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uld be able to profit rather substantially in the long run from commit- ments of this kind. In making such purchases, partiality should evidently be shown to those companies in which most of the senior capital is in the
form of preferred stock rather than bonds. Such an arrangement removes or minimizes the danger of extinction of the junior equity through default in bad times and thus permits the shoe-string common stockholder to maintain his position until prosperity returns. (But just because the pre- ferred-stock contract benefits the common shareholder in this way, it is clearly disadvantageous to the preferred stockholder himself.)
We must not forget, however, the peculiar practical difficulty in the way of realizing the full amount of prospective gain in any one of the pur- chases. As we pointed out in the analogous case of convertible bonds, as soon as a substantial profit appears the holder is in a dilemma, because he can hold for a further gain only by risking that already accrued. Just as a convertible bond loses its distinctive advantages when the price rises to a point that carries it clearly outside of the straight investment class, so a shoe-string common-stock commitment is transformed into a more and more substantial commitment as the price continues to rise. In our Mohawk Rubber example the intelligent purchaser at 15 could not have expected to hold it beyond 100—even though its quotation did reach 250—because at 100, or before, the shares had lost the distinctive characteristics of a speculatively capitalized junior issue.
Chapter 41
LOW-PRICED COMMON STOCKS.
ANALYSIS OF THE SOURCE OF INCOME
LOW-PRICED STOCKS
The characteristics discussed in the preceding chapter are generally thought of by the public in connection with low-priced stocks. The major- ity of issues of the speculatively capitalized type do sell within the low- priced range. The definition of “low-priced” must, of course, be somewhat arbitary. Prices below $10 per share belo |
inctive characteristics of a speculatively capitalized junior issue.
Chapter 41
LOW-PRICED COMMON STOCKS.
ANALYSIS OF THE SOURCE OF INCOME
LOW-PRICED STOCKS
The characteristics discussed in the preceding chapter are generally thought of by the public in connection with low-priced stocks. The major- ity of issues of the speculatively capitalized type do sell within the low- priced range. The definition of “low-priced” must, of course, be somewhat arbitary. Prices below $10 per share belong to this category beyond question; those above $20 are ordinarily excluded; so that the dividing line would be set somewhere between $10 and $20.
Arithmetical Advantage of Low-priced Issues. Low-priced com- mon stocks appear to possess an inherent arithmetical advantage arising from the fact they can advance so much more than they can decline. It is a commonplace of the securities market that an issue will rise more read- ily from 10 to 40 than from 100 to 400. This fact is due in part to the pref- erences of the speculative public, which generally is much more partial to issues in the 10-to-40 range than to those selling above 100. But it is also true that in many cases low-price common stocks give the owner the advantage of an interest in, or “call” upon, a relatively large enterprise at relatively small expense.
A statistical study of the relative price behavior of industrial stocks in various price groups was presented in the April 1936 issue of The Journal of Business of the University of Chicago.1 The study was devoted to the period 1926–19352 and revealed a continuous superiority of diversified,
1 Fritzemeier, Louis H., “Relative Price Fluctuations of Industrial Stocks in Different Price Groups,” loc. cit., pp. 133–154.
2 See pp. 473–474 of the 1934 edition of this work for reference to an earlier study devoted to the relative behavior of low-priced and high-priced issues when purchased at or near the
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Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGra |
versity of Chicago.1 The study was devoted to the period 1926–19352 and revealed a continuous superiority of diversified,
1 Fritzemeier, Louis H., “Relative Price Fluctuations of Industrial Stocks in Different Price Groups,” loc. cit., pp. 133–154.
2 See pp. 473–474 of the 1934 edition of this work for reference to an earlier study devoted to the relative behavior of low-priced and high-priced issues when purchased at or near the
[520]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
low-priced issues over diversified, high-priced issues as speculative media. The following quotation from the study summarizes the results and conclusions reached by the author:
Unless there are serious uncompensated errors in the statistical work here presented, this investigation would seem to establish the existence of certain relationships between price level and price fluctuations which have hitherto gone unreported by students of stock-market phenomena. These relation- ships may be briefly stated as follows:
1. Low-price stocks tend to fluctuate relatively more than high-price stocks.
2. In a “bull” market the low-price stocks tend to go up relatively more than high-price stocks, and they do not lose these superior gains in the recessions which follow. In other words, the downward movement of low-price stocks is less than proportional to their upward movement, when compared with the upward and downward movement of high-price stocks.
*********
Assuming (1) that the future behavior of the various price groups will be similar to their past behavior and (2) that the selection of stocks on the basis of the activity for the current year does not account completely, if at all, for the superior performance of the stocks in the low-price groups, it seems logical to conclude the following:
1. Low-price industrial stocks offer greater opportunities for speculative prof- its than high-price industrial stocks.
2. In case two or m |
tocks.
*********
Assuming (1) that the future behavior of the various price groups will be similar to their past behavior and (2) that the selection of stocks on the basis of the activity for the current year does not account completely, if at all, for the superior performance of the stocks in the low-price groups, it seems logical to conclude the following:
1. Low-price industrial stocks offer greater opportunities for speculative prof- its than high-price industrial stocks.
2. In case two or more issues of industrial stocks seem to offer equal prospec- tive profits, the speculator should purchase the shares selling at the lowest price.
Some Reasons Why Most Buyers of Low-priced Issues Lose Money. The pronounced liking of the public for “cheap stocks” would therefore seem to have a sound basis in logic. Yet it is undoubtedly true that most people who buy low-priced stocks lose money on their pur- chases. Why is this so? The underlying reason is that the public buys issues that are sold to it, and the sales effort is put forward to benefit the seller and not the buyer. In consequence the bulk of the low-priced pur- chases made by the public are of the wrong kind; i.e., they do not provide
bottoms of depressions in 1897, 1907, 1914 and 1921. Within its more limited scope this study, published in 1931 by J. H. Holmes and Company, led to conclusions similar to those of Fritzemeier.
the real advantages of this security type. The reason may be either because the companies are in bad financial condition or because the common stock is low-priced in appearance only and actually represents a full or excessive commitment in relation to the size of the enterprise. The latter is preponderantly true of new security offerings in the low-priced range. In such cases, a pseudo-low price is accomplished by the simple artifice of creating so large a number of shares that even at a few dollars per share the total value of the common issue is excessive. This has been true of mining-s |
n bad financial condition or because the common stock is low-priced in appearance only and actually represents a full or excessive commitment in relation to the size of the enterprise. The latter is preponderantly true of new security offerings in the low-priced range. In such cases, a pseudo-low price is accomplished by the simple artifice of creating so large a number of shares that even at a few dollars per share the total value of the common issue is excessive. This has been true of mining-stock flotations from of old and was encountered again in the liquor-stock offerings of 1933 and in the airplane issues in 1938–1939.
A genuinely low-priced common stock will show an aggregate value for the issue which is small in relation to the company’s assets, sales and past or prospective profits. The examples shown herewith will illustrate the difference between a “genuine” and “pseudo-low” price.
Item Wright-Hargreaves Mines, Ltd. (gold mining)
Barker Bros.
Corp. (retail store)
July 1933:
Price of common stock 7 5
Number of shares outstanding 5,500,000 148,500
Total value of common $38,500,000 $ 743,000
Preferred stock at par 2,815,000
Preferred stock at market 500,000
Year 1932:
Sales $ 3,983,000 $ 8,154,000
Net earnings 2,001,000* 703,000(d)
Period 1924–1932:
Maximum sales $ 3,983,000 $16,261,000
Maximum net earnings 2,001,000* 1,100,000
Maximum earnings per share of common $0.36* $7.59
Working capital, Dec. 1932 $ 1,930,000 $ 5,010,000
Net tangible assets, Dec. 1932 4,544,000 7,200,000
* Before depletion.
The Wright-Hargreaves issue was low-priced in appearance only, for in fact the price registered a very high valuation for the company as
compared with all parts of its financial exhibit. The opposite was true of Barker Brothers because here the $743,000 valuation represented by the common stock was exceedingly small in relation to the size of the enter- prise. (Note also that the same statement could be applied to Barker Brothers Preferred, which at i |
32 4,544,000 7,200,000
* Before depletion.
The Wright-Hargreaves issue was low-priced in appearance only, for in fact the price registered a very high valuation for the company as
compared with all parts of its financial exhibit. The opposite was true of Barker Brothers because here the $743,000 valuation represented by the common stock was exceedingly small in relation to the size of the enter- prise. (Note also that the same statement could be applied to Barker Brothers Preferred, which at its quotation of 18 partook of the qualities of a low-priced common stock.)3
Observation of the stock market will show that the stocks of compa- nies facing receivership are likely to be more active than those which are very low in price merely because of poor current earnings. This phenom- enon is caused by the desire of insiders to dispose of their holdings before the receivership wipes them out, thus accounting for a large supply of these shares at a low level and also sometimes for unscrupulous efforts to persuade the unwary public to buy them. But where a low-priced stock fulfills our conditions of speculative attractiveness, there is apt to be no pressure to sell and no effort to create buying. Hence the issue is inactive and attracts little public attention. This analysis may explain why the pub- lic almost always buys the wrong low-priced issues and ignores the really promising opportunities in this field.
Low Price Coupled with Speculative Capitalization. Speculatively capitalized enterprises, according to our definition, are marked by a rela- tively large amount of senior securities and a comparatively small issue of common stock. Although in most cases the common stock will sell at a low price per share, it need not necessarily do so if the number of shares is small. In the Staley case, for example (referred to on pp. 515–516) even at $50 per share for the common in 1933 the capitalization structure would still have been speculative, since the bonds and preferred at |
zed enterprises, according to our definition, are marked by a rela- tively large amount of senior securities and a comparatively small issue of common stock. Although in most cases the common stock will sell at a low price per share, it need not necessarily do so if the number of shares is small. In the Staley case, for example (referred to on pp. 515–516) even at $50 per share for the common in 1933 the capitalization structure would still have been speculative, since the bonds and preferred at par would rep- resent over 90% of the total. It is also true that even where there are no senior securities the common stock may have possibilities equivalent to those in a speculatively capitalized enterprise. These possibilities will occur wherever the market value of the common issue-represents a small
3 See Appendix Note 60, p. 800 on accompanying CD, for the sequel to these examples. For a more recent contrast along the same lines the student is invited to compare the showing of Continental Motors Corporation and Gilchrist Company when both were selling at $5 near the close of 1939. Beyond our basic distinction, founded on the relationship between the val- uation of the company and its assets and sales, there is here a striking contrast in the earn- ings record and working-capital position.
amount of money in relation to the size of the business, regardless of how it is capitalized.
To illustrate this point we append a condensed analysis of Mandel Brothers, Inc., and Gimbel Brothers, Inc., two department-store enter- prises, as of September 1939.
Item Gimbel Bros. Mandel Bros.
September 1939:
Bonds at par $26,753,000
Preferred stock 197,000 sh. @ 50
$9,850,000
Common stock 977,000 sh. @ 8 297,000 sh. @ 5
$7,816,000 $1,485,000
Total capitalization $44,419,000 $1,485,000
Results for 12 months to July 31, 1939:
Sales $87,963,000 $17,883,000
Net before interest 1,073 155,000
Balance for common 1,105(d) 155,000
Earned per share 1.13(d) 0.52
Period 1934–1938*: |
others, Inc., two department-store enter- prises, as of September 1939.
Item Gimbel Bros. Mandel Bros.
September 1939:
Bonds at par $26,753,000
Preferred stock 197,000 sh. @ 50
$9,850,000
Common stock 977,000 sh. @ 8 297,000 sh. @ 5
$7,816,000 $1,485,000
Total capitalization $44,419,000 $1,485,000
Results for 12 months to July 31, 1939:
Sales $87,963,000 $17,883,000
Net before interest 1,073 155,000
Balance for common 1,105(d) 155,000
Earned per share 1.13(d) 0.52
Period 1934–1938*:
Maximum sales (1937) $100,081,000 $19,378,000
Maximum net earnings (1937) for common 2,032,000 414,000
Maximum earnings per share of common (1937) 2.08 1.33
High price of common 293/8 (1937) 18 (1936)
Average earnings per share of common 0.23 0.46
Jan. 31, 1939:
Net current assets $22,916,000 $ 4,043,000
Net tangible assets 75,614,000 6,001,000
Rents paid 1937 1,401,000 867,000
* Based on report for succeeding Jan. 31.
Gimbel Brothers presents a typical picture of a speculatively capital- ized enterprise. On the other hand Mandel Brothers has no senior secu- rities ahead of the common, but despite this fact the relatively small market value of the entire issue imparts to the shares the same sort of speculative possibilities (though in somewhat lesser degree) as are found in the Gimbel Brothers set-up. Note, however, that the rental payments
of Mandel Brothers are proportionately much higher than those of Gim- bel Brothers and that these rental charges are equivalent in good part to senior securities.
Large Volume and High Production Cost Equivalent to Specula- tive Capital Structure. This example should lead us to widen our con- ception of a speculatively situated common stock. The speculative or marginal position may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure and that therefore serves to create a subnormal value for the common stock in relation to the volume of business. Unusually high operating or production |
o senior securities.
Large Volume and High Production Cost Equivalent to Specula- tive Capital Structure. This example should lead us to widen our con- ception of a speculatively situated common stock. The speculative or marginal position may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure and that therefore serves to create a subnormal value for the common stock in relation to the volume of business. Unusually high operating or production costs have the identical effect as excessive senior charges in cutting down the percentage of gross available for common. The following hypothetical examples of three copper producers will make this point more intelligible and also lead to some conclusions on the subject of large output versus low operating costs.
Item Company A Company B Company C
Capitalization:
6% Bonds Common stock
Output
Cost of production (before interest) Interest charge per pound
Total cost per pound
A
Assumed price of copper Profit per pound
Output per share Profit per share
Value of stock at 10 times earnings Output per $1 of market value of stock
B
Assumed price of copper Profit per pound
Profit per share
Value per share at ten times earnings Output per $1 of market price of stock
1,000,000 sh.
100,000,000 lb.
7¢
7¢
$50,000,000 1,000,000 sh.
150,000,000 lb.
7¢
2¢
9¢
1,000,000 sh.
150,000,000 lb.
9¢
9¢
10¢
3¢ 100 lb.
$3
$30 31/3 lb. 10¢
1¢ 150 lb.
$1.50
$15 10 lb.
13¢
6¢
$6
$60 12/3 lb. 13¢
4¢
$6
$60 21/2 lb.
It is scarcely necessary to point out that the higher production cost of Company C will have exactly the same effect as the bond-interest require- ment of Company B (assuming output and production costs to continue as stated).
General Principle Derived. The foregoing table is perhaps more use- ful in showing concretely the inverse relationship that usually exists between profit per unit and output per dollar of stock value.
The general principle may be stated that the lower the |
6
$60 21/2 lb.
It is scarcely necessary to point out that the higher production cost of Company C will have exactly the same effect as the bond-interest require- ment of Company B (assuming output and production costs to continue as stated).
General Principle Derived. The foregoing table is perhaps more use- ful in showing concretely the inverse relationship that usually exists between profit per unit and output per dollar of stock value.
The general principle may be stated that the lower the unit cost the lower the production per dollar of market value of stock and vice versa. Since Company A has a 7-cent cost, its stock naturally sells at a higher price per pound of output than Company C with its 9-cent cost. Con- versely, Company C produces more pounds per dollar of stock value than Company A. This fact is not without significance from the standpoint of speculative technique. When a rise in the price of the commodity occurs, there will ordinarily be a larger advance, percentagewise, in the shares of high-cost producers than in the shares of low-cost producers. The foregoing table indicates that a rise in the price of copper from 10 to 13 cents would increase the value of Company A shares by 100% and the value of Company B and C shares by 300%. Contrary to the general impression in Wall Street, the stocks of high-cost producers are more logical commitments than those of the low-cost producers when the buyer is convinced that a rise in the price of the product is imminent and he wishes to exploit this conviction to the utmost.4 Exactly the same advantage attaches to the purchase of speculatively capitalized common stocks when a pronounced improvement in sales and profits is confi- dently anticipated.
THE SOURCES OF INCOME
The “source of income” will ordinarily be thought of as meaning the same thing as the “type of business.” This consideration enters very largely into the basis on which the public will value the earnings per share shown by a given common stock |
and he wishes to exploit this conviction to the utmost.4 Exactly the same advantage attaches to the purchase of speculatively capitalized common stocks when a pronounced improvement in sales and profits is confi- dently anticipated.
THE SOURCES OF INCOME
The “source of income” will ordinarily be thought of as meaning the same thing as the “type of business.” This consideration enters very largely into the basis on which the public will value the earnings per share shown by a given common stock. Different “multipliers” are used for different sorts of enter- prise, but we must point out that these distinctions are themselves subject to
4 The action of the market in advancing Company B shares from 15 to 60 because copper rises from 10 to 13 cents is in itself extremely illogical, for there is ordinarily no warrant for suppos- ing that the higher metal price will be permanent. However, since the market does in fact behave in this irrational fashion, the speculator must recognize this behavior in his calculation.
change with the changing times.5 Prior to the World War the railroad stocks were valued most generously of all, because of their supposed stability. In 1927–1929 the public-utility group sold at the highest ratio to earnings, because of their record of steady growth. Between 1933 and 1939 adverse legislation and, in particular, the fear of government competition greatly reduced the relative popularity of the utility stocks. The most liberal valua- tions have recently been accorded to the large and well-entrenched indus- trial enterprises which were able to maintain substantial earnings during the depression and are considered to possess favorable long-term prospects. Because of these repeated variations in relative behavior and popularity, secu- rity analysis must hesitate to prescribe any definitive rules for valuing one type of business as against another. It is a truism to say that the more impres- sive the record and the more promising the prospects of |
been accorded to the large and well-entrenched indus- trial enterprises which were able to maintain substantial earnings during the depression and are considered to possess favorable long-term prospects. Because of these repeated variations in relative behavior and popularity, secu- rity analysis must hesitate to prescribe any definitive rules for valuing one type of business as against another. It is a truism to say that the more impres- sive the record and the more promising the prospects of stability and growth the more liberally the per-share earnings should be valued, subject always to our principle that a multiplier higher than about 20 (i.e., an “earnings basis” of less than 5%) will carry the issue out of the investment price range.
A Special Phase: Three Examples. A more fruitful field for the tech- nique of analysis is found in those cases where the source of income must be studied in relation to specific assets owned by the company, instead of in relation merely to the general nature of the business. This point may be quite important when a substantial portion of the income accrues from investment holdings or from some other fixed and dependable source. Three examples will be used to illuminate this rather subtle aspect of common-stock analysis.
1. Northern Pipe Line Company. For the years 1923–1925 the North- ern Pipe Line Company reported earnings and dividends as follows:
Year Net earnings Earned per share* Dividend paid
1923
1924
1925 $308,000 214,000
311,000 $7.70 5.35
7.77 $10, plus $15 extra 8
6
* Capitalization, 40,000 shares of common stock.
5 See Cowles, Alfred, 3d, and associates (Common Stock Indexes, 1871–1937), pp. 43–46, 404–418, Bloomington, Ind., 1938, for a study of earnings-price ratios for different industrial groups in suc- cessive years from 1871 through 1937. Ratios for 1934–1938 and for 1936–1938 are supplied in our analysis of the New York Stock Exchange industrial list in Appendix Note 61, p. 800 on accompanying CD.
In 1924 |
$7.70 5.35
7.77 $10, plus $15 extra 8
6
* Capitalization, 40,000 shares of common stock.
5 See Cowles, Alfred, 3d, and associates (Common Stock Indexes, 1871–1937), pp. 43–46, 404–418, Bloomington, Ind., 1938, for a study of earnings-price ratios for different industrial groups in suc- cessive years from 1871 through 1937. Ratios for 1934–1938 and for 1936–1938 are supplied in our analysis of the New York Stock Exchange industrial list in Appendix Note 61, p. 800 on accompanying CD.
In 1924 the shares sold as low as 72, in 1925 as low as 671/2 and in 1926 as low as 64. These prices were on the whole somewhat less then ten times the reported earnings and reflected a lack of enthusiasm for the shares, due to a pronounced decline in profits from the figures of preceding years and also to the reductions in the dividend.
Analysis of the income account however, would have revealed the fol- lowing division of the sources of income:6
1923 1924 1925
Income Total Per share Total Per share Total Per share
Earned from:
Pipe-line operations Interest and rents Nonrecurrent items
$179,000 164,000
dr. 35,000
$4.48 4.10
dr. 0.88
$ 69,000
159,000
dr. 14,000
$1.71 3.99
0.35
$103,000 170,000
cr. 38,000
$2.57 4.25
cr. 0.95
$308,000 $7.70 $214,000 $5.35 $311,000 $7.77
This income account is exceptional in that the greater part of the prof- its were derived from sources other than the pipe-line business itself. About $4 per share were regularly received in interest on investments and rentals. The balance sheet showed holdings of nearly $3,200,000 (or $80 per share) in Liberty Bonds and other gilt-edged marketable securities, on which the interest income was about 4%.
This fact meant that a special basis of valuation must be applied to the per-share earnings, inasmuch as the usual “ten-times-earnings” basis would result in a nonsensical conclusion. Gilt-edged investments of $80 per share would yield an income of $3.20 per share, and at ten times earn- ings this $80 would be “ |
rentals. The balance sheet showed holdings of nearly $3,200,000 (or $80 per share) in Liberty Bonds and other gilt-edged marketable securities, on which the interest income was about 4%.
This fact meant that a special basis of valuation must be applied to the per-share earnings, inasmuch as the usual “ten-times-earnings” basis would result in a nonsensical conclusion. Gilt-edged investments of $80 per share would yield an income of $3.20 per share, and at ten times earn- ings this $80 would be “worth” only $32 per share, a reductio ad absur- dum. Obviously, that part of the Northern Pipe Line income that was derived from its bond holdings should logically be valued at a higher basis than the portion derived from the fluctuating pipe-line business. A sound valuation of Northern Pipe Line stock would therefore have to proceed along the lines suggested below. The pipe-line earnings would have to be valued at a low basis because of their unsatisfactory trend. The interest
6 Although the company’s reports to its stockholders contained very little information, com- plete financial and operating data were on file with the Interstate Commerce Commission and open to public inspection.
and rental income must presumably be valued on a basis corresponding with the actual value of the assets producing the income. This analysis indicated clearly that, at the price of 64 in 1926, Northern Pipe Line stock was selling considerably below its intrinsic value.7
Average 1923–1925* Valuation basis Value per share
Earned per share from pipe line. $2.92 Earned per share from interest and rentals 4.10 Total $7.02 15% (62/3 times earnings) 5% (20 times earnings) $ 20
80
$100
* The nonrecurrent profits and losses are not taken into account.
2. Lackawanna Securities Company. This company was organized to hold a large block of Glen Alden Coal Company 4% bonds formerly owned by the Delaware, Lackawanna and Western Railroad Company, and its shares were distributed pro rata to the Delawar |
basis Value per share
Earned per share from pipe line. $2.92 Earned per share from interest and rentals 4.10 Total $7.02 15% (62/3 times earnings) 5% (20 times earnings) $ 20
80
$100
* The nonrecurrent profits and losses are not taken into account.
2. Lackawanna Securities Company. This company was organized to hold a large block of Glen Alden Coal Company 4% bonds formerly owned by the Delaware, Lackawanna and Western Railroad Company, and its shares were distributed pro rata to the Delaware, Lackawanna and Western stockholders. The Securities Company had outstanding 844,000 shares of common stock. On December 31, 1931 its sole asset—other than about $1 per share in cash—consisted of $51,000,000 face value of Glen Alden 4% first mortgage bonds. For the year 1931, the income account was as follows:
Interest received on Glen Alden bonds $2,084,000
Less:
Expenses 17,000
Federal taxes 250,000
Balance for stock 1,817,000
Earned per share $2.15
Superficially, the price of 23 in 1932 for a stock earning $2.15 did not appear out of line. But these earnings were derived, not from ordinary commercial or manufacturing operations, but from the holding of a bond
7 A parallel situation existed in the case of Davis Coal and Coke Company prior to the distri- bution of $50 per share to stockholders out of its large holdings of government bonds in 1937–1938. Shortly prior to this action the stock had sold at 35. The student can see from the annual reports that the average earnings of $2.06 per share and average dividends of
$2.56 in 1934–1937 came entirely from sources other than the coal business.
issue which presumably constituted a high-grade investment. (In 1931 the Glen Alden Coal Company earned $9,550,000 available for interest charges of $2,151,000, thus covering the bond requirements 41/2 times.) By valuing this interest income on about a 10% basis the market was in fact valuing the Glen Alden bonds at only 37 cents on the dollar. (The price of 23 for a share of Lack |
.06 per share and average dividends of
$2.56 in 1934–1937 came entirely from sources other than the coal business.
issue which presumably constituted a high-grade investment. (In 1931 the Glen Alden Coal Company earned $9,550,000 available for interest charges of $2,151,000, thus covering the bond requirements 41/2 times.) By valuing this interest income on about a 10% basis the market was in fact valuing the Glen Alden bonds at only 37 cents on the dollar. (The price of 23 for a share of Lackawanna Securities was equivalent to $60 face value of Glen Alden bonds at 37, plus $1 in cash)
Here again, as in the Northern Pipe Line example, analysis would show convincingly that the customary ten-times-earnings basis resulted in a glaring undervaluation of this specially situated issue.
TOBACCO PRODUCTS CORPORATION
Item Price: December 1931
Market value
Capitalization
2,240,000 shares of 7% Class A (par $20) 3,300,000 shares common
$6
21/4
$13,440,000 7,425,000
Total
Net income for the year 1931 Earned per share of Class A
Earned for common after Class A dividends
Dividend paid on Class A
$20,825,000
about $2,200,000 about $1
nil
$0.80
3. Tobacco Products Corporation of Virginia. In this example, as in the other two, the company was selling in the market for about ten times the latest reported earnings. But the 1931 earnings of Tobacco Products were derived entirely from a lease of certain of its assets to American Tobacco Company, which provided for an annual rental of $2,500,000 for 99 years from 1923. Since the American Tobacco Company was able to meet its obligation without question, this annual rental income was equivalent to interest on a high-grade investment. Its value was therefore much more than ten times the income therefrom. This meant that the market valua- tion of the Tobacco Products stock issues in December 1931 was far less than was justified by the actual position of the company. (The value of the lease was in fact calculated to be about $35,6 |
$2,500,000 for 99 years from 1923. Since the American Tobacco Company was able to meet its obligation without question, this annual rental income was equivalent to interest on a high-grade investment. Its value was therefore much more than ten times the income therefrom. This meant that the market valua- tion of the Tobacco Products stock issues in December 1931 was far less than was justified by the actual position of the company. (The value of the lease was in fact calculated to be about $35,600,000 on an amortized basis. The company also owned a large amount of United Cigar Stores’
stock, which later proved to be practically worthless, but these additional holdings did not, of course, detract from the value of its American Tobacco lease.)
Relative Importance of Situations of This Kind. The field of study represented by the foregoing examples is not important quantitatively, because, after all, only a very small percentage of the companies examined will fall within this group. Situations of this kind arise with sufficient fre- quency, however, to give this discussion practical value. It should be use- ful also in illustrating again the wide technical difference between the critical approach of security analysis and the highly superficial reactions and valuations of the stock market.
Two Lines of Conduct Suggested. When it can be shown that cer- tain conditions, such as those last discussed, tend to give rise to under- valuations in the market, two different lines of conduct are thereby suggested. We have first an opportunity for the securities analyst to detect these undervaluations and eventually to profit from them. But there is also the indication that the financial set-up that causes this undervalua- tion is erroneous and that the stockholders’ interests require the correc- tion of this error. The very fact that a company constituted like Northern Pipe Line or Lackawanna Securities tends to sell in the market far below its true value proves as strongly as po |
ct are thereby suggested. We have first an opportunity for the securities analyst to detect these undervaluations and eventually to profit from them. But there is also the indication that the financial set-up that causes this undervalua- tion is erroneous and that the stockholders’ interests require the correc- tion of this error. The very fact that a company constituted like Northern Pipe Line or Lackawanna Securities tends to sell in the market far below its true value proves as strongly as possible that the whole arrangement is wrong from the stand-point of the owners of the business.
At the bottom of these cases there is a basic principle of consistency involved. It is inconsistent for most of the capital of a pipe-line enterprise actually to be employed in the ownership of gilt-edged bonds. The whole set-up of Lackawanna Securities was also inconsistent, because it replaced a presumably high-grade bond issue, which investors might be willing to buy at a fair price, by a nondescript stock issue which no one would pur- chase except at an exceptionally low price. (In addition a heavy and need- less burden of corporate income tax was involved, as was true in the Tobacco Products case.)
Illogical arrangements of this kind should be recognized by the real parties in interest, i.e., the stockholders, and they should insist that the anomaly be rectified. This was finally done in the three examples just given. In the case of Northern Pipe Line the capital not needed in the pipe-line business was returned to the stockholders by means of special
distributions aggregating $70 per share. The Lackawanna Securities Com- pany was entirely dissolved and the Glen Alden bonds in its treasury dis- tributed pro rata to the stockholders in lieu of their stock. Finally, the Tobacco Products Corporation was recapitalized on a basis by which 61/2% bonds were issued against the American Tobacco lease, so that this asset of fixed value was represented by a fixed-value security (which l |
ine business was returned to the stockholders by means of special
distributions aggregating $70 per share. The Lackawanna Securities Com- pany was entirely dissolved and the Glen Alden bonds in its treasury dis- tributed pro rata to the stockholders in lieu of their stock. Finally, the Tobacco Products Corporation was recapitalized on a basis by which 61/2% bonds were issued against the American Tobacco lease, so that this asset of fixed value was represented by a fixed-value security (which later were redeemed at par) instead of by shares of stock in a corporation sub- ject to highly speculative influences. By means of these corporate rearrangements the real values were speedily established in the market price.8
The situations that we have just analyzed required a transfer of atten- tion from the income account figures to certain related features revealed in the balance sheet. Hence the foregoing topic—Sources of Income— carries us over into our next field of inquiry: The Balance Sheet.
8 The student is invited to consider two further examples illustrating this point in 1939, viz.
1. Westmoreland Coal Company, selling at 8 although the company held some $18 per share in cash assets alone. This case is broadly similar to our Davis Coal and Coke example, although there were some differences. See discussion of this company on pp. 588–589.
2. American Cigarette and Cigar. In this case there is also a long-term lease to American Tobacco Company (as in the Tobacco Products example), but the situation is complicated by the company’s own operations, which have produced losses, and by ownership of other assets.
Attention is drawn also to our discussion of Lehigh Coal and Navigation Company on
p. 451, in which we suggested that the mining losses were perhaps inseparable from the large income from lease of the railroad.
PART VI
BALANCE-SHEET ANALYSIS. IMPLICATIONS OF ASSET VALUES
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Co |
Products example), but the situation is complicated by the company’s own operations, which have produced losses, and by ownership of other assets.
Attention is drawn also to our discussion of Lehigh Coal and Navigation Company on
p. 451, in which we suggested that the mining losses were perhaps inseparable from the large income from lease of the railroad.
PART VI
BALANCE-SHEET ANALYSIS. IMPLICATIONS OF ASSET VALUES
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I n tr oduc tion to P ar t VI
DECONSTRUC TING THE BALANCE SHEE T
BY BRUCE GREENWALD
he enduring value of Security Analysis rests on certain critical ideas developed by Graham and Dodd that were then, and remain, fun- damental to any well-conceived investment strategy. The first of
these is the distinction between “investment” and “speculation” as defined by Graham and Dodd:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. (p. 106)
The critical parts of this definition are “thorough analysis” and “safety of principal and a satisfactory return.” Nothing about these requirements has changed since 1934.
A second related idea is that of focusing on the intrinsic value of a security. It is, according to Graham and Dodd,
that value which is justified by the facts, e.g., the assets, earnings, divi- dends, [and] definite prospects, as distinct, let us say, from market quota- tions established by market manipulation or distorted by psychological excesses. (p. 64)
In an ideal world, intrinsic value would be the true value of a security; in today’s language it would be the present discounted value of the
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expected future cash flows it gen |
, e.g., the assets, earnings, divi- dends, [and] definite prospects, as distinct, let us say, from market quota- tions established by market manipulation or distorted by psychological excesses. (p. 64)
In an ideal world, intrinsic value would be the true value of a security; in today’s language it would be the present discounted value of the
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Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
expected future cash flows it generates. If these expected cash flows and an appropriate discount rate could be calculated perfectly from the avail- able facts, then the intrinsic and true values would be the same. How- ever, Graham and Dodd recognized that this was never possible. “Inadequate or incorrect data and [the] uncertainties of the future” meant that intrinsic value would always be “an elusive concept.”
Nevertheless, thorough investigation of intrinsic value was, in this view, central to any investment process worthy of the name. It served first of all to organize examination and use of the available information, ensuring that the relevant facts would be brought to bear and irrelevant noise ignored. Second, it would produce an appreciation of the range of uncertainty associated with any particular intrinsic value calculation.
Graham and Dodd recognized that even a very imperfect intrinsic value would be useful in making investment decisions. In their words,
It needs only to establish that the value is adequate—e.g., to protect a bond or justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price . . . [and] the degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased. (pp. 66–67)
The purchase of securities should then be made only at prices far enough below the intrinsic value to provide a margin of safety that would offer appropriate protec |
te—e.g., to protect a bond or justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price . . . [and] the degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased. (pp. 66–67)
The purchase of securities should then be made only at prices far enough below the intrinsic value to provide a margin of safety that would offer appropriate protection against this “indistinctness” in the cal- culated intrinsic value. In essence, what Graham and Dodd required was that an investor, as opposed to a speculator, should know as far as possi- ble the value of any security purchased and also the degree of uncer- tainty attached to that value. An investment would be made only at a price that provided a sufficient margin of safety to compensate for the uncertainty involved. As a prescription for obtaining “protection of prin- cipal and a satisfactory return,” this approach has obvious advantages over almost any conceivable alternative.
The compelling logic of these foundations is one source of the con- tinuing relevance of Security Analysis. But the book also provides a detailed roadmap of what a “thorough analysis” looks like that is exem- plary in its completeness.
With regard to common stock investments, Graham and Dodd exam- ine the roles of both present and future prospects (with an appropriately skeptical view of the latter). They consider the implications of the quanti- tative analyses of financial statements and qualitative appreciations of less easily quantifiable factors, like management. In the key area of quan- titative analysis, they look comprehensively at all financial statements, including most notably a firm’s balance sheet.
In this they were at odds with their contemporaries. In describing those practices, Graham and Dodd noted,
We find little beyond the rather indefinite concept that “a good stock is a good |
y consider the implications of the quanti- tative analyses of financial statements and qualitative appreciations of less easily quantifiable factors, like management. In the key area of quan- titative analysis, they look comprehensively at all financial statements, including most notably a firm’s balance sheet.
In this they were at odds with their contemporaries. In describing those practices, Graham and Dodd noted,
We find little beyond the rather indefinite concept that “a good stock is a good investment.” “Good” stocks are those of either (1) leading compa- nies with satisfactory records, . . . or (2) any well-financed enterprise believed to have especially attractive prospects of increased future earn- ings Balance-sheet values are considered to be entirely out of the
picture. Average [historical] earnings have little significance when there is a marked trend. The so-called “price-earnings ratio” is applied variously, sometimes to the past, sometimes to the present, and sometimes to the near future. (p. 29)
This description might have been written today. So-called price- earnings ratios continue to dominate valuation discussions. They are applied even more “variously” than in the past; now they include the ratio of a stock’s price to its earnings before interest and taxes (EBIT) and/or more perniciously the ratio of a stock’s price to its earnings before interest, taxes, depreciation, and amortization (EBITDA). Balance sheets are once again almost “entirely out of the picture.” Today, as in 1934, a “thorough” analysis of intrinsic value encompassing all the rele- vant information remains the exception rather than the rule.
With respect to the balance sheet, Graham and Dodd describe four fundamental areas of usefulness. First, the balance sheet identifies the quantity and nature of resources tied up in a business. For an economically viable enterprise, these resources are the basis of its returns. In a competi- tive environment, a firm without resources cannot |
ture.” Today, as in 1934, a “thorough” analysis of intrinsic value encompassing all the rele- vant information remains the exception rather than the rule.
With respect to the balance sheet, Graham and Dodd describe four fundamental areas of usefulness. First, the balance sheet identifies the quantity and nature of resources tied up in a business. For an economically viable enterprise, these resources are the basis of its returns. In a competi- tive environment, a firm without resources cannot generally expect to earn any significant profits. If an enterprise is not economically viable, then the balance sheet can be used to identify the resources that can be recovered in liquidation and how much cash the resources might return.
Second, the resources on a balance sheet provide a basis for analyz- ing the nature and stability of sources of income. As Graham and Dodd note,
There are indeed certain presumptions in favor of purchases far below asset value and against those made at a high premium above it. A
business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely. Conversely, in the case of a business selling at a large discount because of abnormally low earn-
ings. The absence of new competition, the withdrawal of old competition from the field and other natural economic forces may tend eventually to improve the situation and restore a normal rate of profit on the invest- ment. (pp. 557–558)
Here, they recognize that earnings on assets that are well in excess of a company’s cost of capital will be sustainable only under special circum- stances. Thus, earnings estimates will be more realistic and accurate if they are supported by appropriate asset values. Earnings without such support are likely to be of short duration and, thus, of less value than earnings protected by the necessary returns on assets in place.
Third, the liabiliti |
al rate of profit on the invest- ment. (pp. 557–558)
Here, they recognize that earnings on assets that are well in excess of a company’s cost of capital will be sustainable only under special circum- stances. Thus, earnings estimates will be more realistic and accurate if they are supported by appropriate asset values. Earnings without such support are likely to be of short duration and, thus, of less value than earnings protected by the necessary returns on assets in place.
Third, the liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm. A high level of short-term debt (or long-term debt that expires in the near future) indi-
cates a possibility of debilitating financial distress. Under these circum- stances, even a slight impairment in profits may lead to significant per- manent loss in the value of a business.
Fourth, the evolution of the balance sheet over time provides a check on the quality of earnings. Today, this is covered, in principle, by the statement of cash flows, which should reconcile revenue and cost flows with changes in overall financial position. However, it remains true, as Graham and Dodd noted, that
the form of the balance sheet is better standardized than the income statement [or the statement of cash flows] and it does not offer such fre- quent grounds for criticism. (p. 93)
A balance sheet is a snapshot of a company’s assets and liabilities at a particular time. It can be checked for accuracy and value at that moment. This places significant constraints on the degree to which the assets and liabilities can be manipulated. In contrast, flow variables such as revenue and earnings measure changes over time that by their nature are evanescent. If they are to be monitored, they must be monitored over an extended period. In 1934, and today, this fundamental difference accounts for the superior reliability (in theory) of balance sheet figures. Indeed, as we will discuss later, |
for accuracy and value at that moment. This places significant constraints on the degree to which the assets and liabilities can be manipulated. In contrast, flow variables such as revenue and earnings measure changes over time that by their nature are evanescent. If they are to be monitored, they must be monitored over an extended period. In 1934, and today, this fundamental difference accounts for the superior reliability (in theory) of balance sheet figures. Indeed, as we will discuss later, while the stock market was celebrating WorldCom’s earnings growth in the late 1990s, signs of financial stress were already showing up in the balance sheet, stresses that would even- tually lead to one of the largest bankruptcies in history as measured by the face value of the company’s debts.
Thorough Analysis
The special importance that Graham and Dodd placed on balance sheet valuations remains one of their most important contributions to the idea of what constitutes a “thorough” analysis of intrinsic value. It is also,
unfortunately, one of their most frequently overlooked contributions outside the relatively small community of value investors.
The reason that the balance sheet is often ignored goes back to the times that produced Security Analysis. Back then, the economy and busi- nesses were operating under severely depressed conditions. As a result, Graham and Dodd went to balance sheets to determine liquidation values or, as a proxy for these, current assets minus all liabilities. The logic behind this predisposition was compelling and conservative. If a company could be bought at a price well below its liquidation value, then it seemed unam- biguously to be a bargain. Earnings could pick up because of either an improvement in a firm’s industry environment (competition eases or demand recovers) or better management. If the earnings improvement pro- duced a market value above liquidation value, all well and good. On the other hand, if such positive earnings developmen |
ies. The logic behind this predisposition was compelling and conservative. If a company could be bought at a price well below its liquidation value, then it seemed unam- biguously to be a bargain. Earnings could pick up because of either an improvement in a firm’s industry environment (competition eases or demand recovers) or better management. If the earnings improvement pro- duced a market value above liquidation value, all well and good. On the other hand, if such positive earnings developments failed to materialize and if this happened before the liquidation value of the firm was significantly damaged, then the company could be liquidated and the proceeds distrib- uted to its shareholders. In either case, the shareholders who bought below liquidation value would earn a “satisfactory return” on their investment.
The only risk, of which Graham and Dodd were well aware, was that management would continue to operate the firm unprofitably and, in the process, dissipate the value of the assets. Thus, they advocated their own version of shareholder activism as a necessary complement to this kind of investing. As they wrote,
The choice of a common stock is a single act; its ownership is a continu- ing process. Certainly there is just as much reason to exercise care and judgment in being a stockholder as in becoming a stockholder. It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity. (p. 575)
Taken as a whole, this approach was unimpeachable and, in its time, successful in practice.
Since then the practice of buying below liquidation value has been undermined by two factors. First, the rapid rise in tax rates post-1940 has meant that strategies like this one, which have often involved realizing short-term gains over relatively short periods, have incurred high tax costs. Second, and more importantly, opportunities to buy stocks at prices below liquidation value, which were abundant in the 1930s, hav |
this approach was unimpeachable and, in its time, successful in practice.
Since then the practice of buying below liquidation value has been undermined by two factors. First, the rapid rise in tax rates post-1940 has meant that strategies like this one, which have often involved realizing short-term gains over relatively short periods, have incurred high tax costs. Second, and more importantly, opportunities to buy stocks at prices below liquidation value, which were abundant in the 1930s, have effectively disappeared in the long-term prosperity that has followed.
Relatively few industries in recent times have become economically non- viable and hence candidates for liquidation. This reality has been embod- ied in the general level of stock prices, with the result that Graham and Dodd’s much beloved “net nets”—that is, companies selling below the value of their current assets less all liabilities—are rare. And, when net nets are available, their second requirement—namely, that management not be dissipating those assets at a rapid rate—is seldom met.
However, the broader lessons that led Graham and Dodd to focus on the balance sheets of firms continue to apply, with extensions that are much within the spirit of their original approach. First, it is now recog- nized that for economically viable firms, assets wear out or become obsolete and have to be replaced. Thus, replacement value—the lowest possible cost of reproducing a firm’s net assets by the competitors who are best positioned to do it—continues to serve the role that Graham and Dodd recognized. If projected profit levels for a firm imply a return on assets well above the cost of capital, then competitors will be drawn in. That, in turn, will drive down profits and with them the value of the firm. Thus, earnings power unsupported by asset values—measured as reproduction values—will, absent special circumstances, always be at risk from erosion due to competition. Both “safety of principal” and the promise of |
ositioned to do it—continues to serve the role that Graham and Dodd recognized. If projected profit levels for a firm imply a return on assets well above the cost of capital, then competitors will be drawn in. That, in turn, will drive down profits and with them the value of the firm. Thus, earnings power unsupported by asset values—measured as reproduction values—will, absent special circumstances, always be at risk from erosion due to competition. Both “safety of principal” and the promise of “a satisfactory return,” therefore, require that “thorough” investors support their earnings projections with a careful assessment of the replacement values of a firm’s assets. Investors who do this will have
an advantage over those who do not, and they should outperform these less thorough investors in the long run.
What appears to have deterred Graham and Dodd from considering the replacement value of assets was the potential difficulty of calculating them. They chose to focus on the wealth of new financial information made available through the establishment of the Securities and Exchange Commission. With today’s computers, that information can be obtained and digested almost instantaneously. Moreover, industry reports and trade publications, many of them available online, provide a wealth of information on asset values that was inconceivable to Graham and Dodd.
For example, the cost estimates of adding to existing reserves of oil and gas are widely available, at least for U.S. companies. So are estimates of recoverable deposits. As a result, investors today can calculate the val- ues of resource companies’ holdings with a precision that was unattain- able in the authors’ time. Physical property and equipment can also be valued with a higher degree of accuracy. For real estate, assessors with access to extensive transactions data can quickly and cheaply estimate the cost of purchasing comparable properties.
For other plant and equipment, consulting engineers and industry |
mpanies. So are estimates of recoverable deposits. As a result, investors today can calculate the val- ues of resource companies’ holdings with a precision that was unattain- able in the authors’ time. Physical property and equipment can also be valued with a higher degree of accuracy. For real estate, assessors with access to extensive transactions data can quickly and cheaply estimate the cost of purchasing comparable properties.
For other plant and equipment, consulting engineers and industry experts can provide this information. Using these sources, the cost of adding aluminum fabricating capacity to existing plants could be esti- mated at about $1,000 per ton per year. Existing capacity was available to handle any foreseeable demand. The then current earnings of alu- minum fabricators lead to market valuations which implied that their existing capacity was worth well in excess of $1,000 per ton per year. The result: a race to build new capacity to take advantage of the potential earnings to be had in the fabricating business. This overexpansion resulted in falling earnings and lower stock prices. Such companies proved to be unsatisfactory investments. You could have anticipated this development only through a thorough analysis of the balance sheet.
Another area of difficulty that Graham and Dodd recognized was the valuation of intangible assets—product portfolios, customer relation- ships, trained workers, brand recognition—many of which do not even appear on a firm’s balance sheet. But today available information some- times allows these balance sheet items to be usefully estimated. Some of this information comes from financial statements. For example, the cost of replicating product portfolios, assuming these are not protected by patents, can be estimated using historical research and development data both from a company itself or other companies in its industry.
This analysis can be supplemented by expert information. Investment initiatives—whether new pro |
balance sheet. But today available information some- times allows these balance sheet items to be usefully estimated. Some of this information comes from financial statements. For example, the cost of replicating product portfolios, assuming these are not protected by patents, can be estimated using historical research and development data both from a company itself or other companies in its industry.
This analysis can be supplemented by expert information. Investment initiatives—whether new products, new store openings, or brand launches—are almost always based on detailed business plans. These plans identify the costs of such initiatives with reasonable accuracy and the benefits more fancifully. Investors can use these data to estimate the cost of producing intangible assets. Industry managers with substantial experience will be able to estimate such costs.
More importantly, many intangible assets trade just like real property.
Cable franchises, clothing brands, new drug discoveries, store chains, and even music labels are bought by sophisticated buyers (usually larger companies) from sophisticated sellers (usually smaller companies). The prices paid in these private market transactions are presumably made with the alternative cost of internal development in mind. Thus, if a com- pany like Liz Claiborne buys a brand that is similar to its own in-house brands for 50 cents per dollar of sales, then presumably this is reason- ably close—but lower than—the cost of reproducing its own brands.
These private market values are often used by sophisticated investors to price intangible assets.
Once a thorough analysis of asset and earnings power value is com- plete, there are three possible situations. The first is one in which the asset value of a company exceeds the value of its foreseeable earnings. That tells you the assets are not being used to full advantage by management. Here,
the critical factor for value investors is the prospect of some catalyst that will alter |
ts own brands.
These private market values are often used by sophisticated investors to price intangible assets.
Once a thorough analysis of asset and earnings power value is com- plete, there are three possible situations. The first is one in which the asset value of a company exceeds the value of its foreseeable earnings. That tells you the assets are not being used to full advantage by management. Here,
the critical factor for value investors is the prospect of some catalyst that will alter either the behavior or identity of current management. Graham and Dodd were aware of this although they were not cognizant of the range of interventions available to activist investors today.
A second possibility is that earnings power may exceed the asset value of a company. To maintain those superior profits, there needs to be some economic factors to protect the firm from competition. Today, these factors are referred to as “moats,” franchises, barriers to entry, or competitive advantages. What they look like and how they can be assessed is an essential part of modern income statement analysis.
However, even in this case where asset values are least relevant, they do provide useful information about the value a firm will retain if the factors erode in the future.
The third case is one in which the earnings power and asset value of a firm are approximately equal. This is the circumstance that should hold with reasonable management and no special protections from competi- tion. If qualitative judgments support such conclusions, then the asset value provides a critical check on the validity of earnings projections. A thorough asset valuation then helps to provide a complete picture of what an investor is getting for a security and helps that investor settle with confidence on an appropriate margin of safety.
Beyond these specific uses of asset valuations in current practice, there is one final inescapable area in which asset values must be used. Firms often have some assets— |
alitative judgments support such conclusions, then the asset value provides a critical check on the validity of earnings projections. A thorough asset valuation then helps to provide a complete picture of what an investor is getting for a security and helps that investor settle with confidence on an appropriate margin of safety.
Beyond these specific uses of asset valuations in current practice, there is one final inescapable area in which asset values must be used. Firms often have some assets—most notably cash—that are superfluous to the operation of their basic businesses. Such assets do not usually contribute to operating earnings, but they may represent an important part of the intrinsic value of a purchased security. The value of these assets must be added to any earnings-based value estimate (after appro- priate subtraction of their interest income so as not to double count).
Performing a comprehensive asset valuation ensures that they are not forgotten.
WorldCom: A Case Study
The financial statements of WorldCom, the telecom giant whose bankruptcy filing in the summer of 2002 was at its time the largest ever, illustrate the usefulness of a balance sheet analysis for tracking the financial condition of companies. Indeed, anyone who had been studying the balance sheet in the few years ahead of the bankruptcy would have suspected the company would come to no good end. For instance, in the middle of 1999, WorldCom had an equity market value of $125 billion.
This compared to a year-end 1999 book value of $51.2 billion, which had been created almost entirely by issuing shares for acquisitions, notably
$12 billion for MFS Communications in 1996 and $30 billion for MCI in 1997. Retained earnings over the company’s 15-year history were negli- gible, so over 85% of the book value was goodwill and other intangibles. The ratio of market value to tangible net equity was in excess of 15. Such ratios will vary by industry, but in this case, 15 is ridiculously high.
How v |
d to a year-end 1999 book value of $51.2 billion, which had been created almost entirely by issuing shares for acquisitions, notably
$12 billion for MFS Communications in 1996 and $30 billion for MCI in 1997. Retained earnings over the company’s 15-year history were negli- gible, so over 85% of the book value was goodwill and other intangibles. The ratio of market value to tangible net equity was in excess of 15. Such ratios will vary by industry, but in this case, 15 is ridiculously high.
How valuable were those intangibles? Not worth as much as the company said because they included neither significant patents nor developed process technologies. Even more important, WorldCom’s busi- ness was characterized by high rates of customer churn and vigorous price competition for its telecommunications and data transmission ser- vices. Nor did there appear to be large barriers to entry that might have supported a market value significantly in excess of reproduction value, or what it would cost to reproduce the network. WorldCom’s markets were characterized by many new entrants (including those companies acquired by WorldCom) and vigorous expansion by powerful existing competitors like AT&T. If anything, to the extent that economies of scale were relevant, WorldCom would have been operating at a significant competitive disadvantage to its larger competitor, AT&T.
However, what is more remarkable than the improbable market value placed on WorldCom’s assets is the detailed story told by the evolution
of its balance sheet. From year-end 1999 to year-end 2000, net property, plant, and equipment increased by 27%, or about $8 billion. In contrast, revenues increased by only 8%. That raised the question, why was such an aggressive investment program underway at the company? In fact, the investment figures turned out to have been fraudulently inflated by booking operating expenses as investments. However, even if they had not been fraudulent, the aggressive acceleration in proper |
y the evolution
of its balance sheet. From year-end 1999 to year-end 2000, net property, plant, and equipment increased by 27%, or about $8 billion. In contrast, revenues increased by only 8%. That raised the question, why was such an aggressive investment program underway at the company? In fact, the investment figures turned out to have been fraudulently inflated by booking operating expenses as investments. However, even if they had not been fraudulent, the aggressive acceleration in property, plant, and equipment growth (up from about $5 billion in 1999) in the face of decelerating revenue growth should have raised questions about the management’s judgment. The likelihood of a bad outcome from this insouciant attitude toward overexpansion should have been apparent.
Over the course of 2001, these consequences became clearly evident. During 2001, WorldCom’s short-term debt almost entirely disappeared as current debt liabilities fell from $7.2 billion to $172 million. In marked contrast, long-term debt rose by about $12.5 billion. In fact, it actually increased by about $14 billion since an examination of the balance sheet footnotes indicated that more than $1 billion of additional long-term debt had disappeared by the accounting expedient of deconsolidating the subsidiary responsible for that debt. The fact that, in the face of now- declining revenues, WorldCom felt that it needed an additional $7 billion in debt financing—all of it long term—should have set off an alarm with any investor who bothered to look at the balance sheet.
What happened? In 2000, WorldCom’s management lost control of its finances, making at best a highly risky bet on future revenue growth and at worst a calculated effort to disguise deteriorating operating margins by capitalizing expenses. In 2001, WorldCom scrambled for long-term financing, by which the company hoped to give management many years to solve problems. There was really no choice since attempting to sell equity in the face o |
with any investor who bothered to look at the balance sheet.
What happened? In 2000, WorldCom’s management lost control of its finances, making at best a highly risky bet on future revenue growth and at worst a calculated effort to disguise deteriorating operating margins by capitalizing expenses. In 2001, WorldCom scrambled for long-term financing, by which the company hoped to give management many years to solve problems. There was really no choice since attempting to sell equity in the face of a falling stock price would have sent a disastrous signal to the market. The primary vehicle WorldCom used was an
$11.9 billion debt sale to the public in May 2001, underwritten by finan- cial institutions that justified the issue in terms of future earnings and cash flow.
If these institutions and their customers had followed Graham’s advice to look carefully at the WorldCom balance sheet, they would have known better. They might not have fully anticipated the fraud and subsequent bankruptcy of WorldCom, but they would have seen enough to avoid both its stock and bonds as investments unlikely to provide either pro- tection of principal or promise of a satisfactory return.
Chapter 42
BALANCE-SHEET ANALYSIS.
SIGNIFICANCE OF BOOK VALUE
ON NUMEROUS OCCASIONS prior to this point we have expressed our conviction that the balance sheet deserves more attention than Wall Street has been willing to accord it for many years past. By way of introduction to this section of our work, let us list five types of information and guid- ance that the investor may derive from a study of the balance sheet:
1. It shows how much capital is invested in the business.
2. It reveals the ease or stringency of the company’s financial condition, i.e., the working-capital position.
3. It contains the details of the capitalization structure.
4. It provides an important check upon the validity of the reported earnings.
5. It supplies the basis for analyzing the sources of income.
In dealing with th |
us list five types of information and guid- ance that the investor may derive from a study of the balance sheet:
1. It shows how much capital is invested in the business.
2. It reveals the ease or stringency of the company’s financial condition, i.e., the working-capital position.
3. It contains the details of the capitalization structure.
4. It provides an important check upon the validity of the reported earnings.
5. It supplies the basis for analyzing the sources of income.
In dealing with the first of these functions of the balance sheet, we shall begin by presenting certain definitions. The book value of a stock is the value of the assets applicable thereto as shown in the balance sheet. It is customary to restrict this value to the tangible assets, i.e., to eliminate from the calculation such items as good-will, trade names, patents, fran- chises, leaseholds. The book value is also referred to as the “asset value,” and sometimes as the “tangible-asset value,” to make clear that intangi- bles are not included. In the case of common stocks, it is also frequently termed the “equity.”
Computation of Book Value. The book value per share of a common stock is found by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares.
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In many cases the following formula will be found to furnish a short cut to the answer:
Book Value per share of common
Common Stock + Surplus Items - Intangibles
=
Number of shares outstanding
By Surplus Items are meant not only items clearly marked as surplus but also premiums on capital stock and such reserves as are really part of the surplus. This would include, for example, reserves for preferred-stock retirement, for plant improvement, and for contingencies (unless known to be actually needed). Reserves of this character may be termed “ |
to furnish a short cut to the answer:
Book Value per share of common
Common Stock + Surplus Items - Intangibles
=
Number of shares outstanding
By Surplus Items are meant not only items clearly marked as surplus but also premiums on capital stock and such reserves as are really part of the surplus. This would include, for example, reserves for preferred-stock retirement, for plant improvement, and for contingencies (unless known to be actually needed). Reserves of this character may be termed “Volun- tary Reserves.”
CALCULATION OF BOOK VALUE OF UNITED STATES STEEL COMMON ON DECEMBER 31, 1938 CONDENSED BALANCE SHEET DECEMBER 31, 1938 (IN MILLIONS)
Assets Liabilities
1. Property Investment Account 7. Common Stock . . . . . . . . . . . . . . $653
(less depreciation) . . . . . . . . . . . . . $1,166 8. Preferred Stock . . . . . . . . . . . . . . 360
2. Mining Royalties . . . . . . . . . . . . . . 9 9. Subsidiary Stocks Publicly Held 5
3. Deferred Charges* . . . . . . . . . . . . . 4 10. Bonded Debt . . . . . . . . . . . . . . . 232
4. Miscellaneous Investments . . . . . 19 11. Mining Royalty Notes . . . . . . . 12
5. Miscellaneous Other Assets . . . . 3 12. Current Liabilities . . . . . . . . . . . 79
6. Current Assets . . . . . . . . . . . . . . . . 510 13. Contingency and Other Reserves 39
14. Insurance Reserves . . . . . . . . . . 46
15. Capital Surplus . . . . . . . . . . . . . 38
16. Earned Surplus . . . . . . . . . . . . . 247
$1,711 $1,711
Tangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,711,000,000
Less: All liabilities ahead of common (Sum of items 8–12) . . . . . . . . 688,000,000
Net assets for common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,023,000,000
Book value per share (on 8,700,000 shares). . . . . . . . . . . . . . . . . . . . . $117.59
* Considerable argument could be staged over the question whether Deferred Charges are intangible or tangible a |
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,711,000,000
Less: All liabilities ahead of common (Sum of items 8–12) . . . . . . . . 688,000,000
Net assets for common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,023,000,000
Book value per share (on 8,700,000 shares). . . . . . . . . . . . . . . . . . . . . $117.59
* Considerable argument could be staged over the question whether Deferred Charges are intangible or tangible assets, but as the amount involved is almost always small, the matter has no practical importance. It is more convenient, of course, to include the Deferred Charges with the other assets.
The alternative method of computation, which is usually shorter than the foregoing, is as follows:
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $653,000,000
Surplus and voluntary reserves (Sum of items 13–16) . . . . . . . . . . 370,000,000
Net assets for common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,023,000,000
Treatment of Preferred Stock When Calculating Book Value of Common. In calculating the assets available for the common stock, care must be taken to subtract preferred stock at its proper valuation. Ordi- narily, this will be the par or stated value of the preferred stock as it appears in the balance sheet. But there is a growing number of cases in which preferred stock is carried in the balance sheet at arbitrary values far lower than the real liability attaching thereto.
Island Creek Coal Company has a preferred stock of $1 par, which is entitled to annual dividends of $6 and to $120 per share in the event of dissolution. In 1939 the price of this issue ruled about 120. In the calcula- tion of the asset value of Island Creek Coal Common the preferred stock should be deducted not at $1 per share but at $100 per share, its “true” or “effective” par, or else at 120. Capital Administration Company |
arbitrary values far lower than the real liability attaching thereto.
Island Creek Coal Company has a preferred stock of $1 par, which is entitled to annual dividends of $6 and to $120 per share in the event of dissolution. In 1939 the price of this issue ruled about 120. In the calcula- tion of the asset value of Island Creek Coal Common the preferred stock should be deducted not at $1 per share but at $100 per share, its “true” or “effective” par, or else at 120. Capital Administration Company, Ltd., an investment trust, has outstanding preferred stock entitled to $3 cumula- tive dividends and to $50 or $55 in liquidation, but its par value is $10. It has also a Class A stock entitled to $20 in liquidation plus 70% of the assets remaining and to 70% of the earnings paid out after preferred dividends, but the par value of this issue is $1. Finally it has Class B stock, par 1 cent, entitled to the residue of earnings and assets. Obviously a balance sheet set up on the basis of par value is worse than meaningless in this case, and it must be corrected by the analyst somewhat as follows:
BALANCE SHEET DECEMBER 31, 1938
As published As revised
Total assets (at cost) $5,335,300 (at mkt.) $5,862,500
Payables and accruals 1,661,200 1,661,200
Preferred stock (at par $10) 434,000 (at 55*) 2,387,000
Class A stock (at par $1) 143,400 (at 20*) 2,868,000
Common stock (at par 1 cent) 2,400 1,043,600(d)
Surplus and reserves 3,094,300
Total liabilities $5,335,300 $5,862,600
* These approximate the effective par values of the issues.
Coca-Cola Company has outstanding a no-par Class A stock entitled to preferential dividends of $3 per share, cumulative, and redeemable at 55. The company carries this issue as a liability at its “stated value” of $5 per share. But the true par value is clearly $50.1
In all instances such as the above an “effective par value” must be set up for the preferred stock that will correspond properly to its dividend rate. A strong argument may be adva |
proximate the effective par values of the issues.
Coca-Cola Company has outstanding a no-par Class A stock entitled to preferential dividends of $3 per share, cumulative, and redeemable at 55. The company carries this issue as a liability at its “stated value” of $5 per share. But the true par value is clearly $50.1
In all instances such as the above an “effective par value” must be set up for the preferred stock that will correspond properly to its dividend rate. A strong argument may be advanced in favor of valuing all preferred stocks on a uniform dividend basis, say 5%, unless callable at a lower figure. This would mean that a $1,000,000 five per cent issue would be valued at
$1,000,000, a $1,000,000 four per cent issue would be given an effective value of $800,000 and a $1,000,000 seven per cent noncallable issue would be given an effective value of $1,400,000. But it is more convenient, of course, to use the par value, and in most cases the result will be sufficiently accurate.2 A simpler method, which would work well for most practical purposes, is to value preferred issues at par (plus back dividends) or mar- ket, whichever is higher.
Calculation of Book Value of Preferred Stocks. In calculating the book value of a preferred stock issue it is treated as a common stock and the issues junior to it are left out of consideration. The following compu- tations from the December 31, 1932, balance sheet of Tubize Chatillon Corporation will illustrate the principles involved.
1 Amusingly enough, in 1929 the company carried as an asset 194,000 repurchased shares of Class A stock at their cost of $9,434,000, although the entire issue of 1,000,000 shares appeared as a liability of only $5,000,000. For a similar accounting absurdity applied to com- mon stocks, see the June 1939 balance sheet of Hecker Products—on which its net stated lia- bility for its capital stock works out as a minus figure.
2 Standard Statistics Company, Inc., follows the practice of deducting p |
.
1 Amusingly enough, in 1929 the company carried as an asset 194,000 repurchased shares of Class A stock at their cost of $9,434,000, although the entire issue of 1,000,000 shares appeared as a liability of only $5,000,000. For a similar accounting absurdity applied to com- mon stocks, see the June 1939 balance sheet of Hecker Products—on which its net stated lia- bility for its capital stock works out as a minus figure.
2 Standard Statistics Company, Inc., follows the practice of deducting preferred stock at its value in case of involuntary liquidation, when computing the book value of the common. This is scarcely logical, because dissolution or liquidation is almost always a remote contin- gency and would take place under conditions quite different from those obtaining at the time of analysis. The Standard Statistics Company method results in placing a “value” of
$115 per share on Procter and Gamble Company $5 Second Preferred and a value of only
$100 per share on the same company’s $8 First Preferred. The real or practical value of the preferred stockholder’s claims in this case would be much nearer in the proportion of 160 for the First Preferred against 100 for the Second Preferred, a 5% dividend yield basis for both. In the case of investment-trust issues, liquidation values of preferred issues are more relevant and should generally be used.
TUBIZE CHATILLON CORPORATION BALANCE SHEET, DECEMBER 31, 1932
Property and
Assets
Liabilities
7% First Preferred Stock
Equipment . . . . . . . . . . . . . . . $19,009,000 (par $100) . . . . . . . . . . . . . . . $ 2,500,000
Patents, Processes, etc. . . . . . . . 802,000 $7 Second Preferred Stock
Miscellaneous Assets . . . . . . . . 478,000 (par $1) . . . . . . . . . . . . . . . . . 136,000
Current Assets . . . . . . . . . . . . . . 4,258,000 Common Stock (par $1) . . . . . 294,000
Bonded Debt . . . . . . . . . . . . . . . 2,000,000
Current Liabilities . . . . . . . . . . . 613,000
Reserve for Depreci |
k
Equipment . . . . . . . . . . . . . . . $19,009,000 (par $100) . . . . . . . . . . . . . . . $ 2,500,000
Patents, Processes, etc. . . . . . . . 802,000 $7 Second Preferred Stock
Miscellaneous Assets . . . . . . . . 478,000 (par $1) . . . . . . . . . . . . . . . . . 136,000
Current Assets . . . . . . . . . . . . . . 4,258,000 Common Stock (par $1) . . . . . 294,000
Bonded Debt . . . . . . . . . . . . . . . 2,000,000
Current Liabilities . . . . . . . . . . . 613,000
Reserve for Deprecia-
tion, etc . . . . . . . . . . . . . . . . . . 11,456,000
Surplus . . . . . . . . . . . . . . . . . . . . 7,548,000
Total Assets . . . . . . . . . . . . . . $24,547,000 Total Liabilities . . . . . . . . . . . $24,547,000
The book value of the First Preferred is computed as follows:
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
802,000 $24,547,000
Reserve for Depreciation, etc . . . . . . . . . . . . . . . . . . . . . . . . . 11,456,000
Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000
Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613,000 14,871,000
Net assets for First Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,676,000
Book value per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $387
Alternative method:
Capital Stock at par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,930,000
Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,548,000
$10,478,000
Less Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 802,000
Net assets for First Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
. . . . . . . . . . . . . . . $387
Alternative method:
Capital Stock at par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,930,000
Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,548,000
$10,478,000
Less Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 802,000
Net assets for First Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$9,676,000
The Reserve for Depreciation and Miscellaneous Purposes was very large and might have included arbitrary allowances belonging in Surplus. But in the absence of details a reserve of this kind must be deducted from the assets. (It later transpired that a substantial part of the reserve was needed to absorb a write-off of plant abandoned owing to obsolescence.)
The book value of the Second Preferred stock is readily computed from the foregoing, as follows:
Net assets for First Preferred $9,676,000
Less: First Preferred at par 2,500,000
Net assets for Second Preferred $7,176,000
Book value per share . . . . . . . . . . . . . . . . . . . . . . . . . . $52.75
In computing the book value of the common it would be an obvious error to deduct the Second Preferred at its nonrepresentative par value of
$1. The “effective par” should be taken at not less than $100 per share, in view of the $7 dividend. Hence there are no assets available for the com- mon stock, and its book value is nil.
Current-asset Value and Cash-asset Value. In addition to the well- known concept of book value, we wish to suggest two others of similar character, viz., current-asset value and cash-asset value.
The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue. It excludes not only the intangible assets but the fixed and miscellaneous assets as well.
The cash-asset value of a stock consists of the cash assets alone, minus a |
alue is nil.
Current-asset Value and Cash-asset Value. In addition to the well- known concept of book value, we wish to suggest two others of similar character, viz., current-asset value and cash-asset value.
The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue. It excludes not only the intangible assets but the fixed and miscellaneous assets as well.
The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the issue.3 Cash assets, other than cash itself, are defined as those directly equivalent to and held in place of cash. They include certificates of deposit, call loans, marketable securities at market value and cash-surrender value of insurance policies.
The following is an example of the computation of the three categories of asset value:
OTIS COMPANY (COTTON GOODS) BALANCE SHEET, JUNE 29, 1929
Assets Liabilities
1. Cash . . . . . . . . . . . . . . . . . . $532,000 8. Accounts Payable . . . . . . . $79,000
2. Call Loans . . . . . . . . . . . . . 1,200,000 9. Accrued Items, etc. . . . . . . 291,000
3. Accounts Receivable 10. Reserve for
(less reserve) . . . . . . . . . . . 1,090,000 Equipment, etc . . . . . . . . . 210,000
4. Inventory (less reserve of 11. Preferred Stock . . . . . . . . . 400,000
$425,000)* . . . . . . . . . . . . . 1,648,000 12. Common Stock . . . . . . . . . 4,079,000
5. Prepaid Items . . . . . . . . . . 108,000 13. Earned Surplus . . . . . . . . . 1,944,000
6. Investments . . . . . . . . . . . . 15,000 14. Paid-in Surplus . . . . . . . . . 1,154,000
7. Plant (less Depreciation) . 3,564,000
$8,157,000 $8,157,000
* Inventories before reserves are valued at cost or market, whichever is lower.
3 Cash assets per share of common are sometimes calculated without deduction of any liabil- ities. In our opinion this is a useful concept only when the other current assets exceed all liabilities ahead of the common.
A |
urplus . . . . . . . . . 1,944,000
6. Investments . . . . . . . . . . . . 15,000 14. Paid-in Surplus . . . . . . . . . 1,154,000
7. Plant (less Depreciation) . 3,564,000
$8,157,000 $8,157,000
* Inventories before reserves are valued at cost or market, whichever is lower.
3 Cash assets per share of common are sometimes calculated without deduction of any liabil- ities. In our opinion this is a useful concept only when the other current assets exceed all liabilities ahead of the common.
A. Calculation of book value of common stock:
B.
C.
In these calculations it will be noted, first, that the inventory is increased by restoring the reserve of $425,000 subtracted therefrom in the balance sheet. This is done because the deduction taken by the com- pany is clearly a reserve for contingent decline in value that has not yet taken place. As such it is entirely arbitrary or voluntary, and consistency of method would require the analyst to regard it as a surplus item. The same is true of the $210,000 “Reserve for Equipment and Other Expenses,” which, as far as can be seen, represents neither an actual lia- bility nor a necessary deduction from the value of any specific asset.
In June 1929 Otis Company common stock was selling at 35. The reader will observe an extraordinary divergence between this market price and the current-asset value of the shares. Its significance will engage our attention later.
Practical Significance of Book Value. The book value of a common stock was originally the most important element in its financial exhibit. It was supposed to show “the value” of the shares in the same way as a mer- chant’s balance sheet shows him the value of his business. This idea has almost completely disappeared from the financial horizon. The value of a company’s assets as carried in its balance sheet has lost practically all its significance. This change arose from the fact, first, that the value of the fixed assets, as stated, frequently |
ue of a common stock was originally the most important element in its financial exhibit. It was supposed to show “the value” of the shares in the same way as a mer- chant’s balance sheet shows him the value of his business. This idea has almost completely disappeared from the financial horizon. The value of a company’s assets as carried in its balance sheet has lost practically all its significance. This change arose from the fact, first, that the value of the fixed assets, as stated, frequently bore no relationship to the actual cost and, secondly, that in an even larger proportion of cases these values bore no relationship to the figure at which they would be sold or the figure which would be justified by the earnings. The practice of inflating the book value of the fixed property is giving way to the opposite artifice of cutting it down to nothing in order to avoid depreciation charges, but both have the same consequence of depriving the book-value figures of any real sig- nificance. It is a bit strange, like a quaint survival from the past, that the leading statistical services still maintain the old procedure of calculating the book value per share of common stock from many, perhaps most, bal- ance sheets that they publish.
Before we discard completely this time-honored conception of book value, let us ask if it may ever have practical significance for the analyst. In the ordinary case, probably not. But what of the extraordinary or extreme case? Let us consider the four exhibits shown on p. 556, as representative of extreme relationships between book value and market price.
No thoughtful observer could fail to be impressed by the disparities revealed in the examples given. In the case of General Electric and Com- mercial Solvents the figures proclaim more than the bare fact that the mar- ket was valuing the shares at many times their book value. The stock ticker seems here to register an aggregate valuation for these enterprises that is totally unrelated to th |
exhibits shown on p. 556, as representative of extreme relationships between book value and market price.
No thoughtful observer could fail to be impressed by the disparities revealed in the examples given. In the case of General Electric and Com- mercial Solvents the figures proclaim more than the bare fact that the mar- ket was valuing the shares at many times their book value. The stock ticker seems here to register an aggregate valuation for these enterprises that is totally unrelated to their standing as ordinary business enterprises. In other words, these are in no sense business valuations; they are products of Wall Street’s legerdemain, or possibly of its clairvoyance.
Financial Reasoning vs. Business Reasoning. We have here the point that brings home more strikingly perhaps than any other the widened rift between financial thought and ordinary business thought. It is an almost unbelievable fact that Wall Street never asks, “How much is the business selling for?” Yet this should be the first question in considering a stock purchase. If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price
by 20 and thus establish a proposed value of $200,000 for the entire undertaking. The rest of his calculation would turn about the question whether or not the business was a “good buy” at $200,000.
Item General Electric Pepperell Manufacturing
Price (1930) 95 (1932) 18
Number of shares 28,850,000 97,600
Market value of common $2,740,000,000 $ 1,760,000
Balance sheet (Dec. 1929) (June 1932)
Fixed assets (less depreciation) $ 52,000,000 $ 7,830,000
Miscellaneous assets 183,000,000 230,000
Net current assets 206,000,000 9,120,000
Total net assets $ 441,000,000 $17,180,000
Less bonds and preferred 45,000,000
Book value of common $ 396,000,000 $17,180,000
Book value per share $13.75 $176
Item Commercial Solvents Pennsylvania Coal and Coke
Price (July 1933) 57 (July 1933) 3
Number of shares 2, |
00
Market value of common $2,740,000,000 $ 1,760,000
Balance sheet (Dec. 1929) (June 1932)
Fixed assets (less depreciation) $ 52,000,000 $ 7,830,000
Miscellaneous assets 183,000,000 230,000
Net current assets 206,000,000 9,120,000
Total net assets $ 441,000,000 $17,180,000
Less bonds and preferred 45,000,000
Book value of common $ 396,000,000 $17,180,000
Book value per share $13.75 $176
Item Commercial Solvents Pennsylvania Coal and Coke
Price (July 1933) 57 (July 1933) 3
Number of shares 2,493,000 165,000
Market value of common $142,000,000 $ 495,000
Balance sheet (Dec. 1932) (Dec. 1932)
Fixed assets (less depreciation) 6,500,000
Miscellaneous assets 2,600,000 990,000
Net current assets 6,000,000 740,000
Total assets for common $ 8,600,000 $8,230,000
Book value per share $3.50 $50
This elementary and indispensable approach has been practically aban- doned by those who purchase stocks. Of the thousands who “invested” in General Electric in 1929–1930 probably only an infinitesimal number had any idea that they were paying on the basis of about 21/2 billions of dollars for the company, of which over two billions represented a premium above the money actually invested in the business. The price of 57 established for Commercial Solvents in July 1933 was more of a gambling phenomenon,
induced by the expected repeal of prohibition. But the gamblers in this instance were acting no differently from those who call themselves investors, in their blithe disregard of the fact that they were paying 140 millions for an enterprise with about 10 millions of resources. (The fixed assets of Commercial Solvents, written down to nothing in the balance sheet, had real value, of course, but not in excess of a few millions.)
The contrast in the other direction shown by our examples is almost as impressive. A going but unsuccessful concern like Pennsylvania Coal and Coke can be valued in the market at about one-sixteenth of its stated resources almost on the same day as a speculati |
t they were paying 140 millions for an enterprise with about 10 millions of resources. (The fixed assets of Commercial Solvents, written down to nothing in the balance sheet, had real value, of course, but not in excess of a few millions.)
The contrast in the other direction shown by our examples is almost as impressive. A going but unsuccessful concern like Pennsylvania Coal and Coke can be valued in the market at about one-sixteenth of its stated resources almost on the same day as a speculatively attractive issue is bid for at sixteen times its net worth. The Pepperell example is perhaps more striking still, because of the unquestioned reality of the figures of book value and also because of the high reputation, large earnings, and liberal dividends of the enterprise covering a long stretch of years. Yet part own- ers of this business—under the stress of depression, it is true—were will- ing to sell out their interest at one-tenth of the value that a single private owner would have unhesitatingly placed upon it.
Recommendation. These examples, extreme as they are, suggest rather forcibly that the book value deserves at least a fleeting glance by the pub- lic before it buys or sells shares in a business undertaking. In any partic- ular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention. But this testimony should be examined before it is rejected. Let the stock buyer, if he lays any claim to intelligence, at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.
There are indeed certain presumptions in favor of purchases made far below asset value and against those made at a high premium above it. (It is assumed that in the ordinary case the book figures may be accepted as roughly indicative of the actual cash invested in the enterprise.) A busi- ness that sells at a premium does so because |
ble to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.
There are indeed certain presumptions in favor of purchases made far below asset value and against those made at a high premium above it. (It is assumed that in the ordinary case the book figures may be accepted as roughly indicative of the actual cash invested in the enterprise.) A busi- ness that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely. Conversely in the case of a busi- ness selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces may tend eventually to improve the situation and restore a normal rate of profit on the investment.
Although this is orthodox economic theory, and undoubtedly valid in a broad sense, we doubt if it applies with sufficient certainty and celerity to make it useful as a governing factor in common-stock selection. It may be pointed out that under modern conditions the so-called “intangibles,” e.g., good-will or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery.4 Earnings based on these intangibles may be even less vulnerable to com- petition than those which require only a cash investment in productive facilities. Furthermore, when conditions are favorable the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a busi- ness requiring a large plant investment per dollar of sales.
We do not think, therefore, that any rules may reasonably be laid down on the sub |
ose which require only a cash investment in productive facilities. Furthermore, when conditions are favorable the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a busi- ness requiring a large plant investment per dollar of sales.
We do not think, therefore, that any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchaser know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.
4 Judicial valuations of intangible assets (in the case of close corporations) still seem to adhere to the old concept that they are less “real” than tangible assets and thus need larger earnings, relatively, to support them. The divergence between the stock market’s bases of val- uation and those of business men and the courts, as applied to private enterprises, would provide excellent material for a critical study.
For a quantitative study leading to the conclusion that “good-will” has, on the whole, proved more profitable than tangible assets, see Lawrence N. Bloomberg, The Investment Value of Goodwill, Baltimore, 1938.
Chapter 43
SIGNIFICANCE OF THE
CURRENT-ASSET VALUE
THE CURRENT-ASSET VALUE of a common stock is more likely to be an important figure than the book value, which includes the fixed assets. Our discussion of this point will develop the following theses:
1. The current-asset value is generally a rough index of the liquidat- ing value.
2. A large number of common stocks sell for less than their current- asset value and therefore sell below the amount realizable in liquidation.
3. The phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It means that a serious error is being committed, |
the book value, which includes the fixed assets. Our discussion of this point will develop the following theses:
1. The current-asset value is generally a rough index of the liquidat- ing value.
2. A large number of common stocks sell for less than their current- asset value and therefore sell below the amount realizable in liquidation.
3. The phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It means that a serious error is being committed, either: (a) in the judgment of the stock market, (b) in the policies of the company’s management, or (c) in the attitude of the stockholders toward their property.
Liquidating Value. By the liquidating value of an enterprise we mean the money that the owners could get out of it if they wanted to give it up. They might sell all or part of it to some one else, on a going-concern basis. Or else they might turn the various kinds of assets into cash, in piecemeal fashion, taking whatever time is needed to obtain the best realization from each. Such liquidations are of everyday occurrence in the field of private business. By contrast, however, they are very rare indeed in the field of publicly owned corporations. It is true that one company often sells out to another, usually at a price well above liqui- dating value, also that insolvency will at times result in the piecemeal sale of the assets; but the voluntary withdrawal from an unprofitable business, accompanied by the careful liquidation of the assets, is an infi- nitely more frequent happening among private than among publicly owned concerns. This divergence is not without its cause and meaning, as we shall show later.
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Realizable Value of Assets Varies with Their Character. A com- pany’s balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints which m |
on of the assets, is an infi- nitely more frequent happening among private than among publicly owned concerns. This divergence is not without its cause and meaning, as we shall show later.
[559]
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Realizable Value of Assets Varies with Their Character. A com- pany’s balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints which may prove useful. The first rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount. The value to be ascribed to the assets, however, will vary according to their character. The following schedule indicates fairly well the relative depend- ability of various types of assets in liquidation.
Type of asset % of liquidating value to book value
Normal range Rough average
Current assets:
Cash assets (including securities at market) Receivables (less usual reserves)* Inventories (at lower of cost or market)
Fixed and miscellaneous assets:
(Real estate, buildings, machinery, equipment, nonmarketable investments, intangibles, etc.)
100
100
75–90 80
50–75 662/3
1–50
15 (approx.)
* Note: Retail installment accounts must be valued for liquidation at a lower rate. Range about 30 to 60%. Average about 50%.
Calculation Illustrated. The calculation of approximate liquidating value in a specific case is illustrated as follows:
Example: White Motor Company. (See next page.)
Object of This Calculation. In studying this computation it must be borne in mind that our object is not to determine the exact liquidating value of White Motor but merely to form a rough idea of this liquidating value in order to ascertain whether or not the shares are selling for less than the stock- holders could actually take out of the business. The latte |
calculation of approximate liquidating value in a specific case is illustrated as follows:
Example: White Motor Company. (See next page.)
Object of This Calculation. In studying this computation it must be borne in mind that our object is not to determine the exact liquidating value of White Motor but merely to form a rough idea of this liquidating value in order to ascertain whether or not the shares are selling for less than the stock- holders could actually take out of the business. The latter question is answered very definitely in the affirmative. With full allowance for possible error, there was no doubt at all (in 1931) that White Motor would liquidate for a great deal more than $8 per share, or $5,200,000 for the company. The striking fact that the cash assets alone considerably exceed this figure, after deduct- ing all liabilities, completely clinched the argument on this score.
Current-asset Value a Rough Measure of Liquidating Value. The esti- mated values in liquidation as given for White Motor are somewhat lower
in respect of inventories and somewhat higher as regards the fixed and mis- cellaneous assets than one might be inclined to adopt in other examples. We are allowing for the fact that motor-truck inventories are likely to be less sal- able than the average. On the other hand some of the assets listed as non- current, in particular the investment in White Motor Securities Corporation,
WHITE MOTOR COMPANY
Capitalization: 650,000 shares of common stock. Price in December 1931: $8 per share.
Total market value of the company: $5,200,000.
BALANCE SHEET, DECEMBER 31, 1931 (000 OMITTED)
Item
Book value Estimated liquidating value
% of book value
Amount
Cash
U.S. Govt. and New York City bonds $ 4,057
4,573
100
$ 8,600
Receivables (less reserves) 5,611 80 4,500
Inventory (lower of cost or market) 9,219 50 4,600
Total current assets
$23,460 $17,700
Less current liabilities 1,353 1,400
Net current assets
$22,107 $16,300
Plant accou |
ice in December 1931: $8 per share.
Total market value of the company: $5,200,000.
BALANCE SHEET, DECEMBER 31, 1931 (000 OMITTED)
Item
Book value Estimated liquidating value
% of book value
Amount
Cash
U.S. Govt. and New York City bonds $ 4,057
4,573
100
$ 8,600
Receivables (less reserves) 5,611 80 4,500
Inventory (lower of cost or market) 9,219 50 4,600
Total current assets
$23,460 $17,700
Less current liabilities 1,353 1,400
Net current assets
$22,107 $16,300
Plant account 16,036
Less depreciation 7,491
Plant account, net
Investments in subsidiaries, etc. $ 8,545
4,996 20 4,000
Deferred charges 388
Good-will 5,389
Total net assets for common stock $41,425 $20,300
Estimated liquidating value per share $31
Book value per share 55
Current-asset value per share 34
Cash-asset value per share $11
Market price per share 8
would be likely to yield a larger proportion of their book values than the ordinary property account. It will be seen that White Motor’s estimated liquidating value (about $31 per share) was not far from the current-asset value ($34 per share). In the typical case it may be said that the noncurrent assets are likely to realize enough to make up most of the shrinkage suffered in the liquidation of the current assets. Hence our first thesis, viz., that the current-asset value affords a rough measure of the liquidating value.
Prevalence of Stocks Selling below Liquidating Value. Our sec- ond point is that for some years past a considerable number of common stocks have been selling in the market well below their liquidating value. Naturally the percentage was largest during the depression. But even in the bull market of 1926–1929 instances of this kind were by no means rare. It will be noted that the striking case of Otis Company, presented in the last chapter, occurred during June 1929, at the very height of the boom. The Northern Pipe Line example, given in Chap. 41, dates from 1926. On the other hand, our Pepperel |
a considerable number of common stocks have been selling in the market well below their liquidating value. Naturally the percentage was largest during the depression. But even in the bull market of 1926–1929 instances of this kind were by no means rare. It will be noted that the striking case of Otis Company, presented in the last chapter, occurred during June 1929, at the very height of the boom. The Northern Pipe Line example, given in Chap. 41, dates from 1926. On the other hand, our Pepperell and White Motor illustrations were phenomena of the 1931–1933 collapse.
It seems to us that the most distinctive feature of the stock market of those three years was the large proportion of issues which sold below their liquidating value. Our computations indicate that over 40% of all the indus- trial companies listed on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets. A considerable num- ber actually sold for less than their cash-asset value, as in the case of White Motor.1 On reflection this must appear to be an extraordinary state of affairs. The typical American corporation was apparently worth more dead than alive. The owners of these great businesses could get more for their interest by shutting up shop than by selling out on a going-concern basis. In the recession of 1937–1938 this situation was repeated on a smaller scale. Available data indicate that 20.5% of the industrial companies listed on the New York Stock Exchange sold in early 1938 at less than their net-current-asset value. (At the close of 1938, when the general price level was by no means abnormally low, a total of 54 companies out of 648
industrials studied sold for less than their net current assets.2)
1 See Appendix Note 62, p. 814 on accompanying CD, for a representative list of issues sell- ing for less than liquidating value in 1932.
2 See Appendix Note 61, p. 800 on accompanying CD, for other details on this point.
It is important to observe th |
d in early 1938 at less than their net-current-asset value. (At the close of 1938, when the general price level was by no means abnormally low, a total of 54 companies out of 648
industrials studied sold for less than their net current assets.2)
1 See Appendix Note 62, p. 814 on accompanying CD, for a representative list of issues sell- ing for less than liquidating value in 1932.
2 See Appendix Note 61, p. 800 on accompanying CD, for other details on this point.
It is important to observe that these widespread discrepancies between price and current-asset value are a comparatively recent development. In the severe market depression of 1921 the proportion of industrial stocks in this class was quite small. Evidently the phenomena of 1932 (and 1938) were the direct out-growth of the new-era doctrine which transferred all the tests of value to the income account and completely ignored the bal- ance-sheet picture. In consequence, a company without current earnings was regarded as having very little real value, and it was likely to sell in the market for the merest fraction of its realizable resources. Most of the sell- ers were not aware that they were disposing of their interest at far less than its scrap value. Many, however, who might have known the fact would have justified the low price on the ground that the liquidating value was of no practical importance, since the company had no intention of liquidating.
Logical Significance of This Phenomenon. This brings us to the third point, viz., the logical significance of this “subliquidating-value” phenomenon from the standpoint of the market, of the managements and of the stockholders. The whole issue may be summarized in the form of a basic principle, viz.:
When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated.
Two corollaries may be deduced from this principle:
Corollary I. Such a price should impel the stockholders to raise the qu |
third point, viz., the logical significance of this “subliquidating-value” phenomenon from the standpoint of the market, of the managements and of the stockholders. The whole issue may be summarized in the form of a basic principle, viz.:
When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated.
Two corollaries may be deduced from this principle:
Corollary I. Such a price should impel the stockholders to raise the question whether or not it is in their interest to continue the business.
Corollary II. Such a price should impel the management to take all proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business.
The truth of the principle above stated should be self-evident. There can be no sound economic reason for a stock’s selling continuously below its liquidation value. If the company is not worth more as a going concern than in liquidation, it should be liquidated. If it is worth more as a going concern, then the stock should sell for more than its liquidating value. Hence, on either premise, a price below liquidating value is unjustifiable. Twofold Application of Foregoing Principle. Stated in the form of a log- ical alternative, our principle invites a twofold application. Stocks selling below liquidation value are in many cases too cheap and so offer an attractive medium for purchase. We have thus a profitable field here for
the technique of security analysis. But in many cases also the fact that an issue sells below liquidating value is a signal that mistaken policies are being followed and that therefore the management should take correc- tive action—if not voluntarily, then under pressure from the stockhold- ers. Let us consider these two lines of inquiry in order.
ATTRACTIVENESS OF SUCH ISSUES
AS COMMITMENTS |
ses too cheap and so offer an attractive medium for purchase. We have thus a profitable field here for
the technique of security analysis. But in many cases also the fact that an issue sells below liquidating value is a signal that mistaken policies are being followed and that therefore the management should take correc- tive action—if not voluntarily, then under pressure from the stockhold- ers. Let us consider these two lines of inquiry in order.
ATTRACTIVENESS OF SUCH ISSUES
AS COMMITMENTS
Common stocks in this category practically always have an unsatisfac- tory trend of earnings. If the profits had been increasing steadily, it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue and that the resources will be dis- sipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this does actually happen in individual cases. On the other hand, there is a much wider range of potential developments which may result in establishing a higher market price. These include the following:
1. The creation of an earning power commensurate with the company’s assets. This may result from:
a. General improvement in the industry.
b. Favorable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
2. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
3. Complete or partial liquidation.
Examples of Effect of Favorable Developments on Such Issues. General Improvement in the Industry. Examples already given, and cer- tain others, will illustrate the operation of these various kinds of favor- able developments. In the case of Pepperell the low price of 171/2 coincide |
fitable lines, etc.
2. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
3. Complete or partial liquidation.
Examples of Effect of Favorable Developments on Such Issues. General Improvement in the Industry. Examples already given, and cer- tain others, will illustrate the operation of these various kinds of favor- able developments. In the case of Pepperell the low price of 171/2 coincided with a large loss for the year ended June 30, 1932. In the fol- lowing year conditions in the textile industry improved; Pepperell earned over $9 per share and resumed dividends; consequently the price of the stock advanced to 100 in January 1934 and to 1493/4 in 1936.
Changes in Operating Policies. Hamilton Woolen Company, another example in the textile field, is a case of individual rather than of general improvement. For several years prior to 1928 the company had operated at substantial losses, which amounted to nearly $20 and $12 per share in 1926 and 1927, respectively. Late in 1927 the common stock sold at $13 per share, although the company had net current assets of $38.50 per share at that time. In 1928 and 1929 changes in management and in man- agerial policies were made, new lines of product and direct sales meth- ods were introduced, and certain phases of production were reorganized. This resulted in greatly improved earnings which averaged about $5.50 per share during the succeeding four years, and within a single year the stock had risen to a price of about $40.3
Sale or Merger. The White Motor instance is typical of the genesis and immediate effect of a sale or merger, as applied to an issue selling for less than liquidating value. (The later developments, however, were quite unusual.) The heavy losses of White Motor in 1930–1932 impelled the management to seek a new alignment. Studebaker Corporation believed it could combine its own operations with those o |
the succeeding four years, and within a single year the stock had risen to a price of about $40.3
Sale or Merger. The White Motor instance is typical of the genesis and immediate effect of a sale or merger, as applied to an issue selling for less than liquidating value. (The later developments, however, were quite unusual.) The heavy losses of White Motor in 1930–1932 impelled the management to seek a new alignment. Studebaker Corporation believed it could combine its own operations with those of White to mutual advan- tage, and it was greatly attracted by White’s large holdings of cash. Hence in September 1932 Studebaker offered to purchase all White Motor’s stock, paying for each share as follows:
$5 in cash.
$25 in 10-year 6% notes of Studebaker Corporation. 1 share of Studebaker common, selling for about $10.
It will be seen that these terms of purchase were based not on the recent market price of White—below $7 per share—but primarily upon the current-asset value. White Motor shares promptly advanced to 27 and later sold at the equivalent of 311/2.4
An interesting example of the same kind, but of more recent date, is afforded by Standard Oil Company of Nebraska. The facts may be out- lined as follows:
3 For the later history of Hamilton Woolen Company, see pp. 584–585.
4 An extraordinary sequel of this transaction was the receivership of Studebaker Corporation in April 1933, ostensibly caused by the opposition of minority stockholders of White Motor to a merger of the two companies. But this development is quite unrelated to our point of discus- sion, which turns upon the fact that in a sale or merger full recognition should always be, and is ordinarily, given to liquidating value, even though the current market price may be much lower.
Early in 1939 the stock was selling at about $6, representing a total valuation of $1,000,000 for 161,000 shares comprising the entire capital- ization. The December 31, 1938, balance sheet is summarized in the appended table |
wo companies. But this development is quite unrelated to our point of discus- sion, which turns upon the fact that in a sale or merger full recognition should always be, and is ordinarily, given to liquidating value, even though the current market price may be much lower.
Early in 1939 the stock was selling at about $6, representing a total valuation of $1,000,000 for 161,000 shares comprising the entire capital- ization. The December 31, 1938, balance sheet is summarized in the appended table.
Assets Liabilities
Fixed and miscellaneous assets (net) . . $2,794,000 Current liabilities $176,000
Cash assets . . . . . . . . . . . . . . . . . . . . . . . . . 1,155,000 Capital stock and surplus 4,734,000
Other current assets . . . . . . . . . . . . . . . . . 961,000 $4,910,000
$4,910,000
(Net) Cash assets per share $6.07
Net current assets per share 12.05
Net tangible assets per share 29.33
The company was engaged in the distribution of petroleum products in Nebraska. It was carrying on an annual business of some $5,000,000 without appreciable profit. For the years 1935–1938 the reported earnings before depreciation averaged $0.69 per share; after “expended deprecia- tion” there was an average profit of $0.39 per share; and after depreciation as taken by the company there was an average loss of $0.39 per share.
Here was a company clearly selling for much less than liquidating value, the reason being its unsatisfactory earnings record. There was good reason to believe, however, that the company was really worth more than bare liquidating value, because the outlet it provided for gasoline, etc., would make its numerous retail and bulk stations a desirable acquisition for some large refining company.
In April 1939 private interests offered to pay $12 per share for 662/3% of the outstanding stock. This bid failed of acceptance by a sufficient majority, but it was followed immediately by an offer to pay $17.50 per share, made by Standard Oil Company of Indiana, the refine |
that the company was really worth more than bare liquidating value, because the outlet it provided for gasoline, etc., would make its numerous retail and bulk stations a desirable acquisition for some large refining company.
In April 1939 private interests offered to pay $12 per share for 662/3% of the outstanding stock. This bid failed of acceptance by a sufficient majority, but it was followed immediately by an offer to pay $17.50 per share, made by Standard Oil Company of Indiana, the refiner that had been supplying Standard Oil Company of Nebraska with its gasoline and that evidently was loath to lose this important outlet. The deal was promptly ratified; hence the stock of Standard Oil Company of Nebraska nearly tripled in value during a four-month’s period in which the general market had suffered a decline.5
5 See I. Benesch and Sons, and United Shipyards “A” in the table on p. 585 for other examples of a rise in price due to sale of properties.
Complete Liquidation. Mohawk Mining Company supplies an excel- lent example of a cash profit equivalent to a large advance in market value caused by the actual liquidation of the enterprise.
In December 1931 the stock sold at $11 per share, representing a total valuation of $1,230,000 for the 112,000 shares outstanding. The balance sheet at the end of 1931 showed the following:
Cash and marketable securities at market $1,381,000
Receivables 9,000
Copper at market value, about 1,800,000
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,000
$3,261,000
Less current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000
Net current assets $3,193,000
Fixed assets, less depreciation and depletion 2,460,000
Miscellaneous assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000
Total assets for common stock $5,821,000
Book value per share* $52
Cur |
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,000
$3,261,000
Less current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000
Net current assets $3,193,000
Fixed assets, less depreciation and depletion 2,460,000
Miscellaneous assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000
Total assets for common stock $5,821,000
Book value per share* $52
Current-asset value per share* 28.50
Cash-asset value per share* 11.75
Market price per share 11
* After reducing securities and copper inventory to market value.
Shortly thereafter the management decided to liquidate the property. Within the years 1932–1934 regular and liquidating dividends were paid, aggregating $28.50 per share. It will be noted that the amount actually received in liquidation proved identical with the current-asset value just before the liquidation began, and it was 21/2 times the ruling market price at that time.
Partial Liquidation. Northern Pipe Line Company and Otis Com- pany, already discussed, are examples of the establishment of a higher market value through partial liquidation. The two companies made the exhibits as shown in the table following.
In September 1929 Otis Company paid a special dividend of $4 per share, and in 1930 it made a distribution of $20 in partial liquidation, reducing the par value from $100 to $80. In April 1931 the shares sold at 45 and in April 1932 at 41. These prices were higher than the quotation in June 1929, despite the distributions of $24 per share made in the
interim, and despite the fact also that the general market level had changed from fantastic inflation to equally fantastic deflation. Later the company went out of business altogether and paid its stockholders an additional $74 per share in liquidation—making the total received by them $102 per share since June 1929 (inclusive of other dividends in 1929–1934 a |
d in April 1932 at 41. These prices were higher than the quotation in June 1929, despite the distributions of $24 per share made in the
interim, and despite the fact also that the general market level had changed from fantastic inflation to equally fantastic deflation. Later the company went out of business altogether and paid its stockholders an additional $74 per share in liquidation—making the total received by them $102 per share since June 1929 (inclusive of other dividends in 1929–1934 amounting to $4 per share).6
Item Northern Pipe Line Otis Company
Date 1926 June 1929
Market price $64 $35
Cash-asset value per share 79 231/2
Current-asset value per share 82 101
Book value per share 116 191
Northern Pipe Line Company distributed $50 per share to its stockhold- ers in 1928, as a return of capital, i.e., partial liquidation. This development resulted in an approximate doubling of the market price between 1926 and 1928. Later a second distribution of $20 per share was made, so that the stockholders received more in cash than in the low market price of 1925 and 1926, and they also retained their full interest in the pipe-line business. Similar liberal distributions were made by most of the pipe-line companies of the so-called Standard Oil group. (Note also the partial liquidation of Davis Coal and Coke Company, described in the footnote on p. 529.)
Discrimination Required in Selecting Such Issues. There is scarcely any doubt that common stocks selling well below liquidating value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase. Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this cate- gory. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments list |
ting value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase. Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this cate- gory. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above. Or else he will be partial to such as reveal other attractive statistical features
6 For other examples of liquidation bringing stockholders more than the previous market price see the table on p. 585.
besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.
Examples: This latter point will be illustrated by the following com- parison of two companies, the shares of which sold well below liquidat- ing value early in 1933.
Item
Manhattan Shirt Company Hupp Motor Car Corporation
Price, January 1933 6 21/2
Total market value of Company $1,476,000 $3,323,000
Balance sheet Nov. 30, 1932 Nov. 30, 1929 Dec. 31, 1932 Dec. 31, 1929
Preferred stock at par $ 300,000
Number of shares of common 246,000 281,000 1,329,000 1,475,000
Cash assets $1,961,000 $ 885,000 $ 4,615,000 $10,156,000
Receivables 771,000 2,621,000 226,000 1,246,000
Inventories 1,289,000 4,330,000 2,115,000 8,481,000
Total current assets $4,021,000 $7,836,000 $ 6,956,000 $19,883,000
Current liabilities 100,000 2,574,000 1,181,000 2,541,000
Net current assets $3,921,000 $5,262,000 $ 5,775,000 $17,342,000
Other tangible assets 1,124,000 2,066,000 9,757,000 17,870,000
Total assets for common
(and preferred) $5,045,000 $7,328,000 $15,532,000 $35,212,000
Cash-asset value per share $ 7.50 Nil |
00 $10,156,000
Receivables 771,000 2,621,000 226,000 1,246,000
Inventories 1,289,000 4,330,000 2,115,000 8,481,000
Total current assets $4,021,000 $7,836,000 $ 6,956,000 $19,883,000
Current liabilities 100,000 2,574,000 1,181,000 2,541,000
Net current assets $3,921,000 $5,262,000 $ 5,775,000 $17,342,000
Other tangible assets 1,124,000 2,066,000 9,757,000 17,870,000
Total assets for common
(and preferred) $5,045,000 $7,328,000 $15,532,000 $35,212,000
Cash-asset value per share $ 7.50 Nil $2.625 $ 5.125
Current-asset value per share 16.00 $17.50 4.375 11.75
Both of these companies disclose an interesting relationship of cur- rent assets to market price at the close of 1932. But a comparison with the balance-sheet situation of three years previously will yield much more satisfactory indications for Manhattan Shirt than for Hupp Motors. The latter concern had lost more than half of its cash assets and more than 60% of its net current assets during the depression period. On the other hand, the current-asset value of Manhattan Shirt common was reduced by only 10% during these difficult times, and furthermore, its cash-asset position was greatly improved. The latter result was obtained through the
liquidation of receivables and inventories, the proceeds of which paid off the 1929 bank loans and largely increased the cash resources.
From the viewpoint of past indications, therefore, the two companies must be placed in different categories. In the Hupp Motors case, we should have to take into account the possibility that the remaining excess of cur- rent assets over market price might soon be dissipated. This is not true so far as Manhattan Shirt is concerned, and in fact the achievement of the company in strengthening its cash position during the depression must be given favorable consideration. We shall recur later to this phase of secu- rity analysis, viz., the comparison of balance sheets over a period in order to determine the true progress of an enterprise. |
ld have to take into account the possibility that the remaining excess of cur- rent assets over market price might soon be dissipated. This is not true so far as Manhattan Shirt is concerned, and in fact the achievement of the company in strengthening its cash position during the depression must be given favorable consideration. We shall recur later to this phase of secu- rity analysis, viz., the comparison of balance sheets over a period in order to determine the true progress of an enterprise. The former point—that attention should be paid also to the past earnings record—may be brought home by a brief comparison of two companies in early 1939.
Item Ely & Walker Dry Goods Co. Pacific Mills
Price, January, 1939 17 14
Per share: Dec. 31, 1932 Dec. 31, 1938 Dec. 31, 1932 Dec. 31, 1938
Net current assets $30.00 $39.50 $26.95 $24.50
Net tangible assets 37.73 46.42 90.85 79.50
Average earnings, 1933–1938 1.82 2.41(d)
Average dividend, 1933–1938 1.25 0.50
The losses of Pacific Mills did not have a serious effect upon the bal- ance-sheet position because they have come mainly out of the balance sheet via the depreciation allowance. But unless there were special reasons to expect a reversal of the operating results, the analyst would obviously prefer Ely & Walker as an investment purchase.
Bargains of This Type. Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.
It may be pointed out, however, that investment in such bargain is |
power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.
It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low. The purchase of “cheap stocks” when the market as a whole seems much higher than it should be, e.g., in 1929 or early 1937, will not work out well, because the ensuing decline is likely to bear almost as severely on these neg- lected or unappreciated issues as on the general list. On the other hand, when all stocks are very cheap—as in 1932—there would seem to be fully as much reason to buy undervalued leading issues as to pick out less popular stocks, even though these may be selling at even lower prices by comparison.
A Common Stock Representing the Entire Business Cannot Be Less Safe than a Bond Having a Claim to Only a Part Thereof. In considering these issues it will be helpful to apply the converse of the proposition developed earlier in this book with reference to senior securities. We pointed out (Chap. 26) that a bond or preferred stock could not be worth more than its value would be if it represented full ownership of the company, i.e., if it were a common stock without senior claims ahead of it. The converse is also true. A common stock cannot be less safe than it would be if it were a bond, i.e., if instead of representing full ownership of the company it were given a fixed and limited claim, with some new common stock cre- ated to o |
ith reference to senior securities. We pointed out (Chap. 26) that a bond or preferred stock could not be worth more than its value would be if it represented full ownership of the company, i.e., if it were a common stock without senior claims ahead of it. The converse is also true. A common stock cannot be less safe than it would be if it were a bond, i.e., if instead of representing full ownership of the company it were given a fixed and limited claim, with some new common stock cre- ated to own what was left. This idea, which may appear somewhat abstract at first, may be clarified by a concrete comparison between a common stock and a bond issue of the types just described. Two compa- nies in the investment-trust field are particularly well suited to illustrate our point, because they were both organized by the same banking inter- ests, and they have identical officers.
Our table (p. 572) should make clear that Shawmut Association stock cannot be less safe intrinsically than the Investment Trust senior deben- tures at 85. For, with the same management behind them, the stock invest- ment has behind it 180% in assets, whereas the bonds are protected by only 122% (of their market price) in assets. In addition to having this greater protection the Association stock represents the entire ownership of the company’s assets, whereas the interest of the Investment Trust bonds is limited to their principal amount, the balance of the equity belonging to the junior holders. (In fact this junior equity can be fairly substantial, as measured by market price, even when the bonds are sell- ing at a considerable discount.)
As of December 1939
Shawmut Association Shawmut Bank Investment Trust
Bonds None $3,040,000 Senior Debenture 41/2s and 5s @ 85 (average)
= $2,585,000
$950,000 Junior Debenture 6s @ 50 (est) = $480,000
75,000 sh. @ 31/2 260,000
Stock
Total capitalization
Net asset value (September 1939)
Ratio: Senior bonds at market to net assets
Ratio: Total capitalization |
is junior equity can be fairly substantial, as measured by market price, even when the bonds are sell- ing at a considerable discount.)
As of December 1939
Shawmut Association Shawmut Bank Investment Trust
Bonds None $3,040,000 Senior Debenture 41/2s and 5s @ 85 (average)
= $2,585,000
$950,000 Junior Debenture 6s @ 50 (est) = $480,000
75,000 sh. @ 31/2 260,000
Stock
Total capitalization
Net asset value (September 1939)
Ratio: Senior bonds at market to net assets
Ratio: Total capitalization at market to net assets
12 months’ investment income* Per cent earned on capitalization
at market
390,000 sh. @ 101/4 $4,000,000
$4,000,000 7,201,000
55%
(To September 30) 198,000
5.0 $3,325,000
(November 1939) 3,153,000
82%
107%
(To November 30) 114,000
3.5
* Excluding gain or loss on security sales.
That the Shawmut Association stock is more attractive than the Invest- ment Trust debentures at the prices quoted is scarcely open to challenge. Undoubtedly, also, the investor who would consider the bond issue to be “safer” than the Association shares is being misled by the form into over- looking the essence. Yet something remains to be said of the effect of these diverse forms upon the experience of the investor and consequently upon his attitude. The Investment Trust bonds do carry a certain assurance of continued income, because interest must be paid regularly or else the company faces insolvency. It is true for the same reason that special efforts will be made to pay them off at or before maturity in 1942 and 1952. Therefore we find that the company has a special inducement to buy in bonds at a discount—since they must ultimately be paid at par—and thus one-third of the issue has been reacquired. This policy has served to maintain the market price to an important extent and to improve the position of the remaining bonds.
None of this is true with respect to the Shawmut Association shares. They have in fact received continuous dividends since 1929, averaging 65 |
m off at or before maturity in 1942 and 1952. Therefore we find that the company has a special inducement to buy in bonds at a discount—since they must ultimately be paid at par—and thus one-third of the issue has been reacquired. This policy has served to maintain the market price to an important extent and to improve the position of the remaining bonds.
None of this is true with respect to the Shawmut Association shares. They have in fact received continuous dividends since 1929, averaging 65 cents, or 61/2% on the current price. But the rate has been variable, and
the average stockholder feels that he is at the mercy of the management’s decisions. (This is not entirely so in fact, since the penalty clauses in the Revenue Act virtually compel disbursement of the net income realized by investment trusts.) Nor has the market price been maintained by com- pany repurchases at a reasonable discount from break-up value, so that the investor has been unable to look to the management to save him from the hard necessity of sacrificing his shares at as much as 50% below their intrinsic worth.
In the 1934 edition we illustrated this same point by considering American Laundry Machinery stock at its price of 7 in January 1933, which was equivalent to $4,300,000 for the entire company—as compared with over $4,000,000 in cash, $21,000,000 in net current assets,
$27,000,000 in net tangible assets and 10-year average earnings of over
$3,000,000 (including, however, a loss of $1,000,000 in 1932). The last two paragraphs of the chapter were as follows:
Wall Street would have considered American Laundry Machinery stock “unsafe” at 7, but it would unquestionably have accepted a $4,500,000 bond issue of the same company. Its “reasoning” would have run that the interest on the bond was sure to be continued but that the 40-cent dividend then being paid on the stock was very insecure. In one case the directors had no choice but to pay interest and therefore would surely do so; in the ot |
1932). The last two paragraphs of the chapter were as follows:
Wall Street would have considered American Laundry Machinery stock “unsafe” at 7, but it would unquestionably have accepted a $4,500,000 bond issue of the same company. Its “reasoning” would have run that the interest on the bond was sure to be continued but that the 40-cent dividend then being paid on the stock was very insecure. In one case the directors had no choice but to pay interest and therefore would surely do so; in the other case the directors could pay or not as they saw fit and therefore would very likely suspend the dividend. But Wall Street is here confusing the temporary con- tinuance of income with the more fundamental question of safety of princi- pal. Dividends paid to common-stock holders do not in themselves make the stock any safer. The directors are merely turning over to the stockholders part of their own property; if the money were left in the treasury, it would still be the stockholder’s property. There must therefore be an underlying fal- lacy in assuming that if the stockholders were given the power to compel payment of income—i.e., if they were made bondholders in whole or in part—their position would thus be made intrinsically sounder. It is little short of idiocy to assume that the stockholders would be better off if they surren- dered their complete ownership of the company in exchange for a limited claim against the same property at the rate of 5 or 6% on the investment. This is exactly what the public would do if it were willing to buy a $4,500,000 bond issue of American Laundry Machinery but would reject as “unsafe” the present common stock at $7 per share.
Nevertheless, Wall Street persists in thinking in these irrational terms, and it does so in part with practical justification. Somehow or other, common- stock ownership does not seem to give the public the same powers and pos- sibilities—the same values, in short—as are vested in the private owners of a business. |
xactly what the public would do if it were willing to buy a $4,500,000 bond issue of American Laundry Machinery but would reject as “unsafe” the present common stock at $7 per share.
Nevertheless, Wall Street persists in thinking in these irrational terms, and it does so in part with practical justification. Somehow or other, common- stock ownership does not seem to give the public the same powers and pos- sibilities—the same values, in short—as are vested in the private owners of a business. This brings us to the second line of reasoning on the subjects of stocks selling below liquidating value.
Chapter 44
IMPLICATIONS OF LIQUIDATING VALUE. STOCKHOLDER-MANAGEMENT
RELATIONSHIPS
WALL STREET HOLDS THAT liquidating value is of slight importance because the typical company has no intention of liquidating. This view is logical, as far as it goes. When applied to a stock selling below break-up value, the Wall Street view may be amplified into the following: “Although this stock would liquidate for more than its market price, it is not worth buying because
(1) the company cannot earn a satisfactory profit, and (2) it is not going to liquidate. In the previous chapter we suggested that the first assumption is likely to be wrong in a number of instances, for, although past earnings may have been disappointing, there is always a chance that through external or internal changes the concern may again earn a reasonable amount on its capital. But in a considerable proportion of cases the pessimism of the mar- ket will at least appear to be justified. We are led, therefore, to ask the ques- tion: “Why is it that no matter how poor a corporation’s prospects may seem, its owners permit it to remain in business until its resources are exhausted?” The answer to this question takes us into the heart of one of the strangest phenomena of American finance—the relations of stockhold- ers to the businesses that they own. The subject transcends in its scope the narrow field of securi |
es the pessimism of the mar- ket will at least appear to be justified. We are led, therefore, to ask the ques- tion: “Why is it that no matter how poor a corporation’s prospects may seem, its owners permit it to remain in business until its resources are exhausted?” The answer to this question takes us into the heart of one of the strangest phenomena of American finance—the relations of stockhold- ers to the businesses that they own. The subject transcends in its scope the narrow field of security analysis, but we shall discuss it here briefly because there is a distinct relationship between the value of securities and the intelligence and alertness of those who own them. The choice of a common stock is a single act; its ownership is a continuing process.
Certainly there is just as much reason to exercise care and judgment in
being as in becoming a stockholder.
Typical Stockholder Apathetic and Docile. It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity. He does what the board of directors tell him
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to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers. The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who together own a majority of the stock but by a small group known as “the management.” This situation has been effectively described by Berle and Means in their significant work The Modern Cor- poration and Private Property. In Chap. I of Book IV the authors say:
It is traditional that a corporation should be run for the benefit of its owners, the stockholders, and that to them should go any profits which are distrib- uted. We now know, however, that a controlling group may hold the power to divert profits into their own pockets. There is no longer a |
oup known as “the management.” This situation has been effectively described by Berle and Means in their significant work The Modern Cor- poration and Private Property. In Chap. I of Book IV the authors say:
It is traditional that a corporation should be run for the benefit of its owners, the stockholders, and that to them should go any profits which are distrib- uted. We now know, however, that a controlling group may hold the power to divert profits into their own pockets. There is no longer any certainty that a corporation will in fact be run primarily in the interests of the stockhold- ers. The extensive separation of ownership and control, and the strengthen- ing of the powers of control, raise a new situation calling for a decision whether social and legal pressure should be applied in an effort to insure cor- porate operation primarily in the interests of the owners or whether such pres- sure shall be applied in the interests of some other or wider group.
Again (on page 335) the authors restate this view in their concluding chapter as follows:
… A third possibility exists, however. On the one hand, the owners of pas- sive property, by surrendering control and responsibility over the active prop- erty, have surrendered the right that the corporation should be operated in their sole interest—they have released the community from the obligation to protect them to the full extent implied in the doctrine of strict property rights. At the same time, the controlling groups, by means of the extension of corporate powers, have in their own interest broken the bars of tradition which require that the corporation be operated solely for the benefit of the owners of passive property. Eliminating the sole interest of the passive owner, however, does not necessarily lay a basis for the alternative claim that the new powers should be used in the interest of the controlling groups. The lat- ter have not presented, in acts or words, any acceptable defense of the propo- sition |
y means of the extension of corporate powers, have in their own interest broken the bars of tradition which require that the corporation be operated solely for the benefit of the owners of passive property. Eliminating the sole interest of the passive owner, however, does not necessarily lay a basis for the alternative claim that the new powers should be used in the interest of the controlling groups. The lat- ter have not presented, in acts or words, any acceptable defense of the propo- sition that these powers should be so used. No tradition supports that proposition. The control groups have, rather, cleared the way for the claims of a group far wider than either the owners or the control. They have placed the community in a position to demand that the modern corporation serve not alone the owners or the control but all society.
Plausible but Partly Fallacious Assumptions by Stockholders. Alert stockholders—if there are any such—are not likely to agree fully with the conclusion of Messrs. Berle and Means that they definitely have “surrendered the right that the corporation should be operated in their sole interest.” After all, the American stockholder has abdicated not intentionally but by default. He can reassert the rights of control that inhere in ownership. Quite probably he would do so if he were properly informed and guided. In good part his docility and seeming apathy are results of certain traditional but unsound viewpoints which he seems to absorb by inheritance or by contagion. These cherished notions include the following:
1. The management knows more about the business than the stock- holders do, and therefore its judgment on all matters of policy is to be accepted.
2. The management has no interest in or responsibility for the prices at which the company’s securities sell.
3. If a stockholder disapproves of any major policy of the manage- ment, his proper move is to sell his stock.
Assumed Wisdom and Efficiency of Management Not Always Justified. Th |
or by contagion. These cherished notions include the following:
1. The management knows more about the business than the stock- holders do, and therefore its judgment on all matters of policy is to be accepted.
2. The management has no interest in or responsibility for the prices at which the company’s securities sell.
3. If a stockholder disapproves of any major policy of the manage- ment, his proper move is to sell his stock.
Assumed Wisdom and Efficiency of Management Not Always Justified. These statements sound plausible, but they are in fact only half truths—the more dangerous because they are not wholly false. It is nearly always true that the management is in the best position to judge which policies are most expedient. But it does not follow that it will always either recognize or adopt the course most beneficial to the share- holders. It may err grievously through incompetence. Stockholders of any given company appear to take it for granted that their management is capable. Yet the art of selecting stocks is said to turn largely on choosing the well-managed enterprise and rejecting others. This must imply that many companies are poorly directed. Should not this mean also that the stockholders of any company should be open-minded on the question whether its management is efficient or the reverse?
Interests of Stockholders and Officers Conflict at Certain Points. But a second reason for not always accepting implicitly the deci- sions of the management is that on certain points the interests of the offi- cers and the stockholders may be in conflict. This field includes the following:
1. Compensation to officers—Comprising salaries, bonuses, options to buy stock.
2. Expansion of the business—Involving the right to larger salaries and the acquisition of more power and prestige by the officers.
3. Payment of dividends—Should the money earned remain under the control of the management or pass into the hands of the stockholders?
4. Continuance of the stockholders |
n points the interests of the offi- cers and the stockholders may be in conflict. This field includes the following:
1. Compensation to officers—Comprising salaries, bonuses, options to buy stock.
2. Expansion of the business—Involving the right to larger salaries and the acquisition of more power and prestige by the officers.
3. Payment of dividends—Should the money earned remain under the control of the management or pass into the hands of the stockholders?
4. Continuance of the stockholders’ investment in the company— Should the business continue as before, although unprofitable, or should part of the capital be withdrawn, or should it be wound up completely?
5. Information to stockholders—Should those in control be able to benefit through having information not given to stockholders generally? On all of these questions the decisions of the management are inter- ested decisions, and for that reason they require scrutiny by the stock- holders. We do not imply that corporate managements are not to be trusted. On the contrary, the officers of our large corporations constitute a group of men above the average in probity as well as in ability. But this does not mean that they should be given carte blanche in all matters affecting their own interests. A private employer hires only men he can trust, but he does not let these men fix their own salaries or decide how
much capital he should place or leave in the business.
Directors Not Always Free from Self-interest in Connection with These Matters. In publicly owned corporations these matters are passed on by the board of directors, whom the stockholders elect and to whom the officials are responsible. Theoretically, the directors will rep- resent the stockholders’ interests, when need be, as against the opposing interests of the officers. But this cannot be counted upon in practice. In many companies a majority, and in most companies a substantial part, of the board is composed of paid officials. The directors who are |
with These Matters. In publicly owned corporations these matters are passed on by the board of directors, whom the stockholders elect and to whom the officials are responsible. Theoretically, the directors will rep- resent the stockholders’ interests, when need be, as against the opposing interests of the officers. But this cannot be counted upon in practice. In many companies a majority, and in most companies a substantial part, of the board is composed of paid officials. The directors who are not offi- cers are frequently joined by many close ties to the chief executives. It may be said in fact that the officers choose the directors more often than the directors choose the officers. Hence the necessity remains for the stockholders to exercise critical and independent judgments on all mat- ters where the personal advantage of the officers may conceivably be opposed to their own. In other words, in this field the usual presumption of superior knowledge and judgment on the part of the management should not obtain, and any criticism offered in good faith deserves care- ful consideration by the stockholders.
Abuse of Managerial Compensation. Numerous cases have come to light in which the actions of the management in the matter of its own compensation have been open to serious question. Most of these relate to the years before 1933. In the case of Bethlehem Steel Corporation, cash bonuses clearly excessive in amount were paid. In the case of American Tobacco Company, rights to buy stock below the market price, of an enor- mous aggregate value, were allotted to the officers. These privileges to buy stock are readily subject to abuse. In the case of Electric Bond and Share Company, the management permitted itself to buy many shares of stock at far below market price. When later the price of the stock col- lapsed to a figure less than the subscription price, the obligation to pay for the shares was cancelled, and the sums already paid were returned to the officers. A sim |
buy stock below the market price, of an enor- mous aggregate value, were allotted to the officers. These privileges to buy stock are readily subject to abuse. In the case of Electric Bond and Share Company, the management permitted itself to buy many shares of stock at far below market price. When later the price of the stock col- lapsed to a figure less than the subscription price, the obligation to pay for the shares was cancelled, and the sums already paid were returned to the officers. A similar procedure was followed in the case of White Motor Company, which will be more fully discussed later in this chapter.
Some of these transactions are explained, and partly justified, by the extraordinary conditions of 1928–1932. Others are inexcusable from any point of view. Nevertheless, human nature being what it is, such devel- opments are not in the least surprising. They do not really reflect upon the character of corporate managements but rather on the patent unwis- dom of leaving such matters within the virtually uncontrolled discretion of those who are to benefit by their own decisions.
The new regulations have done much to dispel the mist of secrecy that formerly shrouded the emoluments and stockholdings of corporate offi- cials. Information on salaries, bonuses and stock options must be filed in connection with new security offerings, with the registration of issues on a national exchange, with the subsequent annual reports to the Commission and with the solicitation of proxies.1 Although these data are not complete, they are sufficient for the practical purpose of advising the stockholders as to the cost of their management. Similarly, stockholdings of officers, direc- tors and those owning 10% of a stock issue must be revealed monthly.
Since this information is not too readily accessible to the individual stockholder, the statistical agencies could further improve their already excellent service by subjoining the salary and stockholding data to their annual lis |
oxies.1 Although these data are not complete, they are sufficient for the practical purpose of advising the stockholders as to the cost of their management. Similarly, stockholdings of officers, direc- tors and those owning 10% of a stock issue must be revealed monthly.
Since this information is not too readily accessible to the individual stockholder, the statistical agencies could further improve their already excellent service by subjoining the salary and stockholding data to their annual lists of officers and directors.
1 Also, under provisions of the Revenue Act of 1936 the Treasury published the names and compensation of all corporate officers receiving over $15,000 in that year. The Revenue Act of 1938 requires these data for salaries of $75,000 or more, beginning with 1938.
In recent years the question of excessive compensation to manage- ment has excited considerable attention, and the public understands fairly well that here is a field where the officers’ views do not necessarily represent the highest wisdom. It is not so clearly realized that to a con- siderable extent the same limitations apply in matters affecting the use of the stockholders’ capital and surplus. We have alluded to certain aspects of this subject in our discussion of dividend policies (Chap. 29). It should be evident also that the matter of raising new capital for expan- sion is affected by the same reasoning as applies to the withholding of dividends for this purpose.
Wisdom of Continuing the Business Should Be Considered. A third question, viz., that of retaining the stockholder’s capital in the busi- ness, involves considerations that are basically identical. Managements are naturally loath to return any part of the capital to its owners, even though this capital may be far more useful—and therefore valuable—out- side of the business than in it. Returning a portion of the capital (e.g., excess cash holdings) means curtailing the resources of the enterprise, perhaps creating financ |
Business Should Be Considered. A third question, viz., that of retaining the stockholder’s capital in the busi- ness, involves considerations that are basically identical. Managements are naturally loath to return any part of the capital to its owners, even though this capital may be far more useful—and therefore valuable—out- side of the business than in it. Returning a portion of the capital (e.g., excess cash holdings) means curtailing the resources of the enterprise, perhaps creating financial problems later on and certainly reducing some- what the prestige of the officers. Complete liquidation means the loss of the job itself. It is scarcely to be expected, therefore, that the paid officers will consider the question of continuing or winding up the business from the standpoint solely of what is in the best interests of the owners. We must emphasize again that the directors are often so closely allied with the officers—who are themselves members of the board—that they too cannot be counted upon to consider such problems purely from the stockholders’ point of view.
Thus it appears that the question whether or not a business should be continued is one that at times may deserve independent thought by its proprietors, the stockholders. (It should be pointed out also that this is, by its formal or legal nature, an ownership problem and not a manage- ment problem.) And a logical reason for devoting thought to this ques- tion would arise precisely from the fact that the stock has long been selling considerably below its liquidating value. After all, this situation must mean that either the market is wrong in its valuation or the man- agement is wrong in keeping the enterprise alive. It is altogether proper that the stockholders should seek to determine which of these is wrong. In this determination the views and explanations of the management
deserve the most appreciative attention, but the whole proceeding would be stultified if the management’s opinion on this sub |
as long been selling considerably below its liquidating value. After all, this situation must mean that either the market is wrong in its valuation or the man- agement is wrong in keeping the enterprise alive. It is altogether proper that the stockholders should seek to determine which of these is wrong. In this determination the views and explanations of the management
deserve the most appreciative attention, but the whole proceeding would be stultified if the management’s opinion on this subject were to be accepted as final per se.
It is an unhappy fact that in many cases where a management’s poli- cies are attacked the critic has some personal axe to grind. This too is per- haps inevitable. There is very little altruism in finance. Wars against corporate managements take time, energy and money. It is hardly to be expected that individuals will expend all these merely to see the right thing done. In such matters the most impressive and creditable moves are those made by a group of substantial stockholders, having an important stake of their own to protect and impelled thereby to act in the interests of the shareholders generally. Representations from such a source, in any matter where the interest of the officers and the owners may conceivably be opposed, should gain a more respectful hearing from the rank and file of stockholders than has hitherto been accorded them in most cases.2
Broadcast criticisms initiated by stockholders, proxy battles, and var- ious kinds of legal proceedings are exceedingly vexatious to manage- ments, and in many cases they are unwisely or improperly motivated. Yet these should be regarded as one of the drawbacks of being a corporate official and as part of the price of a vigilant stock ownership. The public must learn to judge such controversies on their merits, as developed by statements of fact and by reasoned argument. It must not allow itself to be swayed by mere accusation or by irrelevant personalities.
The subject of liquidatio |
l proceedings are exceedingly vexatious to manage- ments, and in many cases they are unwisely or improperly motivated. Yet these should be regarded as one of the drawbacks of being a corporate official and as part of the price of a vigilant stock ownership. The public must learn to judge such controversies on their merits, as developed by statements of fact and by reasoned argument. It must not allow itself to be swayed by mere accusation or by irrelevant personalities.
The subject of liquidation must not be left without some reference to the employees’ vital interest therein. It seems heartless in the extreme to discuss such a decision solely from the standpoint of what will be best for the stockholder’s pocketbook. Yet nothing is to be gained by confus- ing the issue. If the reason for continuing the business is primarily to keep the workers employed, and if this means a real sacrifice by the owners, they are entitled to know and to face the fact. They should not be told that it would be unwise for them to liquidate, when in truth it would be prof- itable but inhumane. It is fair to point out that under our present economic system the owners of a business are not expected to dissipate their capital for the sake of continuing employment. In privately owned enterprises
2 The proxy regulations of the S.E.C. seek to facilitate the presentation of viewpoints opposed to the management by requiring the company to send out requests for proxies (and covering letters) supplied by individual stockholders, postage to be paid by the latter.
such philanthropy is rare. Whether or not a sacrifice of capital for this pur- pose is conducive to the economic welfare of the country as a whole is a moot point also, but it is not within our province to discuss it here. Our object has been to clarify the issue and to stress the fact that a market price below liquidating value has special significance to the stockholders and should lead them to ask their management some searching quest |
dividual stockholders, postage to be paid by the latter.
such philanthropy is rare. Whether or not a sacrifice of capital for this pur- pose is conducive to the economic welfare of the country as a whole is a moot point also, but it is not within our province to discuss it here. Our object has been to clarify the issue and to stress the fact that a market price below liquidating value has special significance to the stockholders and should lead them to ask their management some searching questions.
Management May Properly Take Some Interest in Market Price for Shares. Managements have succeeded very well in avoiding these questions with the aid of the time-honored principle that market prices are no concern or responsibility of theirs. It is true, of course, that a com- pany’s officers are not responsible for fluctuations in the price of its secu- rities. But this is very far from saying that market prices should never be a matter of concern to the management. This idea is not only basically wrong, but it has the added vice of being thoroughly hypocritical. It is wrong because the marketability of securities is one of the chief qualities considered in their purchase. But marketability must presuppose not only a place where they can be sold but also an opportunity to sell them at a fair price. It is at least as important to the stockholders that they be able to obtain a fair price for their shares as it is that the dividends, earnings and assets be conserved and increased. It follows that the responsibility of managements to act in the interest of their shareholders includes the obligation to prevent—in so far as they are able—the establishment of either absurdly high or unduly low prices for their securities.
It is difficult not to lose patience with the sanctimonious attitude of many corporate executives who profess not even to know the market price of their securities. In many cases they have a vital personal interest in these very market prices, and at times th |
t follows that the responsibility of managements to act in the interest of their shareholders includes the obligation to prevent—in so far as they are able—the establishment of either absurdly high or unduly low prices for their securities.
It is difficult not to lose patience with the sanctimonious attitude of many corporate executives who profess not even to know the market price of their securities. In many cases they have a vital personal interest in these very market prices, and at times they use their inside knowledge to take advantage in the market of the outside public and of their own stockholders.3 Not as a startling innovation but as a common-sense
3 This reached such scandalous proportions “in the good old days” that the Securities Exchange Act of 1934 made “insiders” accountable to the corporation for profits realized on purchases and sales, or vice versa, completed within a six months’ period. Enforcement must be through a stockholder’s suit. This provision has been bitterly criticized in Wall Street as pre- venting legitimate activities of officers and directors, including support of the market price at critical times. Our own view is that, on balance, both logic and practicality are against the pro- vision as it now stands. Publicity of operations—perhaps immediate rather than monthly— should supply a sufficient safeguard against fraud and a check upon questionable conduct.
recognition of things as they are, we recommend that directors be held to the duty of observing the market price of their securities and of using all proper efforts to correct patent discrepancies, in the same way as they would endeavor to remedy any other corporate condition inimical to the stockholders’ interest.
Various Possible Moves for Correcting Market Prices for Shares. The forms that these proper efforts might take are various. In the first place the stockholders’ attention may be called officially to the fact that the liquidating, and therefore the minimum, value of t |
f observing the market price of their securities and of using all proper efforts to correct patent discrepancies, in the same way as they would endeavor to remedy any other corporate condition inimical to the stockholders’ interest.
Various Possible Moves for Correcting Market Prices for Shares. The forms that these proper efforts might take are various. In the first place the stockholders’ attention may be called officially to the fact that the liquidating, and therefore the minimum, value of the shares is substantially higher than the market price. If, as will usually be the case, the directors are convinced that continuance is preferable to liquidation, the reasons leading to this conclusion should at the same time be sup- plied. A second line of action is in the direction of dividends. A special endeavor should be made to establish a dividend rate proportionate at least to the liquidating value, in order that the stockholders should not suffer a loss of income through keeping the business alive. This may be done even if current earnings are insufficient, provided there are accu- mulated profits and provided also the cash position is strong enough to permit such payments.
A third procedure consists of returning to the stockholders such cash capital as is not needed for the conduct of the business. This may be done through a pro rata distribution, accompanied usually by a reduction in par value or through an offer to purchase a certain num- ber of shares pro rata at a fair price. Finally, a careful consideration by the directors of the discrepancy between earning power and liquidat- ing value may lead them to conclude that a sale or winding up of the enterprise is the most sensible corrective step—in which case they should act accordingly.
Examples: Otis Company, 1929–1939. The course of action followed by the Otis Company management in 1929–1930 combined a number of these remedial moves. In July 1929 the president circularized the share- holders, presenting an in |
price. Finally, a careful consideration by the directors of the discrepancy between earning power and liquidat- ing value may lead them to conclude that a sale or winding up of the enterprise is the most sensible corrective step—in which case they should act accordingly.
Examples: Otis Company, 1929–1939. The course of action followed by the Otis Company management in 1929–1930 combined a number of these remedial moves. In July 1929 the president circularized the share- holders, presenting an intermediate balance sheet as of June 30 and emphasizing the disparity between the current bid price and the liquidat- ing value. In September of that year—although earnings were no larger than before—dividend payments were resumed, a step permitted by the company’s large cash holdings and substantial surplus. In 1930 a good part of the cash, apparently not needed in the business, was returned to
the stockholders through the redemption of the small preferred issue and the repayment of $20 per share of common stock on account of capital.4 Subsequently the company embarked on a policy of piecemeal liquida- tion which resulted in a series of payments on capital account. From September 1929 to the final distribution in 1940 there was paid a total of
$94 per share as return of capital, as well as $8 in the form of dividends. As we pointed out in our last chapter, these steps were highly effective in improving the status of the Otis stockholders during a period when most other issues were suffering a shrinkage in value, and ultimately gave them a far larger return than they were likely to receive through the continuance of the business.
Hamilton Woolen Company. The history of this enterprise since 1926 is even more interesting in this connection because it suggests a model technique for the handling by directors of problems affecting the stock- holders’ investment. In 1927 continued operating losses had resulted in a market price well below liquidating value. There was danger that |
ffering a shrinkage in value, and ultimately gave them a far larger return than they were likely to receive through the continuance of the business.
Hamilton Woolen Company. The history of this enterprise since 1926 is even more interesting in this connection because it suggests a model technique for the handling by directors of problems affecting the stock- holders’ investment. In 1927 continued operating losses had resulted in a market price well below liquidating value. There was danger that the losses might continue and wipe out the capital. On the other hand, there was a possibility of much better results in the future, especially if new policies were adopted. A statement of the arguments for and against liq- uidation was forwarded to the stockholders, and they were asked to vote on the question. They voted to continue the business, with a new oper- ating head; and the decision proved a wise one, since good earnings were realized, and the price advanced above liquidating value.
In 1934, however, the company again showed a large loss, occasioned in good part by serious labor difficulties. The management again submit- ted the question of liquidation to the stockholders, and this time a wind- ing up of the business was voted. A sale of the business was promptly arranged, and the stockholders received somewhat more than the Novem- ber 1934 current-asset value.
Particularly noteworthy were the details of the 1927 proceedings. The ultimate decision—to continue or to quit—was put up to the stockhold- ers in whose province it lay; the management supplied information,
4 Other examples of partial return of capital by companies continuing in business include: Cuban Atlantic Sugar Company (1938–1939), Great Southern Lumber Company (1927–1937), Keystone Watch Case Corporation (1932–1933) as well as Davis Coal and Coke Company and the several Standard Oil pipe line companies previously referred to (pp. 529, 568).
expressed its own opinion and permitted an adequate stateme |
ut up to the stockhold- ers in whose province it lay; the management supplied information,
4 Other examples of partial return of capital by companies continuing in business include: Cuban Atlantic Sugar Company (1938–1939), Great Southern Lumber Company (1927–1937), Keystone Watch Case Corporation (1932–1933) as well as Davis Coal and Coke Company and the several Standard Oil pipe line companies previously referred to (pp. 529, 568).
expressed its own opinion and permitted an adequate statement of the other side of the case.
Other Examples of Voluntary Liquidation. The subjoined partial list will demonstrate an obvious but fundamental fact, viz., that the liquida- tion (or sale) of an unprofitable company holding substantial assets (particularly current) is almost certain to realize for the stockholders con- siderably more than the previously existing market price. The reason is, of course, that the market price is governed chiefly by the earnings, whereas the proceeds of liquidation depend upon the assets.
Company
Year liquidation or sale voted Price shortly before vote to liquidate or sell
Amount realized for stock
American Glue 1930 $53 $139.00+
I. Benesch & Sons 1939 21/4 6.63
Federal Knitting Mills 1937 20 34.20
Lyman Mills 1927 112 220.25
Mohawk Mining 1933 11 28.50
Signature Hosiery Pfd 1931 31/8 17.00
Standard Oil of Nebraska 1939 6 17.50
United Shipyards A 1938 21/4 11.10*
* To Dec. 31, 1939.
Repurchase of Shares Pro Rata from Shareholders. The Hamilton Woolen management is also to be commended for its action during 1932 and 1933 in employing excess cash capital to repurchase pro rata a sub- stantial number of shares at a reasonable price. This reversed the proce- dure followed in 1929 when additional shares were offered for subscription to the stockholders. The contraction in business that accom- panied the depression made this additional capital no longer necessary, and it was therefore a logical move to give most of it back to the stock- holders, |
management is also to be commended for its action during 1932 and 1933 in employing excess cash capital to repurchase pro rata a sub- stantial number of shares at a reasonable price. This reversed the proce- dure followed in 1929 when additional shares were offered for subscription to the stockholders. The contraction in business that accom- panied the depression made this additional capital no longer necessary, and it was therefore a logical move to give most of it back to the stock- holders, to whom it was of greater benefit when in their own pockets than in the treasury of the corporation.5
5 Hamilton Woolen sold 13,000 shares pro rata to stockholders at $50 per share in 1929. It repurchased, pro rata, 6,500 shares at $65 in 1932 and 1,200 shares at $50 in 1933. Faultless Rubber Company followed a similar procedure in 1934. Simms Petroleum Company reac- quired stock both directly from the shareholders on a pro rata basis and in the open market. Its repurchases by both means between 1930 and 1933 aggregated nearly 45% of the shares outstanding at the end of 1929. Julian and Kokenge (Shoe) Company made pro rata repur- chases of common stock in 1932, 1934 and 1939.
Abuse of Shareholders through Open-market Purchase of Shares. During the 1930–1933 depression repurchases of their own shares were made by many industrial companies out of their surplus cash assets,6 but the procedure generally followed was open to grave objec- tion. The stock was bought in the open market without notice to the shareholders. This method introduced a number of unwholesome ele- ments into the situation. It was thought to be “in the interest of the corporation” to acquire the stock at the lowest possible price. The con- sequence of this idea is that those stockholders who sell their shares back to the company are made to suffer as large a loss as possible, for the presumable benefit of those who hold on. Although this is a proper view- point to follow in purchasing other kinds of assets |
out notice to the shareholders. This method introduced a number of unwholesome ele- ments into the situation. It was thought to be “in the interest of the corporation” to acquire the stock at the lowest possible price. The con- sequence of this idea is that those stockholders who sell their shares back to the company are made to suffer as large a loss as possible, for the presumable benefit of those who hold on. Although this is a proper view- point to follow in purchasing other kinds of assets for the business, there is no warrant in logic or in ethics for applying it to the acquisition of shares of stock from the company’s own stockholders. The management is the more obligated to act fairly toward the sellers because the company is itself on the buying side.
But, in fact, the desire to buy back shares cheaply may lead to a deter- mination to reduce or pass the dividend, especially in times of general uncertainty. Such conduct would be injurious to nearly all the stockhold- ers, whether they sell or not, and it is for that reason that we spoke of the repurchase of shares at an unconscionably low price as only presumably to the advantage of those who retained their interest.
Example: White Motor Company. In the previous chapter attention was called to the extraordinary discrepancy between the market level of White Motor’s stock in 1931–1932 and the minimum liquidating value of the shares. It will be instructive to see how the policies followed by the management contributed mightily to the creation of a state of affairs so unfortunate for the stockholders.
White Motor Company paid dividends of $4 per share (8%) practically from its incorporation in 1916 through 1926. This period included the depression year 1921, in which the company reported a loss of nearly
$5,000,000. It drew, however, upon its accumulated surplus to maintain the full dividend, a policy that prevented the price of the shares from declining below 29. With the return of prosperity the
6 Figu |
ghtily to the creation of a state of affairs so unfortunate for the stockholders.
White Motor Company paid dividends of $4 per share (8%) practically from its incorporation in 1916 through 1926. This period included the depression year 1921, in which the company reported a loss of nearly
$5,000,000. It drew, however, upon its accumulated surplus to maintain the full dividend, a policy that prevented the price of the shares from declining below 29. With the return of prosperity the
6 Figures published by the New York Stock Exchange in February 1934 revealed that 259 corporations with shares listed thereon had reacquired portions of their own stock.
quotation advanced to 721/2 in 1924 and 1041/2 in 1925. In 1926 the stock- holders were offered 200,000 shares at par ($50), increasing the company’s capital by $10,000,000. A stock dividend of 20% was paid at the same time. Hardly had the owners of the business paid in this additional cash, when the earnings began to shrink, and the dividend was reduced. In 1928 about $3 were earned (consolidated basis), but only $1 was dis- bursed. In the 12 months ending June 30, 1931 the company lost about
$2,500,000. The next dividend payment was omitted entirely, and the price of the stock collapsed to 71/2.
The contrast between 1931 and 1921 is striking. In the earlier year the losses were larger, the profit-and-loss surplus was smaller and the cash holdings far lower than in 1931. But in 1921 the dividend was maintained, and the price thereby supported. A decade later, despite redundant hold- ings of cash and the presence of substantial undistributed profits, a sin- gle year’s operating losses sufficed to persuade the management to suspend the dividend and permit the establishment of a grotesquely low market price for the shares.
During the period before and after the omission of the dividend the company was active in buying its own shares in the open market. These purchases began in 1929 under a plan adopted for the bene |
ice thereby supported. A decade later, despite redundant hold- ings of cash and the presence of substantial undistributed profits, a sin- gle year’s operating losses sufficed to persuade the management to suspend the dividend and permit the establishment of a grotesquely low market price for the shares.
During the period before and after the omission of the dividend the company was active in buying its own shares in the open market. These purchases began in 1929 under a plan adopted for the benefit of “those filling certain managerial positions.” By June 1931 about 100,000 shares had been bought in at a cost of $2,800,000. With the passing of the divi- dend, the officers and employees were relieved of whatever obligations they had assumed to pay for these shares, and the plan was dropped. In the next six months, aided by the collapse in the market price, the com- pany acquired 50,000 additional shares in the market at an average cost of about $11 per share. The total holdings of 150,000 shares were then retired and cancelled.
These facts, thus briefly stated, illustrate the vicious possibilities inher- ent in permitting managements to exercise discretionary powers to pur- chase shares with the company’s funds. We note first the painful contrast between the treatment accorded to the White Motor managerial employ- ees and to its stockholders. An extraordinarily large amount of stock was bought for the benefit of these employees at what seemed to be an attrac- tive price. All the money to carry these shares was supplied by the stock- holders. If the business had improved, the value of the stock would have advanced greatly, and all the benefits would have gone to the employees.
When things became worse, “those in managerial positions” were relieved of any loss, and the entire burden fell upon the stockholders.7
In its transactions directly with its stockholders, we see White Motor soliciting $10,000,000 in new capital in 1926. We see some of this addi- tional capital |
e money to carry these shares was supplied by the stock- holders. If the business had improved, the value of the stock would have advanced greatly, and all the benefits would have gone to the employees.
When things became worse, “those in managerial positions” were relieved of any loss, and the entire burden fell upon the stockholders.7
In its transactions directly with its stockholders, we see White Motor soliciting $10,000,000 in new capital in 1926. We see some of this addi- tional capital (not needed to finance sales) employed to buy back many of these very shares at one-fifth of the subscription price. The passing of the dividend was a major factor in making possible these repurchases at such low quotations. The facts just related without further evidence might well raise a suspicion in the mind of a stockholder that the omission of the dividend was in some way related to a desire to depress the price of the shares. If the reason for the passing of the dividend was a desire to preserve cash, then it is not easy to see why, since there was money avail- able to buy in stock, there was not money available to continue a divi- dend previously paid without interruption for 15 years.
The spectacle of a company overrich in cash passing its dividend, in order to impel desperate stockholders to sell out at a ruinous price, is not pleasant to contemplate.
Westmoreland Coal Company: Another Example. A more recent illus- tration of the dubious advantage accruing to stockholders from a policy of open-market repurchases of common stock is supplied by the case of Westmoreland Coal. In the ten years 1929–1938 this company reported a net loss in the aggregate amounting to $309,000, or $1.70 per share. How- ever, these losses resulted after deduction of depreciation and depletion allowances totaling $2,658,000, which was largely in excess of new capital expenditures. Thus the company’s cash position actually improved con- siderably during this period, despite payment of very ir |
m a policy of open-market repurchases of common stock is supplied by the case of Westmoreland Coal. In the ten years 1929–1938 this company reported a net loss in the aggregate amounting to $309,000, or $1.70 per share. How- ever, these losses resulted after deduction of depreciation and depletion allowances totaling $2,658,000, which was largely in excess of new capital expenditures. Thus the company’s cash position actually improved con- siderably during this period, despite payment of very irregular dividends aggregating $4.10 per share.
In 1935, according to its annual reports, the company began to repur- chase its own stock in the open market. By the end of 1938 it had thus acquired 44,634 shares, which were more than 22% of the entire issue. The average price paid for this stock was $8.67 per share. Note here the extraordinary fact that this average price paid was less than one-half the cash-asset holdings alone per share, without counting the very large other
7 In the sale to Studebaker in 1933 the directors set aside 15,000 shares of treasury stock as a donation to key men in the organization. Some White stockholders brought suit to set aside this donation, and the suit was settled by payment of 31 cents per share on White stock not acquired by Studebaker.
tangible assets. Note also that at no time between 1930 and 1939 did the stock sell so high as its cash assets alone. (At the end of 1938 the com- pany reported cash and marketable securities totaling $2,772,000, while the entire stock issue was selling for $1,400,000.)
If this situation is analyzed, the following facts appear clear:
1. The low market price of the stock was due to the absence of earn- ings and the irregular dividend. Under such conditions the quoted price would not reflect the very large cash holding theoretically available for the shares. Stocks sell on earnings and dividends and not on cash-asset values—unless distribution of these cash assets is in prospect.
2. The true obligation of |
while the entire stock issue was selling for $1,400,000.)
If this situation is analyzed, the following facts appear clear:
1. The low market price of the stock was due to the absence of earn- ings and the irregular dividend. Under such conditions the quoted price would not reflect the very large cash holding theoretically available for the shares. Stocks sell on earnings and dividends and not on cash-asset values—unless distribution of these cash assets is in prospect.
2. The true obligation of managements is to recognize the realities of such a situation and to do all in their power to protect every stockholder against unwarranted depreciation of his investment, and particularly against unnecessary sacrifice of a large part of the true value of his shares. Such sacrifices are likely to be widespread under conditions of this kind, because many stockholders will be moved by necessity or the desire for steady income or by a discouraged view of the coal industry to sell their shares for what they can get.
3. The anomaly presented by exceptionally large cash holdings and an absurdly low market price was obviously preventable. That the company had more cash than it needed is confessed by the fact that it had money available to buy in cheap stock—even if it were not evident from a study of the unusual relationship between cash holdings and annual business done.
4. All cash that could possibly be spared should have been returned to the stockholders on a pro rata basis. The use of some of it to buy in shares as cheaply as possible is unjust to the many stockholders induced by need or ignorance to sell. It favors those strong enough to hold their shares indefinitely. It particularly advantages those in control of the company, for in their case the company’s cash applicable to their stock is readily available to them if they should need it (since they could then bring about a distribution). Just because this situation is distinctly not true of the rank and file of the stockh |
ome of it to buy in shares as cheaply as possible is unjust to the many stockholders induced by need or ignorance to sell. It favors those strong enough to hold their shares indefinitely. It particularly advantages those in control of the company, for in their case the company’s cash applicable to their stock is readily available to them if they should need it (since they could then bring about a distribution). Just because this situation is distinctly not true of the rank and file of the stockholders, the market discounts so cruelly the value of their cash when held by the company instead of themselves.8
8 Two additional factors in this situation deserve brief mention. The company had a rental obligation of 10 cents per ton, but not less than $189,000 annually, for mining coal from leased lands. This liability was an additional consideration, besides the ordinary ones, which argued
Summary and Conclusion. The relationship between stockholders and their managements, after undergoing many unsound developments during the hectic years from 1928 to 1933, have since been subjected to salutary controls—emanating both from S.E.C. regulation and from a more critical viewpoint generally. Certain elementary facts, once well- nigh forgotten, might well be emphasized here: Corporations are in law the mere creatures and property of the stockholders who own them; the officers are only the paid employees of the stockholders; the directors, however chosen, are virtually trustees, whose legal duty it is to act solely in behalf of the owners of the business.9
To make these general truths more effective in practice, it is necessary that the stock-owning public be educated to a clearer idea of what are the true interests of the stockholders in such matters as dividend policies, expansion policies, the use of corporate cash to repurchase shares, the various methods of compensating management, and the fundamental question of whether the owners’ capital shall remain in the business or |
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