One of the unfortunate attributes of trying to invest in excellent companies is that the margin of safety is rarely priced in during times when everything is going well. When Coca-Cola (NYSE:KO) is announcing 8% dividend increases, growing earnings, and stealing market share from PepsiCo (NYSE:PEP), it's usually not the best time to buy Coke stock at a discount. When you see an excellent company like Colgate-Palmolive (NYSE:CL) firing on all cylinders, it's no wonder that shares of the consumer product company trade at 20x earnings. Often, the time to find the margin of safety is when the company is facing a temporary problem that can be fixed, yet the market is overreacting by discounting the long-term earnings potential of an excellent business. This is the process that Warren Buffett, the current CEO of Berkshire Hathaway (NYSE:BRK.B), followed in the early 1960s when he invested in American Express (NYSE:AXP):
"One of Buffett's greatest decisions in the early 1960s was to invest in a big way in American Express (AXP). Late in 1963 a salad oil scandal occurred when an American Express subsidiary found itself possibly liable for hundreds of millions of dollars worth of claims arising from quantities of salad oil that turned out not to exist.
An American Express subsidiary that issued warehouse receipts mistakenly certified the existence of huge quantities of salad oil that had been fraudulently confirmed to it as being in tanks in Bayonne, New Jersey. The crisis could have left American Express with a negative net worth.
'A great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable problem,' Buffett says. In 1964, investing 40% of the net worth of the Buffett Partnership, or roughly $13 million, Buffett bought 5% of American Express stock, which had collapsed to $35 a share from a high of more than $62.
In the next two years American Express stock tripled and the Buffett Partnership reportedly sold out with a $20 million profit. Buffett's investment lesson: when a great company falters, have a look."
In Buffett's case, he was especially successful because not only did he identify an excellent company with a solvable crisis, but he chose to double down and invest heavily as well. Generally, these opportunities arise when a short-term hardship facing a company causes investors to underestimate the long-term strength of the company's business model.
For instance, Walgreen (NYSE:WAG) is currently trading at a P/E of about 10. Looking at numbers dating back to 1996, the lowest average annual pricing multiple that Walgreen has experienced was 14x earnings in 2009. The company is clearly out of favor due to the fallout from the expiration of the Express Scripts (NASDAQ:ESRX) deal. The company is expected to grow profits at a slower pace over the next twelve months-if Walgreen is able to resume its record of 9-11% annual earnings growth within the next two years, this will most likely be an excellent time to buy.
In the case of Becton Dickinson (NYSE:BDX), disappointing performance in the biosciences division has caused analysts to estimate that revenue will grow at only a 2% rate for the rest of this year, and that has caused shares to come down to $73. Meanwhile, the company is planning on spending $500 million to reduce the share count in the second half of the year while the stock prices are low. Now might be a great time to give the shares a look.
Wal-Mart (NYSE:WMT) would have also been a perfect candidate for this list, when the anger over the bribery scandal pushed shares below $60. That was an ideal opportunity to establish a position because the headlines were focused on a story that offered a small likelihood of threatening long-term earnings power. You weren't going to see a mass exodus of people saying, "Oh yeah, I used to shop at Wal-Mart all the time. Then I found out about those bribes in Mexico. Now I'm a Target (NYSE:TGT) guy."
Many times, the big bucks come when you can identify an excellent company currently working its way through a solvable crisis. It would have been great to buy Johnson & Johnson (NYSE:JNJ) during the Tylenol recalls of the 1980s, or Exxon (NYSE:XOM) during the Valdez oil spill. Investors ten years from now might be kicking themselves for not buying shares of BP (NYSE:BP) at these depressed prices. I often talk about buying stock with a margin of safety to protect you when things go wrong. There's a close corollary to that: buying shares of beaten down companies at beaten down prices can reward you quite well once things go right.