THE SALAD OIL SWINDLE
By Dan Ferris
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.
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.
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."
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.
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 |
