Risk is a funny thing. It grows and compounds largely unnoticed. Then it strikes like lightning.
Fannie Mae was a bona fide 10-bagger for Berkshire Hathaway in 2000. Buffett’s investment in Fannie Mae had a market value over $3.0 billion and a cost basis of $300 million. It was one of Buffett’s more successful investments.
By the time Buffett gathered the faithful for the Berkshire Annual Meeting in the spring of 2001, he had sold the entire investment.
Later he called it a potential iceberg. He didn’t like the way Fannie Mae disclosed some figures on one of its tables. While Buffett famously holds investments long after they become fully valued, he doesn’t mess around with risk. According to Buffett at the time, there is a lot you don’t see. You are never 100% sure that management is doing things 100% right.
Eight years and a financial crisis later, the rest of us finally caught up with Buffett. Seventy billion dollars of Fannie Mae market capitalization was wiped out in a matter of months.
Market prices respond to people’s perception of risk, not to the risk itself. The risk comes first. The market responds later.
Risk existed at Lehman Brothers long before anyone acted on it. It went unnoticed for years, then $30 billion of market cap instantly vanished. Risk went unnoticed at WorldCom, Waste Management, and Enron. In each of these disasters, the existence of the risk preceded the market reaction to that risk. In most cases, the delay was years, not months.
Risk didn’t magically appear at Fannie Mae when it lost 98% of its value during the financial crisis. The underlying risk at Fannie Mae existed long before. It grew largely unnoticed. It compounded.
The market action when the underlying risk became obvious was swift and catastrophic.
Risk can fester in the shadows long before most people even know it exists. When the masses become aware of the presence of risk, their coordinated behavior moves market prices to reflect that risk.
Finding risk along with everybody else does no good. When risk becomes obvious, it is too late to protect yourself. Fannie Mae will always be a 10-bagger for Buffett because he found hidden risk before it became obvious.
The trick is to find risk while it is still hidden then do what you can to avoid it.
The problem with finding hidden risk is it is hidden. Sure, there are typically some clues: suspicious behavior, weird or selective disclosures, a business that seems to buck basic economic realities. But, no one will ever lay it out for you. You have to find it yourself.
The only way to find hidden risk, in our view, is the old fashioned way: by systematically and meticulously considering all ways an investment can go bad and then looking for the little hints that one of those bad things is actually happening.
