Warren Buffett once said that it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful.” This statement is somewhat of a contrarian view on stock markets and relates directly to the price of an asset: when others are greedy, prices typically boil over, and one should be cautious lest they overpay for an asset that subsequently leads to anemic returns. When others are fearful, it may present a good value buying opportunity.

Since the price is what you pay, and value is what you get, paying too high a price can decimate returns. To elaborate on this, the value of a stock is relative to the number of earnings it will generate over the life of its business. In particular, this value is determined by discounting all future cash flows back to a present value, or intrinsic value. Pay too high a price and the return that arises as a stock gravitates back to its intrinsic value over time will erode. Act greedy when others are fearful and reap enhanced returns under the right set of circumstances: predictability must be present, and short-term events that create the subsequent downgrade in prices must not be eroding. Here's how Buffett did it.

Of Cigar Butts and Coca-Cola

Warren Buffett is not just a contrarian investor. He may be what you might call a “business-oriented value investor.” This means he does not purchase any and all stocks just because they are on sale. Originally, that approach was Ben Graham’s style (as well as Buffett’s, initially). Known as the “cigar-butt” style of investing, this approach picks up discarded business cigar butts laying on the side of the road, selling them at deep discounts to book value with one good puff left in them. Ben Graham looked for “net-nets” or businesses priced below their net current assets or current assets minus total liabilities.

Although Warren Buffett began his investing career this way, in the face of anemic net-net opportunities, he evolved. With the help of Charlie Munger, he discovered the land of outstanding businesses, the home of See’s Candy and Coca-Cola (KO), businesses with durable, competitive economics—the moat—and rational, honest management. Buffett then looks for a good price and takes advantage of opportunities when others are fearful. As he has said in the past, it is much better to buy a wonderful business at a good price than a good business at a wonderful price.

Salad Oil: Don’t Leave Home Without It

The fear-inducing events that lead to superior investment opportunities can include short-term shock waves created by macroeconomic events such as recessions, wars, sector apathy, or short-term, non-moat damaging business results.

In the 1960s, the value of American Express (AXP) was cut in half when it was discovered that the collateral it had used to secure millions of dollars of warehouse receipts did not exist. The collateral in question was salad oil, and it turns out that commodities trader Anthony De Angelis had faked the inventory levels by filling his tankers with water while leaving small tubes of salad oil within the tanks for the auditors to find. It is estimated that the event cost AXP an excess of $50 million in losses.

After reviewing the company’s business model, Buffett decided that the company’s moat would not be materially impacted by the event, and he subsequently invested 40% of his partnership’s money in the stock. Over the course of five years, AXP increased by five-fold.

The Gecko

In 1976, GEICO was teetering on the edge of bankruptcy due in part to a business model shift in which it extended car insurance policies to risky drivers. With assurances from the then company CEO John J. Byrne that the company would revert to its original business model, Buffett invested an initial sum of $4.1 million in the company, which grew to over $30 million in five years. GEICO is now a wholly-owned subsidiary of Berkshire Hathaway (BRKB).

Shock-waves such as the salad-oil scandal and business model drifts create value and have allowed Warren Buffett to reap substantial returns over the years. To be greedy when others are fearful is a valuable mindset that can reap substantial rewards for the investor.

The Bottom Line

Once the shoeshine boy starts giving out stock tips, then it is time to leave the party. Charlie Munger once likened a frothy stock market to a New Year’s Eve party that has gone on long enough. The bubbly is flowing, everyone is enjoying themselves, the clocks have no arms on them. No one has a clue that it is time to leave, nor do they want to. How about just one more drink? As a business-value investor, it is imperative to know when it is time to leave and to be prepared for that perfect opportunity, to be greedy when others are fearful, yet to be greedy for investment with long-term durable economics and rational, honest management.