Temporary Problems That Can Lower Stock Prices

Why Stocks Become Over / Under Valued - Investing Lesson 2

Stock Price Declines Can Bring Opportunity In Some Cases
There are times when a stock price decline represents a significant buying opportunity. The key is to understand what caused the decline, whether the core business is still healthy, whether the equity will survive, and whether or not you can financially recover if you turn out to be incorrect. traffic_analyzer / Getty Images

Before we continue this investing lesson, there is one more factor that occurs fairly often and can move a stock to extremely low levels. Generally, it goes something like this: a good company runs into temporary trouble that neither endangers its life or threatens long-term profitability. Wall Street nonetheless overreacts in its characteristic way, and punishes the company by driving the stock lower.

 Investors decry the death of the firm and don't want anything to do with it.

This was the case with American Express in 1963. The company had revolutionized travel with the introduction of traveler's checks, and had enjoyed tremendous success with the introduction of the American Express card. The business ran into trouble when one of its subsidiaries, a warehouse in Bayonne, New Jersey, was the subject of massive fraud. A company known as Allied Crude Vegetable Oil Refining parked tanks of vegetable oil in the warehouse in exchange for receipts which guaranteed the tanks existed and contained what they were said to contain (effectively, this was safekeeping the same way custodians can charge investors for safekeeping of stock certificates). Allied used these receipts as collateral on loans.

The problem began when Allied defaulted on its debt. Creditors moved in to take possession of the vegetable oil stored in the American Express warehouse.

When they went to open the tanks, they found that they contained not vegetable oil, as American Express had guaranteed and for which it had issued receipts, but sea water, which is worth far less than salad oil.  To put a number on it, the creditor's collateral was worth a staggering $150,000,000 less than had been believed and American's subsidiary was partially to blame for issuing the guaranteeing receipts.

Although the company may not have been forced to pay anything since the mistake was made by a subsidiary and not the parent company itself - it could have always used the holding company structure to its advantage and put the subsidiary into bankruptcy - then-CEO Howard Clark felt the business was "morally bound" to try to make up the difference. He offered $60,000,000 to Allied's creditors. The stock was driven from $60 per share to $49 1/2, in part because American Express stock at that time was not "fully paid and non-assessable".  Had the firm needed to raise money, its board of directors could have required stockholders to contribute additional money, forcing them to pony up cash to bolster the balance sheet.

Although the loss of sixty million dollars was nothing at which to be scoffed, it certainly was not going to ruin the company. Wall Street had overreacted and punished the stock much more than could be justified by a cold, rational analysis of the numbers. The stock would eventually return to its previous levels, and in ensuing years, climb much higher, making a substantial profit for the investor who was wise enough to recognize that 1.) the company was not in serious danger, and 2.) he or she could take advantage of the temporary situation and Wall Street's folly in over-punishing the business, and pick up the stock for a cheap price.

 In fact, one such investor who did precisely that was Warren Buffett.  Through his investment partnerships, Buffett risked an incredible 40% of his partners' money on the American Express turnaround and made a tremendous amount for both himself and his investors when things turned out favorably.  It was a major success early in his career that helped provide the capital he would later invest to acquire his holding company, Berkshire Hathaway.

This leads us to to the final point of this lesson: Mr. Market. We have now established the reason stock prices are sometimes driven to highs and lows. Now we are going to go one step further and explain how the investor should think about the price swings of the market.

This page is part of Investing Lesson 2 - What Makes Stocks Become Over or Under Valued.