tie. It had never been able to maneuver even one armored division with much success. To rapidly strike out and coordinate the attack of half a dozen divisions would have required divine intervention. There was even less to say about their vaunted air force.

The point is that in crisis, most people do not make objective evaluations. The enormous disparity in quality and effectiveness of allied weaponry and men was, to my knowledge, never discussed. Rather, the media focused overwhelmingly on the devastating problems the U.S. faced. The resuh was that in the third quarter of 1990, the market had its fourth worst drop of the postwar period.

A confluence of factors fed the stock market crisis. One of the most important, as noted in chapter 10, was the fear of a major new energy crisis that would cripple American industry, leave millions shivering in cold homes, and create long hnes at the gas pumps, patiendy waiting hours for a gallon or two of "black gold."

Perception and reality were poles apart. As was obvious even at the time, the energy panic had no basis in fact. The fear of a world shortage of oil did not stand up to even the most cursory examination.

But an important rule to learn in crisis investing is that, true or false, the perceptions driving stock prices take on a life of their own.

This leads to the second rule of crisis investing, which, simple as it is, most investors overlook.

RULE 30

In a crisis, carefully analyze the reasons put forward to support lower stock prices-more often than not they will disintegrate under scrutiny.

But crises are usually multifaceted, which often leads to multifaceted market opportunities. The mania in commercial real estate in the 1980s* led to the worst drop in prices in the postwar period.

Real estate markets tumbled 50%, and even 75% in some areas, with no security behind many of the projects. The banks, S&Ls, and insurance companies were heavily involved. A full-fledged panic in financial stocks began during the Gulf Crisis, in August of 1990. Banks, S&Ls, insurance companies, and other financial stocks, already down 8 1 because of real estate problems, went into a free fall. Fears were now voiced about the viability of the banking system itself, and doubts were expressed as to whether it could withstand the shock of trillion-dollar losses in real estate. From the beginning of the year to the end of Sep-

* We will examine this bubble in more detail in chapter 16.

Essentials for Crisis Investing

When youre in a crisis, how do you know that this time is not the exception, that this is not the rerun of 1929? Sure the charts show how well you would have done in each crisis in the past, but charts are cold comfort when youre watching the tsunami approach. To answer the question and give you a set of systematic rules, lets take the 1990 financial crisis as our case study.

Bank stocks were ultracheap, trading at about 50% of their market values of 9 months earlier. Many banks were priced at 60% or less of book value. At these prices they more than discounted tiieir potential real estate losses, even applying the tighter accounting standards on delinquent loans that the bank examiners had recentiy put into effect, which often required significantiy larger loss reserves.

"Well and good," you might say, "but a number of these banks did belly up. How can you tell which banks to buy and which to pass on?"

You cant. But a number of criteria I used should help you increase your odds substantially. First, we were careful to buy banks that were financially sound. We researched the hundred largest regional banks to see which had recentiy taken loss reserves that seemed to adequately cover their bad real estate loans.

Second, after writing off tiiese large debts, I required tiiem to have more than adequate capital to meet any further unanticipated or undiscovered losses.

Third, we paid careful attention to financial ratios. The banks we bought had to have enough capital to be well over the regulators minimum requirements. Since the name of the game was to buy banks that had a very strong chance of survival, financial ratios were critical to our analysis. Not surprisingly, a large number of banks met our standards- again indicating how much investors had overreacted to the crisis.

Take PNC, a large bank holding company headquartered in Pittsburgh. The bank increased its loan loss reserves by $761 million in 1990, after boosting them by an abnormally large $332 million the year before. At the time, management indicated it believed it had reserved fully against hs potential real estate losses, marking the portfolio down to the value it thought it would receive in the then depressed market. Even after taking major write-offs for real estate in 1990, PNC still had

tember of 1990, money center and regional banks dropped 50%. Some financial stocks fell as much as 80% from their previous highs.

a core capital ratio of 5.7%, well above the regulators requirements. Its book value after the large write-off was $13.40 a share. The stock traded down to under $6.00. At this level its market price was only 44% of a conservative valuation of book value. By comparison, the price-to-book value of die S&P 500 was about 2.5 times. PNC was dius priced at a mere 16% of the book value of the market. Unless management was misrepresenting the situation or had no accounting controls, the bank appeared dirt cheap.

But theres more. PNC never cut its dividend, which had been raised in the crisis to $ 1.06 a share from $ 1.00 the year before. During the panic in die fall of 1990, it yielded a lip-smacldng 14%. The yield was a major inducement to buy the stock, but even more important than the dividend itself, you may recall from chapter 8, was the implicit vote of confidence by management and the board of directors in the banks future. If they were less sure the situation was under control, a dividend cut or else omitting it entirely would have been far more appropriate. This would have forestalled punishing personal lawsuits if things went awry. Too, the regulatory authorities, which at this point were ultraconserv-ative in their examination of possible bad loans, would not have tolerated a high dividend, or indeed any dividend, if die bank didnt appear to be financially sound.

To end the episode, PNCs earnings recovered 8 1 in 1991 and 1992, and by early 1993 the stock had almost sextupled, reaching $35 a share. Not a bad bounce considering the 14% yield in the interim. Dividends continued to increase and by year-end 1997 were 47% above the 1990 rate.

There were numerous banks that met the same criteria. Another example. First Chicago, should provide additional flavor of the times. The bank, which traded at $28 in die fall of 1989, was rocked by die financial crisis and fell as low as $8 a share as investors fears about its large real estate holdings made them question its continued viability. The facts were similar to those of PNC. The bank took large loss reserves, primarily for bad real estate debts, in 1989, 1990, and 1991, with die highest being a charge of $516 million in 1990. Still, the companys capital remained well above the regulators requirements. Near the bottom. First Chicago traded at only 40% of book value, once again a fraction of die S&P 500.

The board of directors, as in the case of PNC, maintained the dividend, resulting in a stock yield of over 14% near the low. Here again was a severe overreaction. By late 1997 the stock had moved up to $80, ten-folding from its 1990 low.