that another admirer of Adolf Hitler has joined him in his morbid redoubt.

The Dark Continent must have twinkled a little on Sunday when news came of the death of Idi Amin. The man was the kind of the dictator the world could hate without feeling unkind. He was mad, of course, in a buffoonish kind of way. He chased Uganda’s Asian residents out of the country, and then distributed their property to his favorites. And then the big, black fat man made white residents of Kampala carry him around on a throne and kneel before him while photographers captured the scene for the papers.

Unlike Diana Mosley, Amin’s hands were caked in blood. Murder, torture, rape, mutilation, theft – he did it all. When Amin told his henchmen to "give him the VIP treatment," it meant that they were supposed to kill the person. "Giving tea," meant the subject was to be whipped and dismembered.

If there were swifter justice in this life, Amin would have been given the VIP treatment long ago. But we are optimists here at the Daily Reckoning. Perhaps now, the big man will be ‘given tea’ every day…and roast forever in some especially hot corner of Hell.

At least, we hope so.