piece of security analysis
stringlengths 659
2k
|
|---|
gal 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 be taken out by them in whole or in part.
for maintenance of a comfortable cash position, but it could not justify the immobilizing of far more cash than the whole company appeared to be worth at any time between 1930 and 1939. In October 1939 the company made application to the S.E.C. to terminate trading in its shares on the Philadelphia Stock Exchange and the New York Curb Exchange, intimating that
the infrequency of transactions might be responsible for their unduly low price. The reader may judge whether or not, in the circumstances, the plight of the stockholders would be relieved in any wise by destroying the established market for their shares. (The application was later withdrawn.)
9 The management of American Telephone and Telegraph Company has repeatedly asserted that it considers itself a trustee for the interests of stockholders, employees and the public, in equal measure. A policy of this kind, if frankly announced and sincerely followed, can scarcely be criticized in the case of a quasi-civic enterprise. But given the ordinary business company, the issue is more likely to be whether the management is acting as trustees for the stockholders or as trustees for the management.
Chapter 45
BALANCE-SHEET ANALYSIS (Concluded)
OUR DISCUSSION IN THE preceding chapters has related chiefly to situa- tions in which the balance-sheet exhibit apparently justified a higher price than prevailed in the market. But the more usual purpose of balance-sheet analysis |
ed in the case of a quasi-civic enterprise. But given the ordinary business company, the issue is more likely to be whether the management is acting as trustees for the stockholders or as trustees for the management.
Chapter 45
BALANCE-SHEET ANALYSIS (Concluded)
OUR DISCUSSION IN THE preceding chapters has related chiefly to situa- tions in which the balance-sheet exhibit apparently justified a higher price than prevailed in the market. But the more usual purpose of balance-sheet analysis is to detect the opposite state of affairs, viz., the presence of financial weaknesses that may detract from the investment or speculative merits of an issue. Careful buyers of securities scrutinize the balance sheet to see if the cash is adequate, if the current assets bear a suitable ratio to the current liabilities, and if there is any indebted- ness of near maturity that may threaten to develop into a refinancing problem.
WORKING-CAPITAL POSITION AND
DEBT MATURITIES
Basic Rules Concerning Working Capital. Nothing useful may be said here on the subject of how much cash a corporation should hold. The investor must form his own opinion as to what is needed in any par- ticular case and also as to how seriously an apparent deficiency of cash should be regarded. On the subject of the working-capital ratio, a mini- mum of $2 of current assets for $1 of current liabilities was formerly regarded as a standard for industrial companies.
But since the late 1920’s a tendency towards a stronger current posi- tion developed in most industries, and we find that the great majority of industrial corporations show a ratio well in excess of 2 to 1.1 There is some tendency now to hold that a company falling below the average of its group
1 See Appendix Note 61, p. 800 on accompanying CD, for comprehensive data with reference to industrial corporations listed on the New York Stock Exchanges at the end of 1938. See also the annual compilations in Moody’s Manual of Industrials.
[591]
Copyri |
er current posi- tion developed in most industries, and we find that the great majority of industrial corporations show a ratio well in excess of 2 to 1.1 There is some tendency now to hold that a company falling below the average of its group
1 See Appendix Note 61, p. 800 on accompanying CD, for comprehensive data with reference to industrial corporations listed on the New York Stock Exchanges at the end of 1938. See also the annual compilations in Moody’s Manual of Industrials.
[591]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
should be viewed with suspicion.2 This idea seems to us to contain something of a logical fallacy, since it necessarily penalizes the lower half of any group, regardless of how satisfactory the showing may be, consid- ered by itself. We are unable to suggest a better figure than the old 2-to-1 criterion to use as a definite quantitative test of a sufficiently comfortable financial position. Naturally the investor would favor companies that well exceed this minimum requirement, but the problem is whether or not a higher ratio must be exacted as a condition for purchase, so that an issue otherwise satisfactory would necessarily be rejected if the current assets are only twice current liabilities. We hesitate to suggest such a rule, nor do we know what new figure to prescribe.
A second measure of financial strength is the so-called “acid test,” which requires that current assets exclusive of inventories be at least equal to current liabilities. Ordinarily the investor might well expect of a com- pany that it meet both the 2-to-1 test and the acid test. If neither of these criteria is met it would in most cases reflect strongly upon the investment standing of a common-stock issue—as it would in the case of a bond or preferred stock—and it would supply an argument against the security from the speculative standpoint as well.
ARCHER-DANIELS-MIDLAND COMPANY
Item June 30, 1933 |
usive of inventories be at least equal to current liabilities. Ordinarily the investor might well expect of a com- pany that it meet both the 2-to-1 test and the acid test. If neither of these criteria is met it would in most cases reflect strongly upon the investment standing of a common-stock issue—as it would in the case of a bond or preferred stock—and it would supply an argument against the security from the speculative standpoint as well.
ARCHER-DANIELS-MIDLAND COMPANY
Item June 30, 1933 June 30, 1932
Cash assets $ 1,392,000 $3,230,000
Receivables 4,391,000 2,279,000
Inventories 12,184,000 4,081,000
Total current assets $17,967,000 $9,590,000
Current liabilities 8,387,000 778,000
Working capital $ 9,580,000 $8,812,000
Working capital excluding inventories -2,604,000 +4,731,000
Exceptions and Examples. As in all arbitrary rules of this kind, excep- tions must be allowed if justified by special circumstances. Consider, for example, the current position of Archer-Daniels-Midland Company on June 30, 1933, as compared with the previous year’s figures.
2 See Roy A. Foulke, Signs of the Times, pp. 17–19, 25 et seq., New York 1938; and Alexander Wall, How to Evaluate Financial Statements, pp. 82–97, New York, 1936. Note, however, Wall’s criticism of mere arithmetical averages as bases for comparison.
The position of this company on June 30, 1933, was evidently much less comfortable than a year before, and, judged by the usual standards, it might appear somewhat overextended. But in this case the increase in payables represented a return to the normal practice in the vegetable-oil industry, under which fairly large seasonal borrowings are regularly incurred to carry grain and flaxseed supplies. Upon investigation, there- fore, the analyst would not consider the financial condition shown in the 1933 balance sheet as in any sense disturbing.
Contrasting examples on this point are supplied by Douglas Aircraft Company and Stokely Brothers and Company in 1936–193 |
xtended. But in this case the increase in payables represented a return to the normal practice in the vegetable-oil industry, under which fairly large seasonal borrowings are regularly incurred to carry grain and flaxseed supplies. Upon investigation, there- fore, the analyst would not consider the financial condition shown in the 1933 balance sheet as in any sense disturbing.
Contrasting examples on this point are supplied by Douglas Aircraft Company and Stokely Brothers and Company in 1936–1938.
A WORKING-CAPITAL COMPARISON (000 OMITTED)
Item Stokely Brothers and Company Douglas Aircraft Company
Current assets:
Cash and receivables Inventories
Total Current liabilities:
Notes payable Other
Total
Bank loans due 1–3 years Total current liabilities
plus 1–3 year notes
Net earnings for year May 31,
1936 May 31,
1937 May 31,
1938 Nov. 30,
1936 Nov. 30,
1937 Nov. 30,
1938
$2,274 5,282 $2,176 7,323 $1,827 6,034 $2,885 6,392 $ 2,559
12,240 $4,673 4,084
$7,556 $9,499 $8,861 $9,277 $14,749 $8,757
$2,000 1,527 $2,000 1,286 $2,500 1,320 $1,390 1,179 $ 5,230
3,183
2,129
$3,527 $3,286 3,000 $3,820 3,000 $2,569 $ 8,413 $2,129
3,527
1,382 6,286
353(d) 6,820
713(d) 2,569
976 8,413
1,082 2,129
2,147
The situation in Douglas Aircraft in 1937 was not a seasonal matter, as in the case of Archer-Daniels-Midland, but grew out of the receipt of cer- tain types of orders requiring considerable working capital. Upon inquiry the investor could have satisfied himself that the need for bank accommo- dation was likely to be temporary and that, in any event, the new business was sufficiently profitable to make any necessary financing an easy affair. The Stokely picture was quite different, since the large current debt had
developed out of expanding inventories in an unprofitable market. Hence the May 1937 balance sheet of Stokely carried a serious warning for the preferred and common stockholder, as the table shows.
A year later Douglas Aircraft had paid off its bank loans and sho |
accommo- dation was likely to be temporary and that, in any event, the new business was sufficiently profitable to make any necessary financing an easy affair. The Stokely picture was quite different, since the large current debt had
developed out of expanding inventories in an unprofitable market. Hence the May 1937 balance sheet of Stokely carried a serious warning for the preferred and common stockholder, as the table shows.
A year later Douglas Aircraft had paid off its bank loans and showed a current ratio of 4 to 1. Stokely suspended preferred dividends in October 1938, and in that year the price of the issue fell from 21 (par $25) to 10.
As we pointed out in our discussion of bond selection (Chap. 13 on accompanying CD), no standard requirements such as we have been dis- cussing are recognized as applicable to railroads and public utilities. It must not be inferred therefrom that the working-capital exhibit of these com- panies is entirely unimportant—the contrary will soon be shown to be true—but only that it is not to be tested by any cut-and-dried formulas.
Large Bank Debt Frequently a Sign of Weakness. Financial dif- ficulties are almost always heralded by the presence of bank loans or of other debt due in a short time. In other words, it is rare for a weak finan- cial position to be created solely by ordinary trade accounts payable. This does not mean that bank debt is a bad sign in itself; the use of a reason- able amount of bank credit—particularly for seasonal needs—is not only legitimate but even desirable. But, whenever the statement shows Notes or Bills Payable, the analyst will subject the financial picture to a some- what closer scrutiny than in cases where there is a “clean” balance sheet.
The postwar boom in 1919 was marked by an enormous expansion of industrial inventories carried at high prices and financed largely by bank loans. The 1920–1921 collapse of commodity prices made these industrial bank loans a major problem. But the depression |
al needs—is not only legitimate but even desirable. But, whenever the statement shows Notes or Bills Payable, the analyst will subject the financial picture to a some- what closer scrutiny than in cases where there is a “clean” balance sheet.
The postwar boom in 1919 was marked by an enormous expansion of industrial inventories carried at high prices and financed largely by bank loans. The 1920–1921 collapse of commodity prices made these industrial bank loans a major problem. But the depression of the 1930’s had different characteristics. Industrial borrowings in 1929 had been remarkably small, due first to the absence of commodity or inventory speculation and secondly to the huge sales of stock to provide additional working capital. (Naturally there were exceptions, such as, notably, Ana- conda Copper Mining Company which owed $35,000,000 to banks at the end of 1929, increased to $70,500,000 three years later.) The large bank borrowings were shown more frequently by the railroads and pub- lic utilities. These were contracted to pay for property additions or to meet maturing debt or—in the case of some railways—to carry unearned fixed charges. The expectation in all these cases was that the bank loans would be refunded by permanent financing; but in many instances such refinancing proved impossible, and receivership resulted. The collapse
of the Insull system of public-utility holding companies was precipitated in this way.
Examples: It is difficult to say exactly how apprehensively the investor or speculator should have viewed the presence of $68,000,000 of bank loans in the New York Central balance sheet at the end of 1932 or the bills payable of $69,000,000 owned by Cities Service Company on December 31, 1931. But certainly this adverse sign should not have been ignored. The more conservatively minded would have taken it as a strong argu- ment against any and all securities of companies in such a position, except possibly issues selling at so low a price as to |
ehensively the investor or speculator should have viewed the presence of $68,000,000 of bank loans in the New York Central balance sheet at the end of 1932 or the bills payable of $69,000,000 owned by Cities Service Company on December 31, 1931. But certainly this adverse sign should not have been ignored. The more conservatively minded would have taken it as a strong argu- ment against any and all securities of companies in such a position, except possibly issues selling at so low a price as to constitute an admitted but attractive gamble. An improvement in conditions will, of course, permit such bank loans to be refunded, but logic requires us to recognize that the improvement is prospective whereas the bank loans themselves are very real and very menacing.3
When a company’s earnings are substantial, it rarely becomes insolvent because of bank loans. But if refinancing is impracticable—as frequently it was in the 1931–1933 period—the lenders may require suspension of div- idends in order to make all the profits available to reduce the debt. It is for this reason that the dividend on Brooklyn-Manhattan Transit Corporation common was passed in 1932 and the preferred dividend of New York Water Service Corporation was passed in 1931, although both companies were reporting earnings about as large as in previous years.
The 1937–1938 recession did not create corporate financial problems comparable with those arising out of the two previous depressions. In this respect there is a significant contrast between the stock markets of 1919–1921 and 1937–1938. For the decline in stock prices was actually greater—both in dollars and percentagewise—in the recent period than in the postwar collapse, although intrinsically the 1937–1938 downturn was of much smaller importance, since it had relatively slight effect upon the position of American corporations generally.4 This may be taken as a rather disquieting sign that stock prices have been growing more irra- tionally sensitive to |
ignificant contrast between the stock markets of 1919–1921 and 1937–1938. For the decline in stock prices was actually greater—both in dollars and percentagewise—in the recent period than in the postwar collapse, although intrinsically the 1937–1938 downturn was of much smaller importance, since it had relatively slight effect upon the position of American corporations generally.4 This may be taken as a rather disquieting sign that stock prices have been growing more irra- tionally sensitive to temporary fluctuations in business—a fact that we
3 Improvement in general business, plus easy money rates (plus in the case of railroads a misguided optimism on the part of investors) enabled many companies to fund bank loans that looked dangerous in 1931–1933.
4 The Stokely case is an exception to this statement, but there were surprisingly few of the kind.
are inclined to ascribe to the disappearance of the old-line distinctions between stock investors and stock speculators.
Intercorporate Indebtedness. Current debt to a parent or to an affiliated company is theoretically as serious as any other short-term lia- bility, but in practice it is rarely made the basis of an embarrassing claim for payment.
Example: United Gas Corporation has owed $26,000,000 on open account to its parent Electric Bond and Share Company since 1930—so that it constantly reports a large excess of current liabilities over current assets. Yet this debt has not prevented it from paying first preferred div- idends in 1936–1939. In 1932, however, with somewhat larger earnings than in 1939, it had been compelled to suspend the senior dividend because it had large bank loans in addition to its intercompany debt. The conservative buyer would naturally prefer to see the obligations to affili- ates in some form other than a current liability.
The Danger of Early Maturing Funded Debt. A large bond issue coming due in a short time constitutes a critical financial problem when operating results are unfavorabl |
ends in 1936–1939. In 1932, however, with somewhat larger earnings than in 1939, it had been compelled to suspend the senior dividend because it had large bank loans in addition to its intercompany debt. The conservative buyer would naturally prefer to see the obligations to affili- ates in some form other than a current liability.
The Danger of Early Maturing Funded Debt. A large bond issue coming due in a short time constitutes a critical financial problem when operating results are unfavorable. Investors and speculators should both give serious thought to such a situation when revealed by a balance sheet. Maturing funded debt is a frequent cause of insolvency.
Examples: Fisk Rubber Company was thrown into receivership by its inability to pay off an $8,000,000 note issue at the end of 1930. The insol- vency of Colorado Fuel and Iron Company and of the Chicago, Rock Island and Pacific Railway Company in 1933 were both closely related to the fact that large bond issues fell due in 1934. The heedlessness of spec- ulators is well shown by the price of $54 established for Colorado Fuel and Iron Preferred in June 1933, when its short-term bond issue (Col- orado Industrial Company 5s, due 1934, guaranteed by the parent com- pany) was selling at 45, an indicated yield of well over 100% per annum. This price for the bonds was an almost certain sign of trouble ahead. Fail- ure to meet the maturity would in all likelihood mean insolvency (for a voluntary extension could by no means be counted upon) and the dan- ger of complete extinction of the stock issues. It was typical of the spec- ulator to ignore so obvious a hazard and typical also that he suffered a large loss for his carelessness. (Two months later, on announcement of the receivership, the price of the preferred stock dropped to 171/4.)
New York, Chicago, and St. Louis Railroad Company has been faced with a continuous financial problem growing out of the sale of a three- year note issue in 1929. Since the first ma |
counted upon) and the dan- ger of complete extinction of the stock issues. It was typical of the spec- ulator to ignore so obvious a hazard and typical also that he suffered a large loss for his carelessness. (Two months later, on announcement of the receivership, the price of the preferred stock dropped to 171/4.)
New York, Chicago, and St. Louis Railroad Company has been faced with a continuous financial problem growing out of the sale of a three- year note issue in 1929. Since the first maturity in 1932 it was repeatedly extended under threat of receivership as an alternative. Typical of spec- ulative disregard of financial problems was the advance of this company’s preferred stock from 181/2 to 453/4 in 1939, against a low price that year of only 50 for the notes due in 1941.
Even when the maturing debt can probably be taken care of in some way, the possible cost of the refinancing must be taken into account.
Examples: This point is well illustrated by the $14,000,000 issue of American Rolling Mill Company 41/2% Notes, due November 1, 1933. In June 1933 the notes were selling at 80, which meant an annual yield basis of about 75%. At the same time the common stock had advanced from 3 to 24 and then represented a total valuation for the common stock of over
$40,000,000. Speculators buying the stock because of improvement in the steel industry failed to consider the fact that, in order to refund the notes in the poor market than existing for new capital issues, a very attractive conversion privilege would have to be offered. This would necessarily react against the profit possibilities of the common stock. As it happened, a new 5% note issue, convertible into stock at 25, was offered in exchange for the 41/2% notes. The result was the establishment of a price of 101 for the notes in August 1933 against a coincident price of 21 for the common stock; and a price of 15 for the stock on November 1, 1933, when the notes were taken care of at par.
The impending maturi |
ractive conversion privilege would have to be offered. This would necessarily react against the profit possibilities of the common stock. As it happened, a new 5% note issue, convertible into stock at 25, was offered in exchange for the 41/2% notes. The result was the establishment of a price of 101 for the notes in August 1933 against a coincident price of 21 for the common stock; and a price of 15 for the stock on November 1, 1933, when the notes were taken care of at par.
The impending maturity of a bond issue is of importance to the hold- ers of all the company’s securities, including mortgage debt ranking ahead of the maturing issue. For even the prior bonds will in all likelihood be seriously affected if the company is unable to take care of the junior issue. This point is illustrated in striking fashion by the Fisk Rubber Company First Mortgage 8s, due 1941. Although they were deemed to be superior in their position to the 51/2% unsecured notes, their holders suffered grievously from the receivership occasioned by the maturity of the 51/2s. The price of the 8s declined from 115 in 1929 to 16 in 1932.5
Bank Loans of Intermediate Maturity. The combination of very low interest rates and the drying up of ordinary commercial bank loans has
5 See other references to the two Fisk bond issues in Chaps. 6, 18, and 50.
produced a new phenomenon in recent years—the loaning of money to cor- porations by banks, repayable over a period of several years. Most of this money has been borrowed for the purpose of retiring bond issues (e.g., Com- mercial Investment Trust Corporation in November 1939) and even pre- ferred stock (e.g., Archer-Daniels-Midland Company in 1939). In some cases such loans have been made for additional working capital (e.g., Western Auto Supply Company in 1937) or to replace ordinary short-term bank credit (e.g., American Commercial Alcohol, Stokely Brothers). In most cases it is stipu- lated or expected that the loans will be retired in annual insta |
n borrowed for the purpose of retiring bond issues (e.g., Com- mercial Investment Trust Corporation in November 1939) and even pre- ferred stock (e.g., Archer-Daniels-Midland Company in 1939). In some cases such loans have been made for additional working capital (e.g., Western Auto Supply Company in 1937) or to replace ordinary short-term bank credit (e.g., American Commercial Alcohol, Stokely Brothers). In most cases it is stipu- lated or expected that the loans will be retired in annual installments.
From the standpoint of security analysis this bank credit resembles the short-term notes that used to be sold to the public as a familiar part of corporate financing. It must be considered partly equivalent to current liabilities and partly to early maturing debt. It is not dangerous if either the current-asset position is so strong that the loans could readily be taken care of as current liabilities or the earning power is so large and dependable as to make refinancing a simple problem. But if neither of these conditions is present (as in the Stokely example on page 593), the analyst must view the presence of a substantial amount of intermediate bank debt as a potential threat to dividends or even to solvency.
It should not be necessary to dilate further upon the prime necessity of examining the balance sheet for any possible adverse features in the nature of bank loans or other short-term debt.
COMPARISON OF BALANCE SHEETS OVER
A PERIOD OF TIME
This important part of security analysis may be considered under three aspects, viz.:
1. As a check-up on the reported earnings per share.
2. To determine the effect of losses (or profits) on the financial position of the company.
3. To trace the relationship between the company’s resources and its earn- ing power over a long period.
Check-up on Reported Earnings per Share, Via the Balance Sheet. Some of this technique has already been used in connection with related phases of security analysis. In Chap. 36 (on accompanyin |
ity analysis may be considered under three aspects, viz.:
1. As a check-up on the reported earnings per share.
2. To determine the effect of losses (or profits) on the financial position of the company.
3. To trace the relationship between the company’s resources and its earn- ing power over a long period.
Check-up on Reported Earnings per Share, Via the Balance Sheet. Some of this technique has already been used in connection with related phases of security analysis. In Chap. 36 (on accompanying CD), for instance, we gave an example of the first aspect, in checking the reported
earnings of American Commercial Alcohol Corporation for 1931 and 1932. As an example covering a larger stretch of years we submit the following contrast between the average earnings of United States Industrial Alcohol Company for the ten years 1929–1938, as shown by the reported per-share figures and as indicated by the changes in its net worth in the balance sheet.
U. S. INDUSTRIAL ALCOHOL COMPANY, 1929–1938
1. NET EARNINGS AS REPORTED
1929 $4,721,000 *per share: $12.63
1930 1,105,000 2.95
1931 1,834,000(d) 4.90(d)
1932 176,000 0.47
1933 1,393,000 3.56
1934 1,580,000 4.03
1935 844,000 2.15
1936 78,000 0.20
1937 456,000(d) 1.17(d)
1938 668,000(d) 1.71(d)
$6,782,000 $18.21
Total for 10 years
* As stated in the company’s annual reports.
2. DISCREPANCY BETWEEN EARNINGS AS ABOVE AND CHANGES IN THE SURPLUS ACCOUNT
Net earnings 1929–1938, as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,782,000
Less dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,959,000
(A) Indicated balance to surplus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 823,000
Earned surplus Dec. 31, 1928 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,214,000
Less charge @ write-down of plant account to $1 in 1933 . . . . . . . . . . . . . . . . 455,000
Ear |
. . . . . . . . $ 6,782,000
Less dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,959,000
(A) Indicated balance to surplus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 823,000
Earned surplus Dec. 31, 1928 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,214,000
Less charge @ write-down of plant account to $1 in 1933 . . . . . . . . . . . . . . . . 455,000
Earned surplus Dec. 31, 1928, as adjusted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,759,000
Earned surplus and contingency reserve, Dec. 31, 1938 . . . . . . . . . . . . . . . . . 5,736,000
(B) Decrease in surplus on balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,023,000
Discrepancy between earnings shown in income accounts
and those indicated by balance sheets $ 8,846,000
3. EXPLANATION OF DISCREPANCY
Charges made to surplus and not deducted in income account
from which earnings per share were computed by company:
Mark-down of inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,500,000
Charge-off and write-down of various assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,969,000
Miscellaneous adjustments, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377,000
$8,846,000
In addition to the foregoing the company wrote down its fixed assets to $1 in 1933 by a charge of $19,301,000, of which $18,846,000 was taken out of capital account and the balance out of surplus. To the extent that depreciation charges since 1932 may have been insufficient because of this write-down (see p. 495 on accompanying CD), the reported earnings for the period were further overstated.
4. RESTATEMENT OF EARNINGS FOR 1929–1938
Earnings per income account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,782,000
Less charges mad |
ixed assets to $1 in 1933 by a charge of $19,301,000, of which $18,846,000 was taken out of capital account and the balance out of surplus. To the extent that depreciation charges since 1932 may have been insufficient because of this write-down (see p. 495 on accompanying CD), the reported earnings for the period were further overstated.
4. RESTATEMENT OF EARNINGS FOR 1929–1938
Earnings per income account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,782,000
Less charges made to surplus 8,846,000
Earnings for period as corrected . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,064,000(d)
5. WORKING CAPITAL COMPARISON: 1938 VS. 1928
Net working capital Dec. 31,1928 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,336,000
Net working capital Dec. 31, 1938 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,144,000
Decrease for ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,192,000
Add proceeds of sales of capital stock . . . . . . . . . . . . . . . . . . . . . . . . . 6,582,000
Real shrinkage in working capital for period . . . . . . . . . . . . . . . . . . . $9,774,000
The foregoing analysis does not require extended discussion, since most of the points involved were covered in Chaps. 31 to 36 (Chaps. 35–36 on accompanying CD). Virtually all the charges made to surplus between 1929 and 1938 (except for the write-down of the plant account to $1) rep- resented a real diminution of the reported earning power of United States Industrial Alcohol during this ten-year period. It seems likely, also, that the surplus would have shrunk considerably farther if the plant account had been carried at a proper figure and appropriate depreciation charged against it since 1932. The fact that the company’s working capital decreased by $3,192,000, despite receipt of $6,582,000 from the sale of additional stock, is further evidence that, instead of there being a surplus above divide |
ion of the reported earning power of United States Industrial Alcohol during this ten-year period. It seems likely, also, that the surplus would have shrunk considerably farther if the plant account had been carried at a proper figure and appropriate depreciation charged against it since 1932. The fact that the company’s working capital decreased by $3,192,000, despite receipt of $6,582,000 from the sale of additional stock, is further evidence that, instead of there being a surplus above dividends as reported, the company actually lost money before div- idends during these ten years.6
Checking the Effect of Losses or Profits on the Financial Posi- tion of the Company. An example of the second aspect was given in
6 An analysis of the exhibit of Stewart Warner Corporation for 1925–1932, leading to similar conclusions, appeared at this point in our 1934 edition. Cf. W. A. Hosmer, “The Effect of Direct Charges to Surplus on the Measurement of Income,” Business and Modern Society, ed. by M.P. McNair and H. T. Lewis. pp. 113–151, Harvard University Press, 1938.
Chap. 43, in the comparison of the 1929–1932 balance sheets of Manhat- tan Shirt Company and Hupp Motor Car Corporation respectively. A similar comparison is shown below, covering the exhibit of Plymouth Cordage Company and H. R. Mallinson and Company during the same period, 1929–1932.
Examples:
Item Plymouth Cordage Co. H. R. Mallinson & Co.
Earnings reported: 1930
1931
1932
Total (3 years) profit
Dividends
Charges to surplus and reserves
Decrease in surplus and reserve for 3 years
$ 288,000
25,000
233,000(d)
$1,457,000(d) 561,000(d)
200,000(d)
$ 80,000
1,348,000
2,733,000 $2,218,000(d) 66,000
116,000
$4,001,000
$2,400,000
COMPARATIVE BALANCE SHEETS (000 OMITTED)
Item Plymouth Cordage H. R. Mallinson
Sept. 30,
1929 Sept. 30,
1932 Dec. 31,
1929 Dec. 31,
1932
Fixed and miscellaneous assets (net)
Cash assets Receivables Inventories
Total assets
Current liabilities Preferred stock Common stock
Surplus |
surplus and reserves
Decrease in surplus and reserve for 3 years
$ 288,000
25,000
233,000(d)
$1,457,000(d) 561,000(d)
200,000(d)
$ 80,000
1,348,000
2,733,000 $2,218,000(d) 66,000
116,000
$4,001,000
$2,400,000
COMPARATIVE BALANCE SHEETS (000 OMITTED)
Item Plymouth Cordage H. R. Mallinson
Sept. 30,
1929 Sept. 30,
1932 Dec. 31,
1929 Dec. 31,
1932
Fixed and miscellaneous assets (net)
Cash assets Receivables Inventories
Total assets
Current liabilities Preferred stock Common stock
Surplus and miscellaneous reserves Total liabilities
Net current assets
Net current assets excluding inventory
$ 7,211
1,721
1,156
8,059
$ 5,157
3,784
668
3,150
$2,539 526
1,177
3,060
$2,224
20
170
621
$18,147 $12,759 $7,302 $3,035
$ 982
8,108
9,057 $ 309
7,394
5,056 $2,292 1,342
500
3,168 $ 486* 1,281
500
768
$18,147 $12,759 $7,302 $3,035
$ 9,954
1,895 $ 7,298
4,143 $2,471
589(d) $ 357
264(d)
* Including $32,000 of “deferred liabilities.”
Despite the large reduction in the surplus of Plymouth Cordage during these years, its financial position was even stronger at the end of the period than at the beginning, and the liquidating value per share (as distinct from book value) was probably somewhat higher. On the other hand, the losses of Mallinson almost denuded it of working capital and thereby created an extremely serious obstacle to a restoration of its former earning power.
Taking Losses on Inventories May Strengthen Financial Position. It is obvious that losses that are represented solely by a decline in the inven- tory account are not so serious as those which must be financed by an increase in current liabilities. If the shrinkage in the inventory exceeds the losses, so that there is an actual increase in cash or reduction in payables, it may then be proper to say—somewhat paradoxically—that the com- pany’s financial position has been strengthened even though it has been suffering losses. This reasoning has a concrete application in analyzing issues selling at less th |
ed solely by a decline in the inven- tory account are not so serious as those which must be financed by an increase in current liabilities. If the shrinkage in the inventory exceeds the losses, so that there is an actual increase in cash or reduction in payables, it may then be proper to say—somewhat paradoxically—that the com- pany’s financial position has been strengthened even though it has been suffering losses. This reasoning has a concrete application in analyzing issues selling at less than liquidating value. It will be recalled that, in esti- mating break-up value, inventories are ordinarily taken at about 50 to 75% of the balance sheet figure, even though the latter is based on the lower of
MANHATTAN SHIRT COMPANY (000 OMITTED)
Balance sheet, Nov. 30, 1929 Balance sheet, Nov. 30, 1932
Item
Book value Estimated liquidating value
Book value Estimated liquidating value
Cash and bonds
at market $ 885 $ 885 $1,961 $1,961
Receivables 2,621 2,100 771 620
Inventories 4,330 2,900 1,289 850
Fixed and other assets 2,065* 500 1,124 300
Total assets $9,901 $6,385 $5,145 $3,731
Current liabilities 2,574 2,574 100 100
Preferred stock 299 299
Balance for common $7,028 $3,513 $5,045 $3,631
Number of shares 281,000 281,000 246,000 246,000
Value per share $25.00 $12.50 $20.50 $14.75
* Excluding good-will.
(Continues)
INCOME ACCOUNT 1930–1932
Balance after preferred dividends:
1930 318,000(d)
1931 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,000
1932 139,000(d)
3 years 364,000(d)
Charges to surplus 505,000*
Common dividends paid 723,000
$1,592,000
Less discount on common stock bought 481,000
Decrease in surplus for period $1,111,000*
* Eliminating transfer of $100,000 to Contingency Reserve.
cost or market. The result is that what appears as an operating loss in the company’s statement may have the actual effect of a profit from the stand- point of the investor who has valued the inventory in his o |
. . . . . . . . . . . . . . . . 93,000
1932 139,000(d)
3 years 364,000(d)
Charges to surplus 505,000*
Common dividends paid 723,000
$1,592,000
Less discount on common stock bought 481,000
Decrease in surplus for period $1,111,000*
* Eliminating transfer of $100,000 to Contingency Reserve.
cost or market. The result is that what appears as an operating loss in the company’s statement may have the actual effect of a profit from the stand- point of the investor who has valued the inventory in his own mind at con- siderably less than the book figure. This idea is concretely illustrated in the Manhattan Shirt Company example beginning on p. 602.
If we consider only the company’s figures there was evidently a loss for the period, with a consequent shrinkage in the value of the common stock. But if an investor had bought the stock, say, at $8 per share in 1930 (the low price in that year was 61/8), he would more logically have appraised the stock in his own mind on the basis of its liquidating value rather than its book value. From his point of view, therefore, the intrinsic value of his hold- ings would have increased during the depression period from $12.50 to
$14.75 per share, even after deducting the substantial dividends paid. What really happened was that Manhattan Shirt turned the larger portion of its assets into cash during these three years and sustained a much smaller loss in so doing than a conservative buyer of the stock would have anticipated. This accomplishment can be summarized in the table on p. 604.
We have here a direct contrast between the superficial indications of the income account and the truer story told by the successive balance sheets. Situations of this kind justify our repeated assertion that income-account analysis must be supplemented and confirmed by balance-sheet analysis.7
7 The student will note a similar development in Manhattan Shirt, though on a smaller scale, between December 1937 and December 1938.
Assets turned into cash and app |
e summarized in the table on p. 604.
We have here a direct contrast between the superficial indications of the income account and the truer story told by the successive balance sheets. Situations of this kind justify our repeated assertion that income-account analysis must be supplemented and confirmed by balance-sheet analysis.7
7 The student will note a similar development in Manhattan Shirt, though on a smaller scale, between December 1937 and December 1938.
Assets turned into cash and application of proceeds
Amount “Expected loss” thereon and application of difference
Reduction in inventory $3,000,000 $1,000,000 350,000
750,000
$2,100,000
800,000
“Gain” on basis of
liquidation values $1,300,000 Applied as follows:
To common dividends $700,000 To increase liquidating
value $600,000
Reduction in receivables 1,800,000
Reduction in plant, etc. 1,000,000
$5,800,000
Actual loss sustained 800,000
Net amount realized $5,000,000
Applied as follows:
To common dividends $ 700,000
To payment of liabilities 2,500,000
To redemption of preferred 300,000
To retirement of common 500,000
To increase in cash assets 1,000,000
$5,000,000
Is Shrinkage in Value of Normal Inventory an Operating Loss? A further question may be raised with respect to changes in the inventory account, i.e., whether or not a mere reduction in the carrying price should be regarded as creating an operating loss. In the case of Plymouth Cordage we note the following comparative figures:
Inventory Sept. 30, 1929 $8,059,000
Inventory Sept. 30, 1932 3,150,000
Decrease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60%
In the meantime the price of fibers had declined more than 50%, and there was good reason to believe that the actual number of pounds of fiber, rope and twine contained in the company’s inventory was not very much smaller in 1932 than in 1929. At least half of the decline in the inventory account was therefore due so |
ntory Sept. 30, 1929 $8,059,000
Inventory Sept. 30, 1932 3,150,000
Decrease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60%
In the meantime the price of fibers had declined more than 50%, and there was good reason to believe that the actual number of pounds of fiber, rope and twine contained in the company’s inventory was not very much smaller in 1932 than in 1929. At least half of the decline in the inventory account was therefore due solely to the fall in unit prices. Did this portion of the shrinkage in inventory values constitute an operating loss? Could it not be argued that its fixed assets had suffered a similar reduction in their appraisal value and that there was as much reason to charge this shrinkage against earnings as to charge the shrinkage in the carrying price of a certain physical amount of inventory?
We have already discussed this point in our exposition of the “nor- mal-stock” basis of inventory valuation (in Chap. 32), a method adopted by Plymouth Cordage itself after 1932. In theory the analyst might attempt to put all companies on a normal-stock basis for the purpose of calculating their earning power exclusive of inventory fluctuations and for uniform comparisons. Actually, he has not the data necessary for such calculations. Hence he is reduced—here, as in many fields of analysis— to the necessity of making general rather than exact allowance for the dis- torting effect of inventory price changes.
Profits from Inventory Inflation. That the importance of inventory price changes is not confined to a depression period is emphatically shown by the events of 1919 and 1920. In 1919 the profits of industrial companies were very large; in 1920 the reported earnings were irregular but in the aggregate quite substantial. Yet the gains shown in these two years were in many cases the result of an inventory inflation, i.e., a huge and speculative advance in commodity prices. Not only was the auth |
ges.
Profits from Inventory Inflation. That the importance of inventory price changes is not confined to a depression period is emphatically shown by the events of 1919 and 1920. In 1919 the profits of industrial companies were very large; in 1920 the reported earnings were irregular but in the aggregate quite substantial. Yet the gains shown in these two years were in many cases the result of an inventory inflation, i.e., a huge and speculative advance in commodity prices. Not only was the authen- ticity of these profits thereby made open to question, but the situation was replete with danger because of the large bank loans contracted to finance these overvalued inventories.
Examples: The following tabulation, which covers a number of the leading industrial companies, will bring out the significant contrast between the apparently satisfactory earnings developments and the
TWELVE INDUSTRIAL COMPANIES (AGGREGATE FIGURES)
Year 1919 Year 1920 Years 1919–1920
Earned for common stock $100,000,000 $ 48,000,000 $148,000,000
Dividends paid 35,000,000 68,000,000 103,000,000
Charges to surplus 5,000,000 10,000,000 15,000,000
Added to surplus 60,000,000 30,000,000 (decr.) 30,000,000
Inventories increased 57,000,000 84,000,000 141,000,000
Change in other net
current assets +30,000,000 131,000,000 (decr.) 101,000,000 (decr.)
Plant, etc. increased 33,000,000 169,000,000 202,000,000
Capitalization increased 69,000,000 141,000,000 210,000,000
Reserve increased 12,000,000 12,000,000
undoubtedly disquieting balance-sheet developments between the end of 1918 and the end of 1920.
The companies included in the foregoing computation were American Can, American Smelting and Refining, American Woolen, Baldwin Loco- motive Works, Central Leather, Corn Products Refining, General Electric,
B. F. Goodrich, Lackawanna Steel, Republic Iron and Steel, Studebaker, United States Rubber.
We append also the individual figures for United States Rubber, in order to add concreteness to our ill |
undoubtedly disquieting balance-sheet developments between the end of 1918 and the end of 1920.
The companies included in the foregoing computation were American Can, American Smelting and Refining, American Woolen, Baldwin Loco- motive Works, Central Leather, Corn Products Refining, General Electric,
B. F. Goodrich, Lackawanna Steel, Republic Iron and Steel, Studebaker, United States Rubber.
We append also the individual figures for United States Rubber, in order to add concreteness to our illustration:
U. S. RUBBER (1919–1920)
Earned for common stock:
1919 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,670,000 Per share: $17.60
1920 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,002,000 19.76
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,672,000 $37.36
Cash dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,580,000
Stock dividend paid . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000,000
Transferred to contingency reserve . . . . . . . . . . . . . .
Adjustments of surplus and reserves . . . . . . . . . . . . . 6,000,000
cr. 2,210,000
Net increase in surplus and miscellaneous reserves $7,300,000
BALANCE SHEET (000 OMITTED)
Item Dec. 31, 1918 Dec. 31, 1920 Increase
Plant and miscellaneous assets (net) $131,000 $185,500 $54,500
Inventories 70,700 123,500 52,800
Cash and receivables 49,500 63,600 14,100
Total assets $251,200 $372,600 $121,400
Current liabilities $ 26,500 $ 74,300 $ 47,800
Bonds 68,600 87,000 18,400
Preferred and common stock 98,400 146,300 49,900
Surplus and miscellaneous reserves 57,700 65,000 7,300
Total liabilities $251,200 $372,600 $121,400
Working capital 93,700 112,800 19,100
Working capital excluding inventory 23,000 10,700(d) 33,700(d)
The United States Rubber figures for 1919–1920 present the complete reverse of Manhattan Shirt’s exhibit for 1930–1932. In the Rubber example we have large earnings but a |
00
Current liabilities $ 26,500 $ 74,300 $ 47,800
Bonds 68,600 87,000 18,400
Preferred and common stock 98,400 146,300 49,900
Surplus and miscellaneous reserves 57,700 65,000 7,300
Total liabilities $251,200 $372,600 $121,400
Working capital 93,700 112,800 19,100
Working capital excluding inventory 23,000 10,700(d) 33,700(d)
The United States Rubber figures for 1919–1920 present the complete reverse of Manhattan Shirt’s exhibit for 1930–1932. In the Rubber example we have large earnings but a coincident deterioration of the finan- cial position due to heavy expenditures on plant and a dangerous expan- sion of inventory. The stock buyer would have been led astray completely had he confined his attention solely to United States Rubber’s reported earnings of nearly $20 per share in 1920; and, conversely, the securities markets were equally mistaken in considering only the losses reported during 1930–1932, without reference to the favorable changes occurring at the same time in the balance-sheet position of many companies.
It will be noted from our discussion here and in Chap. 32 that the mat- ter of inventory profits or losses belongs almost equally in the field of income account and of balance-sheet analysis.
Long-range Study of Earning Power and Resources. The third aspect of the comparison of successive balance sheets is of restricted inter- est because it comes into play only in an exhaustive study of a company’s record and inherent characteristics. The purpose of this kind of analysis may best be conveyed by means of the following applications to the long- term exhibits of United States Steel Corporation and Corn Products Refining Company.
I. UNITED STATES STEEL CORPORATION: ANALYSIS OF OPERATING RESULTS AND FINANCIAL CHANGES BY DECADES, 1903–1932
(ANALYSIS WAS MADE IN 1933)
The balance sheets are adjusted to exclude an intangible item (“water”), amounting to $508,000,000, originally added to the Fixed Property Account. This was subsequently written off between |
d of analysis may best be conveyed by means of the following applications to the long- term exhibits of United States Steel Corporation and Corn Products Refining Company.
I. UNITED STATES STEEL CORPORATION: ANALYSIS OF OPERATING RESULTS AND FINANCIAL CHANGES BY DECADES, 1903–1932
(ANALYSIS WAS MADE IN 1933)
The balance sheets are adjusted to exclude an intangible item (“water”), amounting to $508,000,000, originally added to the Fixed Property Account. This was subsequently written off between 1902 and 1929 by means of an annual sinking-fund charge (aggregating $182,000,000) and by special appropriations from surplus. The sinking-fund charges in question are also eliminated from the income account.
A. OPERATING RESULTS (IN MILLIONS)
Item First decade 1903–1912 Second decade 1913–1922 Third decade 1923–1932 Total for 30 years
Finished goods produced 93.4 tons 123.3 tons 118.7 tons 335.4 tons
Gross sales (excluding inter-
company items) $4,583 $9,200 $9,185 $22,968
Net earnings* 979 1,674 1,096 3,749
Bond interest 303 301 184 788
Preferred dividends 257 252 252 761
Common dividends 140 356 609† 1,105†
Balance to surplus and
“voluntary reserves” 279 765 51 1,095
* After depreciation, but eliminating parent company sinking-fund charges.
† Including $204,000,000 paid in stock.
B. RELATION OF EARNINGS TO AVERAGE CAPITAL (ALL DOLLAR FIGURES IN MILLIONS)
Item First decade Second decade Third decade Total for 30 years
Capital at beginning $ 987 $1,416 $2,072 $ 987
Capital at end 1,416 2,072 2,112 2,112
Average capital about 1,200 1,750 2,100 1,700
% earned on average capital, per year 8.1% 9.6% 5.2% 7.4%
% paid per year in interest and
dividends on average capital 5.8% 5.2% 4.0%* 5.2%*
Average common stock equity (common
stock, surplus, and reserves) $237 $620 $1,389 $816
% earned on common stock equity 17.7% 18.3% 4.8% 9.0%
% paid on common stock equity 5.9% 5.7% 2.9%* 3.7%*
Depreciation per year $24 $34 $46 $35
Average fixed property account 1,000 |
ital at end 1,416 2,072 2,112 2,112
Average capital about 1,200 1,750 2,100 1,700
% earned on average capital, per year 8.1% 9.6% 5.2% 7.4%
% paid per year in interest and
dividends on average capital 5.8% 5.2% 4.0%* 5.2%*
Average common stock equity (common
stock, surplus, and reserves) $237 $620 $1,389 $816
% earned on common stock equity 17.7% 18.3% 4.8% 9.0%
% paid on common stock equity 5.9% 5.7% 2.9%* 3.7%*
Depreciation per year $24 $34 $46 $35
Average fixed property account 1,000 1,320 1,600 1,300
Ratio of depreciation to fixed property 2.4% 2.6% 2.9% 2.7%
* Excluding stock dividend.
C. BALANCE-SHEET CHANGES (ALL FIGURES IN MILLIONS)
Item Dec. 31,
1902 Dec. 31,
1912 Changes in first decade Dec. 31,
1922 Changes in second decade Dec. 31,
1932 Changes in third decade Changes in 30 years
Assets:
Fixed (less deprec.) and misc.* Net current assets
Total
Liabilities:
Bonds Preferred stock
Preferred dividends accrued Common stock
Surplus and “voluntary” reserves*
Total
$820 167
$1,160 256
+$340
+ 89
$1,466 606
+$306
+ 350
$1,741 371
+$275
- 235
+ $921
+ 204
$987 $1,416 +$429 $2,072 +$656 $2,112 +$40 +$1,125
$380 510
508
411(d)
$680 360
508
132(d)
+$300
- 150
+ 279
$571 360
508
633
-$109
+ 765
$116 360
5
952†
679
-$455
+ 5
+ 444
+ 46
- $264
- 150
+ 5
+ 444
+ 1,090
$987 $1,416 +$429 $2,072 +$656 $2,112 + $40 +$1,125
* Eliminating initial mark-up of $508,000,000, later written off.
† Including premiums of $81,000,000 and stock dividend of $204,000,000.
The Significance of the Foregoing Figures. The three decades had, superficially at least, a somewhat equal distribution of good years and bad. In the first decade 1904 and 1908 were depression years, while 1911 and 1912 were subnormal. The second period had three bad years, viz., 1914, 1921 and 1922—the last due to high costs rather than to small vol- ume. The third decade was made up of eight years of prosperity followed by two of unprecedented depression.
The figures show that |
$204,000,000.
The Significance of the Foregoing Figures. The three decades had, superficially at least, a somewhat equal distribution of good years and bad. In the first decade 1904 and 1908 were depression years, while 1911 and 1912 were subnormal. The second period had three bad years, viz., 1914, 1921 and 1922—the last due to high costs rather than to small vol- ume. The third decade was made up of eight years of prosperity followed by two of unprecedented depression.
The figures show that the war period, which occurred in the middle decade, was a windfall for United States Steel and added more than 300 mil- lions to profits, as compared with the rate established in the first ten years. On the other hand, the last ten years were marked by a drastic falling off in the rate of earnings on the invested capital. The difference between the 5.2% actually earned and the 8% that might be regarded as a satisfactory annual average amounted to close to 600 million dollars for the ten-year period.
Viewing the picture from another angle, we note that in the thirty years the actual investment in United States Steel Corporation was more than doubled and its productive capacity was increased threefold. Yet the aver- age annual production was only 27% higher, and the average annual earn- ings before interest charges were only 12% higher, in 1923–1932 than in 1903–1912. This analysis would serve to raise the question: (1) if, since the end of the war, steel production has been transformed from a reasonably prosperous into a relatively unprofitable industry and (2) if this transfor- mation is due in good part to excessive reinvestment of earnings in addi- tional plant, thus creating a condition of overcapacity with resultant reduction in the margin of profit.
Postscript. The soundness of the foregoing analysis, made in 1933, may be judged by developments since then. It should be pointed out that both the plant account figures and the annual earnings should be adjusted downward i |
d from a reasonably prosperous into a relatively unprofitable industry and (2) if this transfor- mation is due in good part to excessive reinvestment of earnings in addi- tional plant, thus creating a condition of overcapacity with resultant reduction in the margin of profit.
Postscript. The soundness of the foregoing analysis, made in 1933, may be judged by developments since then. It should be pointed out that both the plant account figures and the annual earnings should be adjusted downward in the light of the later disclosures, viz.: (1) segregation from plant account in 1937 of $269,000,000 (and write-off of this amount in 1938), representing intangible assets at organization in addition to the
$508,000,000 written off to 1929; (2) a charge to surplus of $270,000,000 in 1935 for additional amortization of fixed assets, presumably applica- ble to the entire preceding period. These later revisions, however, do not affect in any essential degree the conclusions drawn above.
The showing of United States Steel in the years since 1932 would appear to bear out the pessimistic implications of the 1933 study. During the six years 1934–1939, which is most instances supply a fair test period
for judging normal earning power, “Steel” common earned an average of but 14¢ per share. New developments in products, processes or other factors—including war profits—may change the picture for the better, but this has become a matter for speculative anticipation of future improve- ment rather than a reasonable expectation based on past performance.
II. SIMILAR ANALYSIS OF CORN PRODUCTS REFINING COMPANY FEBRUARY 28, 1906 TO DEC. 31, 1935
A. AVERAGE ANNUAL INCOME ACCOUNT (000 OMITTED FROM DOLLAR FIGURES)
1906–1915 1916–1925 1926–1935
Earned before depreciation Depreciation
Balance for interest and dividends Bond interest
Preferred dividends (paid or accrued) Balance for common
Common dividends Balance to surplus
Balance to surplus for period Adjustment of common stock, surplus
an |
er than a reasonable expectation based on past performance.
II. SIMILAR ANALYSIS OF CORN PRODUCTS REFINING COMPANY FEBRUARY 28, 1906 TO DEC. 31, 1935
A. AVERAGE ANNUAL INCOME ACCOUNT (000 OMITTED FROM DOLLAR FIGURES)
1906–1915 1916–1925 1926–1935
Earned before depreciation Depreciation
Balance for interest and dividends Bond interest
Preferred dividends (paid or accrued) Balance for common
Common dividends Balance to surplus
Balance to surplus for period Adjustment of common stock, surplus
and reserves
Increase in common stock, surplus and reserves $3,798 811
2,987
516
2,042
429
429
4,290
cr. 1,282
5,572 $12,770 2,538
10,232
264
1,879
8,089
2,751
5,338
53,384
cr. 6,026
59,410 $14,220 2,557
11,663
88
1,738
9,837
8,421
1,416
14,159
dr. 5,986
7,173
B. BALANCE SHEETS
Feb. 28,
1906 Dec. 31,
1915 Dec. 31,
1925 Dec. 31,
1935
Plant (less depreciation) and miscellaneous assets
Investment in affiliates Net current assets
Total Bonds
Preferred stock
Common stock, surplus and miscellaneous reserves Preferred dividend accrued
Total
$49,000 2,000
1,000
$51,840 4,706
11,091
$ 47,865
16,203
42,528
$ 34,532
33,141
43,192
$52,000 $67,637 $106,596 $110,865
9,571
28,293
14,136 12,763
29,873
19,708
5,293 2,474
25,004
79,118 24,574
86,291
$52,000 $67,637 $106,596 $110,865
C. PERCENTAGE EARNED1 AND PAID ON TOTAL CAPITALIZATION AND ON COMMON-STOCK EQUITY
Item 1906–1915 1916–1925 1926–1935 295/6 years
Average capitalization $59,818 $87,116 $108,730 $81,432
Earned thereon 5.0% 11.8% 10.7% 10.2%
Paid thereon 4.2% 5.6% 9.4% 7.3%
Average common equity $16,922 $49,413 $82,704 $50,213
Earned thereon 2.5% 16.4% 11.9% 12.2%
Paid thereon nil 5.6% 10.2% 7.8%
1 Adjustments to Surplus and Reserves are excluded from earnings.
NOTES ON FOREGOING COMPUTATION
1. The plant account and common-stock equity are corrected throughout to reflect a write- down of $36,000,000 made in 1922 and 1923.
2. Bonds outstanding are increased in 1906 and 1912 to reflect liability for issues of subsidiaries. |
.7% 10.2%
Paid thereon 4.2% 5.6% 9.4% 7.3%
Average common equity $16,922 $49,413 $82,704 $50,213
Earned thereon 2.5% 16.4% 11.9% 12.2%
Paid thereon nil 5.6% 10.2% 7.8%
1 Adjustments to Surplus and Reserves are excluded from earnings.
NOTES ON FOREGOING COMPUTATION
1. The plant account and common-stock equity are corrected throughout to reflect a write- down of $36,000,000 made in 1922 and 1923.
2. Bonds outstanding are increased in 1906 and 1912 to reflect liability for issues of subsidiaries. Plant, etc., is increased in the same amounts.
3. Estimates considered to be sufficiently accurate are used in the initial balance sheet.
4. Deductions for bond interest are partly estimated for the first two periods.
5. The adjustments of Common Stock, Surplus, and Reserves represent chiefly changes in Mis- cellaneous Reserves and shrinkage of marketable securities.
Comment on the Corn Products Refining Company Exhibit. The early period was one of subnormal earnings, which would have been still poorer if more nearly adequate depreciation charges had been made. As in the case of United States Steel, the war period brought enormous earn- ings to Corn Products. The decade 1916–1925 was marked as a whole by a great increase in working capital and a substantial reduction in funded debt and preferred stock. Depreciation charges exceeded expenditures on new plant.
In the 1926–1935 period we note a striking divergence from the exhibit of United States Steel for 1923–1932. Despite inclusion of the depression years Corn Products was almost able to increase its earning power proportionately with its enlarged capital investment. Its annual profits (both before and after depreciation) were about four times as large in this decade as in the period ending in 1915. (If we use the same years for comparison, we shall find that United States Steel actually earned less in 1926–1935 than in 1906–1915.) The balance-sheet changes were
marked by a further substantial shrinkage in the property acc |
the depression years Corn Products was almost able to increase its earning power proportionately with its enlarged capital investment. Its annual profits (both before and after depreciation) were about four times as large in this decade as in the period ending in 1915. (If we use the same years for comparison, we shall find that United States Steel actually earned less in 1926–1935 than in 1906–1915.) The balance-sheet changes were
marked by a further substantial shrinkage in the property account (due to the liberal depreciation charged) but by a larger increase in the invest- ment in affiliated companies—indicating a broad expansion of the com- pany’s activities.
It is clear that the record of Corn Products Refining Company does not suggest the same questions or doubts as arise from an examination of the United States Steel Corporation’s exhibit.
This page intentionally left blank
PART VII
ADDITIONAL ASPECTS OF SECURITY ANALYSIS. DISCREPANCIES BETWEEN PRICE AND VALUE
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
This page intentionally left blank
I n tr oduc tion to P ar t VII
THE GREAT ILLUSION OF THE STOCK MARKET AND THE FUTURE OF VALUE INVESTING
BY DAVID ABR AMS
n value-investing circles, you meet many people who claim to have been inspired by what Benjamin Graham and David Dodd wrote in Security Analysis. Most are, at the very least, stretching the truth. A fair
number of aspiring and practicing value investors may indeed have devoured The Intelligent Investor. But I would wager that few have actually dug deeply into Security Analysis and fewer still have read the classic cover to cover. I have to confess that although I had delved into various parts of Security Analysis, I had never read it from first page to last. So when I was asked to write an introduction to Part VII, which comprises the last hundred pages of the book, it was time to d |
ruth. A fair
number of aspiring and practicing value investors may indeed have devoured The Intelligent Investor. But I would wager that few have actually dug deeply into Security Analysis and fewer still have read the classic cover to cover. I have to confess that although I had delved into various parts of Security Analysis, I had never read it from first page to last. So when I was asked to write an introduction to Part VII, which comprises the last hundred pages of the book, it was time to do my homework. After more than 20 years as an investment professional, I finally read the value investors’ equivalent of Deuteronomy. Entitled “Additional Aspects of Security Analysis. Discrepancies between Price and Value,” Part VII covers a lot of ground: the valuation of warrants; the potential decrease in the value of a company’s common stock when it issues options to manage- ment; the shortcomings of relative value analysis; and the greed of invest- ment bankers. In the 75 years since the original edition was published, both the world at large and the financial markets have undergone cata- clysmic change. Yet, as Graham and Dodd understood, how markets work, how companies are run, and how people—both investors and cor- porate managers—tend to act in certain situations never change.
[617]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
The world likes to categorize things, including investing styles, in neat little boxes. So it is that the financial media frequently label market participants as “value,” “growth,” or “momentum” investors. That’s all fine, but I can tell you that I’ve observed a great many investors over the years, and I’ve never seen a consistently successful one whose strategy was not based on a value approach—paying less for something than it is worth, either today or in the future. True, some people like to buy things that will grow and others are drawn to assets that beckon from the bar- |
oxes. So it is that the financial media frequently label market participants as “value,” “growth,” or “momentum” investors. That’s all fine, but I can tell you that I’ve observed a great many investors over the years, and I’ve never seen a consistently successful one whose strategy was not based on a value approach—paying less for something than it is worth, either today or in the future. True, some people like to buy things that will grow and others are drawn to assets that beckon from the bar- gain counter, while still others like to engage in arbitrage activities, buy- ing one thing and selling another to profit on the price differential, or spread. But every successful investor I’ve ever known makes a calculation that compares an asset’s purchase price to its present or future value.
Whatever their approach, countless investors have used the princi- ples laid out in Security Analysis to uncover bargains. Scads of people have become wealthy doing so, including many of the contributors to this revised edition, not to mention all the people who were smart enough to buy Berkshire Hathaway years ago. Their success is a testa- ment to value investing’s glorious past. But what about its future? Is the road ahead bright and prosperous? Or is it bleak and beggarly? Are there more people practicing Ben Graham’s underlying principles than there are bargains for them to find? Is there just too much money chasing a finite supply of bargains? Or might a serious security analyst still be able to prosper over time?
I am optimistic about the future of value investing. To be sure, there are many bright and savvy people in the financial markets employing Graham and Dodd’s techniques, but the markets themselves have grown exponentially. The chunk of capital being invested by the value-investing crowd is a small percentage of the overall capitalization of global finan- cial markets. Having observed the markets for more than two decades, my sense is that, rather than a glut of Graham |
e able to prosper over time?
I am optimistic about the future of value investing. To be sure, there are many bright and savvy people in the financial markets employing Graham and Dodd’s techniques, but the markets themselves have grown exponentially. The chunk of capital being invested by the value-investing crowd is a small percentage of the overall capitalization of global finan- cial markets. Having observed the markets for more than two decades, my sense is that, rather than a glut of Graham and Dodd acolytes picking through scarce opportunities to find a place for their cash, money is ever
more prone to sloshing around in giant waves, flowing from one fad to the next. If anything, it seems that the people controlling these mega- sums have become less intelligent and less sophisticated over time. The last decade alone has brought incredible extremes in valuation, starting in 1999 and 2000 with the high-altitude Internet bubble that was fol- lowed in short order by the utter collapse of the tech market. In the sum- mer of 2002, we witnessed a tremendous corporate debt meltdown. But soon, these excessively low valuations were pushed off the front pages by the most generous and lax lending standards of all time. Now, as I write this introduction, the mortgage market is imploding, creating per- haps yet another new set of opportunities. That we’ve seen the last of these extreme swings seems doubtful.
What is driving this manic phenomenon? The explanation is some- thing I call the “Great Illusion of the Stock Market.” Investing looks easy, particularly in a world of inexpensive software and online trading. Buy- ing a stock is no more difficult than buying a book on Amazon.com. And because a great many people have gotten wealthy in the stock market, lots of others have come to believe that anyone can get rich with very little effort. They are wrong. All the people I know who’ve built wealth in the stock market have worked very hard at it. Graham and Dodd under- stoo |
ll the “Great Illusion of the Stock Market.” Investing looks easy, particularly in a world of inexpensive software and online trading. Buy- ing a stock is no more difficult than buying a book on Amazon.com. And because a great many people have gotten wealthy in the stock market, lots of others have come to believe that anyone can get rich with very little effort. They are wrong. All the people I know who’ve built wealth in the stock market have worked very hard at it. Graham and Dodd under- stood the effort it took to be successful in the market. They wrote:
Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries?
Mainly by hard and systematic work. (p. 669)
So, yes, you can get rich buying and selling stocks, but, as the authors well knew, it takes hard work and patience. Nevertheless, the Great Illu- sion persists, maybe because, like Woody Allen’s film character Zelig, the market is a chameleon that changes its appearance to suit the times.
Sometimes, it shows up as a tech stock bubble. Other times, it manifests
itself as a ludicrously overvalued stock market as seen in the late 1980s in Japan. In a current incarnation, a raft of financial institutions across America are trying to emulate the success of David Swensen and his col- leagues who manage Yale University’s endowment by allocating large percentages of the capital to “alternative investment managers.”
But the Great Illusion is just that—an illusion. If you want to get wealthy in the financial markets, you’ll need to engage in “hard and sys- tematic work.” And for that, many sections of Part VII of Security Analysis are still essential. Given the drastic changes in the world since the book first appeared, it should come as no surprise that some of the material is no longer relevant |
Yale University’s endowment by allocating large percentages of the capital to “alternative investment managers.”
But the Great Illusion is just that—an illusion. If you want to get wealthy in the financial markets, you’ll need to engage in “hard and sys- tematic work.” And for that, many sections of Part VII of Security Analysis are still essential. Given the drastic changes in the world since the book first appeared, it should come as no surprise that some of the material is no longer relevant for today’s investor, and these shortcomings bear mentioning. So as we take a quick tour through this part, I’ll point out some deficiencies along with the authors’ nuggets of wisdom that still ring true.
One of the shortcomings shows up early in the first chapter of Part VII, in Chapter 46, “Stock-option Warrants,” which is on the accompany- ing CD. This chapter may well be the most dated. When the book was first published, the derivatives market was still in its infancy. Fischer Black and Myron Scholes had not yet developed their famous formula for valu- ing stock options, and the products that now pervade the financial mar- kets—options, interest rate futures, swaps, swaptions, and so on—were not fixtures in the financial markets. Chapter 46 homes in on stock war- rants, one of the few derivative securities available at that time. The authors make some good points with their few specific examples, but their analysis is not sophisticated enough for today’s world.
Take their example of Barnsdall Oil warrants. Graham and Dodd cor- rectly conclude that these warrants were undervalued because the mar- ket priced them at their intrinsic value. It’s not terribly relevant in today’s world because such mispricing wouldn’t last long. Besides pointing out the obvious—it’s better to own a warrant trading at its intrinsic value
than to own the underlying stock—Graham and Dodd note the leverage inherent in warrants and options. This analysis is good as far as it goes, but it just does |
f Barnsdall Oil warrants. Graham and Dodd cor- rectly conclude that these warrants were undervalued because the mar- ket priced them at their intrinsic value. It’s not terribly relevant in today’s world because such mispricing wouldn’t last long. Besides pointing out the obvious—it’s better to own a warrant trading at its intrinsic value
than to own the underlying stock—Graham and Dodd note the leverage inherent in warrants and options. This analysis is good as far as it goes, but it just doesn’t go far enough. The authors were able to identify that the Barnsdall Oil warrants were mispriced relative to the common stock, but they weren’t able to provide the reader with an intellectual frame- work or the tools needed to value the warrants properly.
I should make it clear that just because an asset is overvalued or undervalued, it’s not necessarily a good idea to try to capitalize on that mispricing. If the derivatives market fully understands the misvaluation of the underlying security, there is no particular edge to owning the derivative. However, if the market undervalues the derivatives on a mis- priced security or group of securities, the odds to the derivative investor can be very favorable. In effect, the investor benefits from the double leverage of two mispriced securities—the underlying and the derivative. Although such a situation doesn’t arise often, it can be particularly prof- itable. The ability to capture the compound mispricings can lead to extraordinary profits.
Perhaps the most famous example of this phenomenon occurred in the late 1980s, when the Japanese stock market rose to greater and greater heights, ultimately reaching an absurd level of overvaluation. While some believed that this was a “new era” in which Japan would eco- nomically dominate the world, value investors took a different view, believing instead that it was simply a case of a financial bubble that would ultimately correct itself. On Wall Street, there was a growing and widespread |
ts.
Perhaps the most famous example of this phenomenon occurred in the late 1980s, when the Japanese stock market rose to greater and greater heights, ultimately reaching an absurd level of overvaluation. While some believed that this was a “new era” in which Japan would eco- nomically dominate the world, value investors took a different view, believing instead that it was simply a case of a financial bubble that would ultimately correct itself. On Wall Street, there was a growing and widespread understanding that the Japanese stock market would even- tually decline to more reasonable and rational levels, which spelled opportunity for those able to capitalize on what promised to be a dra- matic price movement.
Against this backdrop, options sellers were, amazingly, willing to offer puts on the Nikkei Index at a remarkably cheap price. I remember asking
the brokers who sold these options, “Who is taking the other side of these trades?” “European institutions,” they said, which is the standard reply of Wall Street brokers who don’t want to tell you what’s really going on. In the end, it turned out that much of the exposure was held by Japanese financial institutions that were so confident their market would never go down that they wrote these multiyear contracts and took the entire premium into income immediately. Ultimately, the Japanese market collapsed, and my then employer, along with many other U.S. investors, profited handsomely as the puts soared in value.
More recently, the derivatives market in asset-backed securities of subprime mortgages offered a similarly distorted risk-reward equation in the form of credit default swaps (CDSs). These securities are a series of puts on bonds backed by subprime mortgages on residential property. When the bonds were issued, they were viewed by both investors and the rating agencies as safe (that is, investment grade) because of the assumptions about how these mortgages would perform. However, some astute investors realize |
y, the derivatives market in asset-backed securities of subprime mortgages offered a similarly distorted risk-reward equation in the form of credit default swaps (CDSs). These securities are a series of puts on bonds backed by subprime mortgages on residential property. When the bonds were issued, they were viewed by both investors and the rating agencies as safe (that is, investment grade) because of the assumptions about how these mortgages would perform. However, some astute investors realized that the underlying collateral was much riskier and subject to far more downside than the buyers originally assumed when they purchased CDSs on subprime bonds and indexes.
When the subprime market collapsed in 2007, some of these securities increased in value more than 50 or 60 times the amount at risk. Every trade always has two sides, so it helps if you can figure out the thought process of the person on the opposite side of the trade. Warren Buffett once wrote: “If you’ve been in the poker game for 30 minutes and you don’t know who the patsy is, you’re the patsy.”
“Work It Out”
Like Graham and Dodd, my own initial approach to the derivatives mar- ket was rather simplistic, and I well remember the day my young eyes were opened to the perils and pitfalls of my naiveté.
It was the early 1980s and I was just starting out on Wall Street. Deriv- atives were still a mostly nascent market, and stock options were among the first of these instruments to attract much attention. Like Graham and Dodd and many others on the Street, I grasped the leveraged nature of stock options and how they could be used to magnify the gains (or losses) of an individual stock position. But my knowledge beyond the basics was scant. I was working in the risk arbitrage department of a firm that did a lot of options arbitrage. And although I didn’t yet understand what that meant, I did understand that the guys sitting next to me were making a lot of money doing it. What is more, they seemed to come in |
and Dodd and many others on the Street, I grasped the leveraged nature of stock options and how they could be used to magnify the gains (or losses) of an individual stock position. But my knowledge beyond the basics was scant. I was working in the risk arbitrage department of a firm that did a lot of options arbitrage. And although I didn’t yet understand what that meant, I did understand that the guys sitting next to me were making a lot of money doing it. What is more, they seemed to come in just before the market opened, left promptly right after the market closed, and never even glanced at the Wall Street Journal, preferring instead to read the gossipy New York Post. My curiosity was aroused. So one day I asked Ira, the head of the firm, to explain to me what he did.
The two-minute conversation that followed forever changed the way I looked at derivatives and profoundly affected the way I’ve approached unfamiliar areas in finance and business ever since.
Ira pointed to a stock (I can’t remember which one, although it could easily have been IBM since, in those days, the sun on Wall Street literally rose and set on whatever IBM was doing) and asked me this question: “What if you buy the $35 calls, sell the $40 calls, buy the $40 puts, and sell the $35 puts all at the same time?” My first thought was, “You’ve got a mess,” but I didn’t say that. I simply looked baffled. Seeing my confu- sion, he said, “Work it out. What’s it worth at expiration?” After a few min- utes with pencil and paper, I looked up, still a bit confused, and said, “It’s always worth $5.” “Right,” he said. But still the light did not flicker in my brain until Ira asked, “What if you could buy it for $4.50?” Bingo! I finally got it. Even though I was new to Wall Street, I had done enough arbi- trage to understand what Ira was saying. Typically, the most liquid
option contracts are those with expiration dates relatively close by;
which means that if you could buy this “box,” as it is called, con |
encil and paper, I looked up, still a bit confused, and said, “It’s always worth $5.” “Right,” he said. But still the light did not flicker in my brain until Ira asked, “What if you could buy it for $4.50?” Bingo! I finally got it. Even though I was new to Wall Street, I had done enough arbi- trage to understand what Ira was saying. Typically, the most liquid
option contracts are those with expiration dates relatively close by;
which means that if you could buy this “box,” as it is called, consisting of two pairs of options for $4.50, you would make a guaranteed 11% on your money in less than six months.
It was my turn to pose a question. “Can you really buy them for
$4.50?” I asked. “Sometimes,” he said. And then I realized who had been the proverbial patsy in the poker game. It was me. By relying on Graham and Dodd’s overly simplistic approach to the options market and not fully understanding the mathematics of the instruments in which I was investing, I didn’t appreciate how the trade might look to the person on the other side. I was ripe for the picking, as they say. Perhaps my trades had been the other side of someone’s buying a box for $4.50. I realized that, in all likelihood, the guy on the other side was probably smarter than I was. Embarrassed by my own ignorance, I vowed to wade into new situations with a greater respect for those on the other side of the trade and with more humility about the limits of my own knowledge.
Never again would I be the patsy. That approach has served me well throughout my career.
Unlike the world in which Graham and Dodd lived and worked, today’s security analyst is at a disadvantage without a good understand- ing of how option pricing models work and what their limitations are.
Not only are derivatives pervasive in the financial markets but many cor- porations and investment entities use them for purposes both prudent and reckless.
As I continued to acquire experience and learned more about options and the models used to va |
roach has served me well throughout my career.
Unlike the world in which Graham and Dodd lived and worked, today’s security analyst is at a disadvantage without a good understand- ing of how option pricing models work and what their limitations are.
Not only are derivatives pervasive in the financial markets but many cor- porations and investment entities use them for purposes both prudent and reckless.
As I continued to acquire experience and learned more about options and the models used to value them, I became aware of a major weak- ness in options theory. By and large, the academic work underpinning derivatives analysis, work that so many on Wall Street rely on, is predi- cated on the assumption that the markets are “efficient.” The authors of Security Analysis would have had a good time arguing with these aca- demics. They understood that the underlying premise of efficiency is not always true, writing:
Evidently the processes by which the securities market arrives at its appraisals are frequently illogical and erroneous. These processes, as we pointed out in our first chapter, are not automatic or mechanical but psychological, for they go on in the minds of people who buy and sell. (p. 669)
Ahead of their time when it came to the question of market effi- ciency, Graham and Dodd weren’t able to foresee a need for the more complex mathematical relationships pointed out by my boss. They looked only at the relationship between the derivative security and the underlying instrument, which made for a somewhat primitive method of warrant analysis. Nevertheless, they did possess a keen understand- ing of how option and warrant issuance can affect the future value of the issuing company’s common stock. In fact, they understood it better than many of today’s accountants and Wall Street analysts. In a subsec- tion entitled “A Dangerous Device for Diluting Stock Values,” the authors write,
The public’s failure to comprehend that all the value of option warrants is deriv |
nstrument, which made for a somewhat primitive method of warrant analysis. Nevertheless, they did possess a keen understand- ing of how option and warrant issuance can affect the future value of the issuing company’s common stock. In fact, they understood it better than many of today’s accountants and Wall Street analysts. In a subsec- tion entitled “A Dangerous Device for Diluting Stock Values,” the authors write,
The public’s failure to comprehend that all the value of option warrants is derived at the expense of the common stock has led to a practice that would be ridiculous if it were not so mischievous. (p. 653 on accompany- ing CD)
Those words could just as easily have been penned any time in the last decade, as some of the compensation schemes recently adopted at certain corporations have been shortchanging shareholders by masking the dilutive impact and inflating the income statement.
Until recently, companies recorded no expense on their income state- ments for the cost of options issued to management and directors. A couple of years ago, the rules were changed, and Generally Accepted Accounting Principles (GAAP) began requiring companies to use one of several methods to value the cost of their stock options. It’s a big improvement over the prior practice of recording no expense, but the
methods mandated by GAAP are the same as those used by analysts to value derivatives not issued by the company. Clearly, something is amiss. There is a huge difference between derivative contracts with third par- ties that do not result in more shares being issued and company-issued options that increase the number of its shares outstanding in the future, thereby diluting the interests of the current stockholders. Long-term shareholders need to fully appreciate the impact of these options issued by corporations to management; otherwise they’ll find themselves short- changed in the years to come.
Beware of the Investment Bankers!
Moving on to Chapter 47, “Cost of Financin |
ivative contracts with third par- ties that do not result in more shares being issued and company-issued options that increase the number of its shares outstanding in the future, thereby diluting the interests of the current stockholders. Long-term shareholders need to fully appreciate the impact of these options issued by corporations to management; otherwise they’ll find themselves short- changed in the years to come.
Beware of the Investment Bankers!
Moving on to Chapter 47, “Cost of Financing and Management,” Gra- ham and Dodd might more aptly have named it, “Beware of the Invest- ment Bankers!” As the saying goes, “The more things change, the more they stay the same.” Or, as a friend once told me with regard to conflicts of interest on Wall Street, “Where there’s no conflict, there’s no interest.” The reader will find it interesting to learn about ancient abuses at the hands of investment bankers, while the folks at Goldman Sachs and Mor- gan Stanley may shed a few tears of nostalgia when they read about the good old days of 20% underwriting spreads on the likes of American Bantam Car Corporation Convertible Preference Stock. But the last page of the chapter really stands out for its enduring relevance. Graham and Dodd wrote,
The relaxation of investment bankers’ standards in the late 1920s, and their use of ingenious means to enlarge their compensation, had unwholesome repercussions in the field of corporate management. Operating officials felt themselves entitled not only to handsome salaries but also to a substantial participation in the profits of the enterprise. . . . But it may not be denied that devious and questionable means were fre- quently employed to secure these large bonuses to the management without full disclosure of their extent to the stockholders With pub-
licity given to this compensation, we believe that the self-interest of stockholders may be relied on fairly well to prevent it from passing all reasonable limits. (p. 642)
So many of the |
nly to handsome salaries but also to a substantial participation in the profits of the enterprise. . . . But it may not be denied that devious and questionable means were fre- quently employed to secure these large bonuses to the management without full disclosure of their extent to the stockholders With pub-
licity given to this compensation, we believe that the self-interest of stockholders may be relied on fairly well to prevent it from passing all reasonable limits. (p. 642)
So many of the recent excesses—from the Internet bubble to the leveraged buyout craze to the subprime mortgage fiasco—bear more than a passing resemblance to the shenanigans Graham and Dodd described years ago. And while the pair probably would not have been surprised at some of the excessive compensation at the corporate level, they likely would have been shocked that these excesses reached into the management of the New York Stock Exchange itself. Today’s investors would do well to view Wall Street with at least the same degree of reproach and skepticism our authors exhibited in their writings.
Jumping ahead, Chapter 50, “Discrepancies between Price and Value,” and Chapter 51, “Discrepancies between Price and Value (Contin- ued),” are among the gems of Part VII, and anyone interested in invest- ing should read them. They provide the reader with a useful list of dos and don’ts, places to look for value, and traps to avoid, illustrated by examples from the 1930s. Many of us have a tendency to romanticize the past, and when investors engage in such fond reminiscence, they often speak wistfully of Graham’s era. Oh, for a return to the days when stocks sold at seven times earnings and less than working capital! And I must admit that when I read the Group A list in Chapter 50, I, too, felt a twinge of envy. How easy it must have been to be an investor in the late 1930s!
But wait a minute, I thought. I’ve encountered numerous opportuni- ties in my own lifetime that would have made Graham green |
icize the past, and when investors engage in such fond reminiscence, they often speak wistfully of Graham’s era. Oh, for a return to the days when stocks sold at seven times earnings and less than working capital! And I must admit that when I read the Group A list in Chapter 50, I, too, felt a twinge of envy. How easy it must have been to be an investor in the late 1930s!
But wait a minute, I thought. I’ve encountered numerous opportuni- ties in my own lifetime that would have made Graham green with envy. The truth is that, from time to time, financial markets present opportuni- ties to buy assets that have remarkable risk-reward characteristics. It can be described only as the best of all worlds when an investor has the chance to make a decent amount of money in the worst case and oodles
in the best case. My personal list begins with the Management Assistance Liquidating Trust—perhaps my first true value investment—and includes Public Service of New Hampshire 18% second mortgage bonds trading at par; Executive Life Muni GICs trading at 25 cents on the dollar in the wake of a trial court judge’s decision later declared on appeal to have “no basis in law or reason”; and Gentiva common stock, a spin-off resulting from a merger that was trading at about a third of its working capital.
Around the same time Ira was enlightening me about the options market, my friend Chris Stavrou introduced me to Management Assis- tance Liquidating Trust when he faxed me the 10-Q, adorned with his handwritten notes. As he walked me through, I could see exactly what he saw: a stock trading at $2 that was worth $4. What’s more, the com- pany was now obligated to pay out to shareholders all the proceeds from the sale of its assets. Knowing that this was a certain double, I promptly sold all my other holdings and put 100% of my assets (all
$10,000 worth) into this one stock. My only regret is that I didn’t buy any for my company because I was afraid my boss, who was on vacation at the time |
is handwritten notes. As he walked me through, I could see exactly what he saw: a stock trading at $2 that was worth $4. What’s more, the com- pany was now obligated to pay out to shareholders all the proceeds from the sale of its assets. Knowing that this was a certain double, I promptly sold all my other holdings and put 100% of my assets (all
$10,000 worth) into this one stock. My only regret is that I didn’t buy any for my company because I was afraid my boss, who was on vacation at the time, would disapprove of the investment.
One of the most recent and spectacular sets of opportunities occurred in mid-2002, amid the epic meltdown in the corporate bond market. Bargains were there for the taking—left, right, and center. Cor- porate bond market investors that year had stories galore. Mine was the AES 10.25% Senior Subordinated Notes, which traded as low as 15 cents on the dollar. At that price, the current yield was close to 66%. AES was a complex company with assets all over the world. Furthermore, it was financed in a nontraditional way with a combination of project-specific debt as well as corporate debt of different levels of seniority. The high degree of leverage combined with the complexity of the asset base caused the market to be concerned that the company would be forced into bankruptcy. Our analysis led us to the conclusion that there was more than sufficient value and cash flow to cover the debt. As it turned
out, we were correct. These bonds never missed a payment and were called at par within a year of hitting their lows. Talk about a windfall! Surely, Ben Graham would have marveled at the bond market’s tempo- rary insanity in the summer of 2002.
As I continued reading through Part VII, I was particularly and delightedly struck by the authors’ use of the English language. Their abil- ity to express ideas cogently and clearly has seldom been matched in the field of finance, with the exception of perhaps their best and most famous student, Warren Buf |
yment and were called at par within a year of hitting their lows. Talk about a windfall! Surely, Ben Graham would have marveled at the bond market’s tempo- rary insanity in the summer of 2002.
As I continued reading through Part VII, I was particularly and delightedly struck by the authors’ use of the English language. Their abil- ity to express ideas cogently and clearly has seldom been matched in the field of finance, with the exception of perhaps their best and most famous student, Warren Buffett. After all, it was Graham and Dodd who created the parable of a manic Mr. Market, the gentleman who may be your friend or your enemy but who is someone whose advice you should never accept. A great example of their effective use of language is found in the discussion of the shortcomings of “market analysis.”
It was also Graham and Dodd who coined the term “margin of safety,” which has special relevance for the investment professionals who con- tributed to this edition of the book. All of us are fundamental analysts who examine securities one at a time, weighing the risk and reward characteristics of each investment at a particular price. While we may, from time to time, have views on where the stock market is headed, we generally do not make bets on its direction. Our reasons are many, but I think Graham and Dodd said it best when they wrote in Chapter 52:
In market analysis there are no margins of safety; you are either right or wrong, and if you are wrong, you lose money. (p. 703)
That really sums it up nicely, doesn’t it? Yet, all these years later, many investors are still consumed with formulating their own market view.
Wall Street’s finest firms employ market strategists, and many investors, professional and otherwise, are eager to hear those views. This, I submit, is simply more evidence that the Great Illusion persists.
In the very last chapter, Graham and Dodd offer advice to different groups of market participants, among them the small investor, the
well-hee |
3)
That really sums it up nicely, doesn’t it? Yet, all these years later, many investors are still consumed with formulating their own market view.
Wall Street’s finest firms employ market strategists, and many investors, professional and otherwise, are eager to hear those views. This, I submit, is simply more evidence that the Great Illusion persists.
In the very last chapter, Graham and Dodd offer advice to different groups of market participants, among them the small investor, the
well-heeled investor, and the institutional investor. How has their advice held up?
For the small investor interested in income, the authors felt that the only suitable investment was U.S. government savings bonds. The securi- ties performed as promised, of course, but there were a couple of devel- opments that Graham and Dodd did not and could not foresee. First and foremost were the ravaging effects of inflation in the late 1970s and early 1980s. The inflationary spiral ultimately led to higher interest rates and large losses for bond investors. Second was the expansion of the fixed income markets and the proliferation of innumerable fixed income securities that created opportunities for value investing in the bond mar- ket for those willing to sift through vast numbers of similar instruments in search of anomalous pricing.
Graham and Dodd advised profit-seeking investors, both large and small, to purchase securities trading below their intrinsic value, and they suggested that investors submit their analytical work for critique by oth- ers. In essence, they were recommending that investors should all become part-time security analysts. Writing in the aftermath of the 1929 crash and ensuing Great Depression, the prospect of the kind of financial market profitability we’ve seen in recent years was unimaginable. In today’s hypercompetitive world, it may be possible to succeed as a part- time investor, but it’s not something I’d recommend. And if you don’t want to devote yourself full- |
it their analytical work for critique by oth- ers. In essence, they were recommending that investors should all become part-time security analysts. Writing in the aftermath of the 1929 crash and ensuing Great Depression, the prospect of the kind of financial market profitability we’ve seen in recent years was unimaginable. In today’s hypercompetitive world, it may be possible to succeed as a part- time investor, but it’s not something I’d recommend. And if you don’t want to devote yourself full-time to researching investments, you’re probably better off engaging some professional assistance.
The prolific pair also advised institutions to invest solely in fixed income investments, if doing so would fulfill their needs. Fortunately, for universities such as Harvard, Yale, and Princeton, men such as Jack Meyer, David Swensen, and Andy Golden didn’t follow that advice. And because of it, those institutions have far more resources at their disposal today than they would have otherwise. Thanks to the insight and inde-
pendent thinking of these individuals, their respective institutions all have endowments measured in the tens of billions that give them a huge and perhaps permanent competitive advantage over many of their less wealthy peers. Beyond any specific advice that Graham and Dodd offered, the most important point investors should take away from Secu- rity Analysis is this: look at the numbers and think for yourself. All the great investors do, and that’s what makes them great.
Interestingly enough, one group of investors was left out when Gra- ham and Dodd were dispensing advice in the last chapter of Security Analysis. They had nary a word for all the young people starting out in financial careers that they undoubtedly hoped would bring them fortune and happiness, if not fame. To rectify that oversight, I offer a few last words of advice to this group. Many of my collaborators on this project are, like me, investment professionals who were once in your shoes— y |
reat.
Interestingly enough, one group of investors was left out when Gra- ham and Dodd were dispensing advice in the last chapter of Security Analysis. They had nary a word for all the young people starting out in financial careers that they undoubtedly hoped would bring them fortune and happiness, if not fame. To rectify that oversight, I offer a few last words of advice to this group. Many of my collaborators on this project are, like me, investment professionals who were once in your shoes— young, new to Wall Street, with little if any money in our bank accounts, but armed with energy, hope, and a good work ethic. We feel a particu- larly strong kinship with you. I think all of us would agree that we made a great career choice. And although we may initially have been moti- vated by the money, it’s been a long time since the accumulation of wealth was the force that sends us into the office each day. We do what we do because we enjoy it. We relish the challenge, the stimulation, and the satisfaction that comes with finding the next bargain the market has to offer.
A number of years ago some professors at the University of Chicago concluded that Graham and Dodd had it all wrong. The market, they said, was efficient. In effect, they told aspiring analysts such as you: “Don’t bother. Don’t waste your time. The market is too efficient for you to be rewarded by your effort. Find something else to do with your life.” For a long time, it was fashionable for people in financial circles to debate this topic, with the professors marshaling arguments in favor of
their position and the practitioners insisting they were wrong, often pointing to the many aberrations that could not be explained by the academic theories.
Recently, the debate has died down, or perhaps it’s just that the prac- titioners are too busy making money, too busy unearthing the next mis- priced security, to find the time to argue anymore. As rewarding as our careers have been, I think all of us would tel |
cles to debate this topic, with the professors marshaling arguments in favor of
their position and the practitioners insisting they were wrong, often pointing to the many aberrations that could not be explained by the academic theories.
Recently, the debate has died down, or perhaps it’s just that the prac- titioners are too busy making money, too busy unearthing the next mis- priced security, to find the time to argue anymore. As rewarding as our careers have been, I think all of us would tell you that it’s been a con- stant intellectual challenge to understand an ever-changing and increas- ingly global financial world in a competition that draws many exceptionally talented, bright, and hardworking entrants. But it is just such rigorous competition among colleagues and friends that brings out the best in us. I, for one, feel fortunate to have met so many intellectually curious, hardworking, and motivated people during my time on Wall Street.
And so, to the aspiring young analyst, I can tell you that the answer to the question of the market’s efficiency or lack thereof is clear: The market is inefficient enough. “Enough for what?” you ask. Inefficient enough for me—and you—to find some great opportunities from time to time. Not every day or every week, but often enough. The Great Illu- sion persists, leaving plenty of opportunities for those who wish to do the hard, sometimes boring, and often tedious work of value investing. Happy hunting!
Chapter 47
COST OF FINANCING
AND MANAGEMENT
LET US CONSIDER IN MORE DETAIL the organization and financing of Petro- leum Corporation of America, mentioned in the last chapter. This was a large investment company formed for the purpose of specializing in secu- rities of enterprises in the oil industry. The public was offered 3,250,000 shares of capital stock at $34 per share. The company received therefore a net amount of $31 per share, or $100,750,000 in cash. It issued to unnamed recipients—presumably promoters, |
ANCING
AND MANAGEMENT
LET US CONSIDER IN MORE DETAIL the organization and financing of Petro- leum Corporation of America, mentioned in the last chapter. This was a large investment company formed for the purpose of specializing in secu- rities of enterprises in the oil industry. The public was offered 3,250,000 shares of capital stock at $34 per share. The company received therefore a net amount of $31 per share, or $100,750,000 in cash. It issued to unnamed recipients—presumably promoters, investment bankers and the management—warrants, good for five years, to buy 1,625,000 shares of additional stock, also at $34 per share.
This example is representative of the investment trust financing of the period. Moreover, as we shall see, the technique on this score that devel- oped in boom years was carried over through the ensuing depression, and it threatened to be accepted as the standard practice for stock financing of all kinds of enterprises. But there is good reason to ask the real meaning of a set-up of this kind, first, with respect to what the buyer of the stock gets for his money, and second, with respect to the position occupied by the investment banking houses floating these issues.
Cost of Management; Three Items. A new investment trust—such as Petroleum Corporation in January 1929—starts with two assets: cash and management. Buyers of the stock at $34 per share were asked to pay for the management in three ways, viz.:
1. By the difference between what the stock cost them and the amount received by the corporation.
It is true that this difference of $3 per share was paid not to the man- agement but to those underwriting and selling the shares. But from the standpoint of the stock buyer the only justification for paying more for
[633]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
the stock than the initial cash behind it would lie in his belief that the management was worth the difference |
st them and the amount received by the corporation.
It is true that this difference of $3 per share was paid not to the man- agement but to those underwriting and selling the shares. But from the standpoint of the stock buyer the only justification for paying more for
[633]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
the stock than the initial cash behind it would lie in his belief that the management was worth the difference.
2. By the value of the option warrants issued to the organizing interests. These warrants in essence entitled the owners to receive one-third of whatever appreciation might take place in the value of the enterprise over the next five years. (From the 1929 view-point a five-year period gave ample opportunity to participate in the future success of the business.)
This block of warrants had a real value, and that value in turn was taken out of the initial value of the common stock.
The price relationships usually obtaining between stock and warrants suggest that the 1,625,000 warrants would take about one-sixth of the value away from the common stock. On this basis, one-sixth of the
$100,750,000 cash originally received by the company would be applica- ble to the warrants, and five-sixths to the stock.
3. By the salaries that the officers were to receive, and also by the extra taxes incurred through the use of the corporate form.
Summarizing the foregoing analysis, we find that buyers of Petroleum Corporation shares were paying the following price for the managerial skill to be applied to the investment of their money:
1. Cost of financing ($3 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,750,000
2. Value of warrants (1/6th of remaining cash) about 16,790,000
3. Future deductions for managerial salaries, etc ?
Total $26,540,000+
The three items together may be said to absorb between 25 and 30% of the amount contributed by the public to the enterprise. |
f Petroleum Corporation shares were paying the following price for the managerial skill to be applied to the investment of their money:
1. Cost of financing ($3 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,750,000
2. Value of warrants (1/6th of remaining cash) about 16,790,000
3. Future deductions for managerial salaries, etc ?
Total $26,540,000+
The three items together may be said to absorb between 25 and 30% of the amount contributed by the public to the enterprise. By this we mean not merely a deduction of that percentage of future profits but an actual sacrifice of invested principal in return for management.
What Was Received for the Price Paid? Carrying the study a step far- ther, let us ask what kind of managerial skill this enterprise was to enjoy? The board of directors consisted of many men prominent in finance, and their judgment on investments was considered well worth having. But two serious limitations on the value of this judgment must here be noted. The first is that the directors were not obligated to devote themselves exclusively or even preponderantly to this enterprise. They were permit- ted, and seemingly intended, to multiply these activities indefinitely. Common sense would suggest that the value of their expert judgment to
Petroleum Corporation would be greatly diminished by the fact that so many other claims were being made upon it at the same time.
A more obvious limitation appears from the Corporation’s projected activities. It proposed to devote itself to investments in a single field— petroleum. The scope for judgment and analysis was thereby greatly cir- cumscribed. As it turned out, the funds were largely concentrated, first in two related companies—Prairie Pipe Line Company and Prairie Oil and Gas Company—and then in a single successor enterprise (Consolidated Oil Corporation). Thus Petroleum Corporation took on the complexion of a holding company, in which the exercise of managerial skill appears to be r |
ties. It proposed to devote itself to investments in a single field— petroleum. The scope for judgment and analysis was thereby greatly cir- cumscribed. As it turned out, the funds were largely concentrated, first in two related companies—Prairie Pipe Line Company and Prairie Oil and Gas Company—and then in a single successor enterprise (Consolidated Oil Corporation). Thus Petroleum Corporation took on the complexion of a holding company, in which the exercise of managerial skill appears to be reduced to a minimum once the original acquisitions are made.1
We are forced to conclude that financial schemes of the kind illus- trated by Petroleum Corporation of America are unsatisfactory from the standpoint of the stock buyer. This is true not only because the total cost to him for management is excessive in relation to the value of the serv- ices rendered but also because the cost is not clearly disclosed, being con- cealed in good measure by the use of the warrant artifice.2 (The foregoing reasoning does not rest in any way upon the fact that Petroleum Corpo- ration’s investments proved unprofitable.3)
Position of Investment Banking Firms in This Connection. The second line of inquiry suggested by this example is also of major impor- tance. What is the position occupied by the investment banking firms floating an issue such as Petroleum Corporation of America, and how
1 The same logical objection to the payment of a large “managerial bonus,” in the form of option warrants to those organizing a holding company, may be urged against the set-up of Alleghany Corporation and United Corporation.
2 In a series of “Notes” on the history of United Corporation financing by Sanford L. Schamus, in Columbia Law Review of May, June and November, 1937, the proposal was advanced that prospectuses issued under S.E.C. legislation should carry a tabulation show- ing the effect of the exercise of warrants on earnings and asset values. See November 1937 issue, pp. 1173–1174.
3 A review of |
ose organizing a holding company, may be urged against the set-up of Alleghany Corporation and United Corporation.
2 In a series of “Notes” on the history of United Corporation financing by Sanford L. Schamus, in Columbia Law Review of May, June and November, 1937, the proposal was advanced that prospectuses issued under S.E.C. legislation should carry a tabulation show- ing the effect of the exercise of warrants on earnings and asset values. See November 1937 issue, pp. 1173–1174.
3 A review of the operations of Petroleum Corporation, published by the S.E.C. in May 1939, criticizes severely a number of deals in which the management was interested on the other side. After 1933 a unique turn was given to the status of Petroleum Corporation through acquisition of a large interest (39.8%) therein by Consolidated Oil. The two companies thus became the largest stockholders of each other, an extraordinary and highly objectionable situation. See Part 3, Chap. II (2d sec.), of the Report of the S.E.C. on Investment Trusts and Investment Companies.
does this compare with the practice of former years? Prior to the late 1920’s, the sale of stock to the public by reputable houses of issue was governed by the following three important principles:
1. The enterprise must be well established and offer a record and finan- cial exhibit adequate to justify the purchase of the shares at the issue price.
2. The investment banker must act primarily as the representative of the buyers of the stock, and he must deal at arm’s-length with the com- pany’s management. His duty includes protecting his clients against the payment of excessive compensation to the officers or any other policies inimical to the stockholders’ interest.
3. The compensation taken by the investment banker must be reason- able. It represents a fee paid by the corporation for the service of raising capital.
These rules of conduct afforded a clear line of demarcation between responsible and disreputable stock financing. |
k, and he must deal at arm’s-length with the com- pany’s management. His duty includes protecting his clients against the payment of excessive compensation to the officers or any other policies inimical to the stockholders’ interest.
3. The compensation taken by the investment banker must be reason- able. It represents a fee paid by the corporation for the service of raising capital.
These rules of conduct afforded a clear line of demarcation between responsible and disreputable stock financing. It was an established Wall Street maxim that capital for a new enterprise must be raised from pri- vate sources.4 These private interests would be in a position to make their own investigation, work out their own deal and keep in close touch with the enterprise, all of which safeguards (in addition to the chance to make a large profit) were considered necessary to justify a commitment in any new venture. Hence the public sale of securities in a new enterprise was confined almost exclusively to “blue sky” promoters and small houses of questionable standing. The great majority of such flotations were either downright swindles or closely equivalent thereto by reason of the uncon- scionable financing charges taken out of the price paid by the public.
Investment-trust financing, by its very nature, was compelled to con- travene these three established criteria of reputable stock flotations. The investment trusts were new enterprises; their management and their bankers were generally identical; the compensation for financing and man- agement had to be determined solely by the recipients, without accepted standards of reasonableness to control them. In the absence of such stan- dards, and in the absence also of the invaluable arm’s-length bargaining
4 An apparent exception might be made sometimes in a case such as Chile Copper Company where the demonstrated presence of huge bodies of ore was regarded as justifying public financing to bring the mine into production. The sale of sto |
cal; the compensation for financing and man- agement had to be determined solely by the recipients, without accepted standards of reasonableness to control them. In the absence of such stan- dards, and in the absence also of the invaluable arm’s-length bargaining
4 An apparent exception might be made sometimes in a case such as Chile Copper Company where the demonstrated presence of huge bodies of ore was regarded as justifying public financing to bring the mine into production. The sale of stock of the Lincoln Motor Company in 1920 was one of the few real exceptions to the rule as here stated. In this instance an unusu- ally high personal reputation was behind the enterprise, but it resulted in disastrous failure.
between corporation and banker, it was scarcely to be hoped that the inter- ests of the security buyer would be adequately protected. Allowance must be made besides for the generally distorted and egotistical views prevalent in the financial world during 1928 and 1929.
Developments since 1929. For a time it appeared that the demoraliz- ing influence of investment-trust financing was likely to spread to the entire field of common-stock flotations and that even the leading bank- ing houses were prepared to sell shares of new or virtually new commer- cial enterprises, without past records and on the basis entirely of their expected future earnings. (There were definite signs of this tendency in the beer-and liquor-stock flotations of 1933.) Fortunately, a reversal of sentiment has since taken place, and we find that the relatively few com- mon-stock issues sponsored by the first-line houses are now similar in character and arrangements to those of former days.5
However, there has been a fair amount of activity in the common-stock flotation field since 1933, carried on by houses of secondary size or stand- ing. Most of these issues represent shares of new enterprises, which in turn tend to fall in whatever industrial group is easiest to exploit at the time |
of sentiment has since taken place, and we find that the relatively few com- mon-stock issues sponsored by the first-line houses are now similar in character and arrangements to those of former days.5
However, there has been a fair amount of activity in the common-stock flotation field since 1933, carried on by houses of secondary size or stand- ing. Most of these issues represent shares of new enterprises, which in turn tend to fall in whatever industrial group is easiest to exploit at the time. Thus in 1933 we had many gold-, liquor- and beer-stock flotations, and in 1938–1939 there was a deluge of airplane issues. The formation of new investment companies, on the other hand, appears to be a perennial indus- try. In surveying such common-stock flotations, the starting point must be the realization that the investment banker behind them is not acting primarily in behalf of his clients who buy the issue. For on the one side the new corporation is not an independent entity, which can negotiate at arm’s-length with various bankers representing clients with money to invest, and on the other side, the banker is himself in part a promoter, in part a proprietor of the new business. In an important sense, he is raising funds from the public for himself.
New Role of Such Investment Bankers. More exactly stated, the investment banker who floats such issues is operating in a double guise. He makes a deal on his own behalf with the originators of the enterprise, and then he makes a separate deal with the public to raise from them the funds he has promised the business. He demands—and no doubt is
5 See, for example, the offerings of New Idea Company common in 1937, General Shoe Company common in 1938, Julius Garfinckel and Company in 1939.
entitled to—a liberal reward for his pains. But the very size of his com- pensation introduces a significant change in his relationship to the pub- lic. For it makes a very real difference whether a stock buyer can consider the investment |
rate deal with the public to raise from them the funds he has promised the business. He demands—and no doubt is
5 See, for example, the offerings of New Idea Company common in 1937, General Shoe Company common in 1938, Julius Garfinckel and Company in 1939.
entitled to—a liberal reward for his pains. But the very size of his com- pensation introduces a significant change in his relationship to the pub- lic. For it makes a very real difference whether a stock buyer can consider the investment banker as essentially his agent and representative or must view the issuing house as a promoter-proprietor-manager of a business, endeavoring to raise funds to carry it on.
When investment banking becomes identified with the latter approach, the interests of the general public are certain to suffer. The Securities Act of 1933 aims to safeguard the security buyer by requiring full disclosure of the pertinent facts and by extending the previously existing liability for concealment or misrepresentation. Although full disclosure is undoubt- edly desirable, it may not be of much practical help except to the skilled and shrewd investor or to the trained analyst. It is to be feared that the typ- ical stock buyer will neither read the long prospectus carefully nor under- stand the implications of all it contains. Modern financing methods are not far different from a magician’s bag of tricks; they can be executed in full view of the public without its being very much the wiser. The use of stock options as part of the underwriter-promoter’s compensation is one of the newer and more deceptive tricks of the trade.
Two examples of new enterprise financing, in 1936 and 1939, will be discussed in some detail, with the object of illustrating both the character of these flotations and the technique of analysis required to appraise them.6 Example A: American Bantam Car Corporation, July 1936. This offer- ing consisted of 100,000 shares of 6% Cumulative Convertible Preference stock, sold to the |
options as part of the underwriter-promoter’s compensation is one of the newer and more deceptive tricks of the trade.
Two examples of new enterprise financing, in 1936 and 1939, will be discussed in some detail, with the object of illustrating both the character of these flotations and the technique of analysis required to appraise them.6 Example A: American Bantam Car Corporation, July 1936. This offer- ing consisted of 100,000 shares of 6% Cumulative Convertible Preference stock, sold to the public at $10 per share, its par value. Each share was convertible into 3 shares of common stock. The “underwriters” received a gross commission of $2 per share, or 20% of the selling price; however, this compensation was for selling effort only, without any guarantee to
take or place the shares.
The new company had acquired the plant of the American Austin Car Company, which had started out in 1929 with $3,692,000 in cash capital and had ended in bankruptcy. The organizers of the Bantam
6 In the 1934 edition we analyzed, at this point, the offering of stock in Mouquin, Inc. (liquor importers) made in September 1933 at $6.75 per share. The facts showed that the public was asked to place a valuation of $1,670,000 on an enterprise with physical assets of $424,000 and no earnings record. The company passed out of existence in 1937, and the public’s investment was wiped out.
enterprise bought in the Austin assets, subject to various liabilities, for only $5,000. They then turned over their purchase, plus $500 in cash, to the new company for 300,000 shares of its common stock. In other words, the entire common issue cost the promoters $5,500 cash plus their time and effort.
The prospectus stated—what was an obvious fact—that the preference stock was “offered as a speculation.” That speculation could work out suc- cessfully only if the conversion privilege proved valuable, since the mere 6% return on a preferred stock was scarcely an adequate reward for the risk involved. (The |
heir purchase, plus $500 in cash, to the new company for 300,000 shares of its common stock. In other words, the entire common issue cost the promoters $5,500 cash plus their time and effort.
The prospectus stated—what was an obvious fact—that the preference stock was “offered as a speculation.” That speculation could work out suc- cessfully only if the conversion privilege proved valuable, since the mere 6% return on a preferred stock was scarcely an adequate reward for the risk involved. (The character of the risk was shown clearly enough in the enormous losses of the predecessor company.) But note that before the conversion privilege could be worth anything, the common stock would have to sell for more than $31/3 per share—and in that case the
$5,500 investment of the organizers would be worth over $1,000,000. In other words, before the public could make any profit, the organizers would have to multiply their stake 180 times.
Sequel. By June 30, 1939, the company had accumulated a deficit of
$750,000; it was compelled to borrow money from the R.F.C., and the pre- ferred-stock holder no longer had any equity in current assets. The price of the preference stock declined to 3, but at the same time the common was quoted at 3/4 bid. This meant (if the quoted price could be trusted) that, although the public had lost 70% of its investment, the organizers’
$5,500 contribution had still a nominal market value of $225,000.
Example B: Aeronautical Corporation of America, December 1939. This company offered to the public 60,000 shares of new common stock at $6.25 per share. The “underwriters,” who made no firm commitment to take any shares, received on the sale of each share the following three kinds of compensation: (1) 90 cents in cash; (2) 1/20 of a share of stock, ostensibly worth 31 cents, donated by the principal stockholders; (3) a warrant to buy 1/2 share of stock at prices varying between $6.25 and $8.00 per share. If the common stock was fairly worth the $6.25 off |
39. This company offered to the public 60,000 shares of new common stock at $6.25 per share. The “underwriters,” who made no firm commitment to take any shares, received on the sale of each share the following three kinds of compensation: (1) 90 cents in cash; (2) 1/20 of a share of stock, ostensibly worth 31 cents, donated by the principal stockholders; (3) a warrant to buy 1/2 share of stock at prices varying between $6.25 and $8.00 per share. If the common stock was fairly worth the $6.25 offering price, these warrants were undoubtedly worth at least $1 per share called for. This would mean an aggregate commission for selling effort of $2.34 per share, or more than one-third the amount paid over by the public.
The company had been in business since 1928 and had been manu- facturing its light Aeronca planes since 1931. Its business had grown steadily from $124,000 sales in 1934 to about $850,000 sales in 1939.
However, the enterprise had been definitely unprofitable to the end of 1938, showing an aggregate deficit at that time of over $500,000 (includ- ing development expense written off). In 91/2 months to October 15, 1939, it had earned $50,000. Prior to this offering of new shares to the public there were outstanding 66,000 shares of stock, which had a net asset value of only $1.28 per share. In addition to the warrants for 30,000 shares to be given the underwriters, there were like warrants for 15,000 shares in the hands of the officers.
There seemed strong reason to believe that the company occupied a favorable position in a growing industry. But analysis would show that the participation of the public in any future increase in earnings was seri- ously diluted in three different ways: by the cash selling expense sub- tracted from the price to be paid for the new stock, by the small tangible assets contributed by the original owners for their stock interest and by the warrants which would siphon off part of any increased value. To show the effect of this dil |
believe that the company occupied a favorable position in a growing industry. But analysis would show that the participation of the public in any future increase in earnings was seri- ously diluted in three different ways: by the cash selling expense sub- tracted from the price to be paid for the new stock, by the small tangible assets contributed by the original owners for their stock interest and by the warrants which would siphon off part of any increased value. To show the effect of this dilution, let us assume that the company proves so suc- cessful that its fair value is twice its tangible assets after completion of this financing—say, about $1,000,000 as compared with $484,000 of tangible assets. What could then be the value of the stock for which the public paid
$6.25? If there were no warrants outstanding, this value would be about
$8 per share on 126,000 shares. But allowing for a value of say $2.00 per share for the warrants, the stock itself would be worth only $7.25 per share. Hence even a very substantial degree of success on the part of this enterprise would add a mere 16% to the value of the public’s purchase. Should things go the other way, a very large part of the investment would soon be dissipated.
Should the Public Finance New Ventures? Fairly complete obser- vation of new-enterprise financing registered with the S.E.C. since 1933 has given us a pessimistic opinion as to its soundness and its economic value to the nation. The venturing of capital into new businesses is essen- tial to American progress, but no substantial contribution to the upbuild- ing of the country has ever been made by new ventures publicly financed. Wall Street has always realized that the capital for such undertakings should properly be supplied on a private and personal basis—by the organizers themselves or people close to them. Hence the sale of shares in new businesses has never been a truly reputable pursuit, and the lead- ing banking houses will not engage in it. The |
businesses is essen- tial to American progress, but no substantial contribution to the upbuild- ing of the country has ever been made by new ventures publicly financed. Wall Street has always realized that the capital for such undertakings should properly be supplied on a private and personal basis—by the organizers themselves or people close to them. Hence the sale of shares in new businesses has never been a truly reputable pursuit, and the lead- ing banking houses will not engage in it. The less fastidious channels
through which such financing is done exact so high an over-all selling cost—to the public—that the chance of success of the new enterprise, small enough at best, is thereby greatly diminished.
It is our considered view that the nation’s interest would be served by amending the Securities Act so as to prohibit the public offering of secu- rities of new and definitely unseasoned ventures. It would not be easy to define precisely the criteria of “seasoning,”—e.g., size, number of years’ operation without loss—and it may be necessary to vest some discretion on this score with the S.E.C. We think, however, that borderline and dif- ficult cases will be relatively few in number (although our second exam- ple above belongs, perhaps, in this category). We should be glad to see the powers and duties of the S.E.C. diminished in many details of minor significance; but on this point of protecting a public incapable of protect- ing itself, our view leans strongly towards more drastic legislation.
Blue-sky Promotions. In the “good old days” fraudulent stock pro- moters relied so largely upon high pressure salesmanship that they rarely bothered to give their proposition any semblance of serious merit. They could sell shares in a mine that was not even a “hole in the ground” or in an invention the chief recommendation for which was the enormous profit made by Henry Ford’s early partners. The victim was in fact buy- ing “blue sky” and nothing else. Any one with the s |
ore drastic legislation.
Blue-sky Promotions. In the “good old days” fraudulent stock pro- moters relied so largely upon high pressure salesmanship that they rarely bothered to give their proposition any semblance of serious merit. They could sell shares in a mine that was not even a “hole in the ground” or in an invention the chief recommendation for which was the enormous profit made by Henry Ford’s early partners. The victim was in fact buy- ing “blue sky” and nothing else. Any one with the slightest business sense could have detected the complete worthlessness of these ventures almost at a glance; in fact, the glossy paper used for the prospectus was in itself sufficient to identify the proposition as fraudulent.
The tightening of federal and state regulations against these swindles has led to a different type of security promotion. Instead of offering some- thing entirely worthless, the promoter selects a real enterprise that he can sell at much more than its fair value. By this means the law can be obeyed and the public exploited just the same. Oil and mining ventures lend them- selves best to such stock flotations, because it is easy to instill in the unini- tiated an exaggerated notion of their true worth. The S.E.C. has been concerning itself more and more seriously with endeavors to defeat this type of semifraud. In theory a promoter may offer something worth $1 per share at $5, provided he discloses all the facts and adds no false represen- tations. The Commission is not authorized to pass upon the soundness of new securities or the fairness of their price (except in the case of public- utility issues which come under the terms of the Public Utility Holding
Company Act of 1935). Actually, it appears to be doing its best, by various pressures, to discourage and even prevent the more grossly inequitable offerings. But it is essential that the public recognize that the Commission’s powers in this respect are severely limited and that only a sceptical analy |
is not authorized to pass upon the soundness of new securities or the fairness of their price (except in the case of public- utility issues which come under the terms of the Public Utility Holding
Company Act of 1935). Actually, it appears to be doing its best, by various pressures, to discourage and even prevent the more grossly inequitable offerings. But it is essential that the public recognize that the Commission’s powers in this respect are severely limited and that only a sceptical analy- sis by the intending buyer can assure him against exploitation.
Promotional activities are attracted especially to any new industry that is in the public eye. Profits made by those first in the field, or even cur- rently by the enterprise floated, can be given a fictitious guise of perma- nence and of future enhancement. Hence gross overvaluations can be made plausible enough to sell. In the liquor flotations of 1933 the degree of overvaluation depended entirely upon the conscience of the sponsors. Accordingly, the list of stock offerings showed all gradations from the thoroughly legitimate down to the almost completely fraudulent.7 A somewhat similar picture is presented by the aircraft flotations of 1938–1939. The public would do well to remember that whenever it becomes easy to raise capital for a particular industry, both the chances of unfair deals are magnified and the danger of overdevelopment of the industry itself becomes very real.
Repercussions of Unsound Investment Banking. The relaxation of investment bankers’ standards in the late 1920’s, and their use of ingen- ious means to enlarge their compensation, had unwholesome repercus- sions in the field of corporate management. Operating officials felt themselves entitled not only to handsome salaries but also to a substan- tial participation in the profits of the enterprise. In this respect the invest- ment-trust arrangements, devised by the banking houses for their own benefit, set a stimulating example to the wor |
g. The relaxation of investment bankers’ standards in the late 1920’s, and their use of ingen- ious means to enlarge their compensation, had unwholesome repercus- sions in the field of corporate management. Operating officials felt themselves entitled not only to handsome salaries but also to a substan- tial participation in the profits of the enterprise. In this respect the invest- ment-trust arrangements, devised by the banking houses for their own benefit, set a stimulating example to the world of “big business.”
Whether or not it is proper for executives of a large and prosperous concern to receive annual compensation running into hundreds of thou- sands or even millions of dollars is perhaps an open question. Its answer will depend upon the extent to which the corporation’s success is due to their unique or surpassing ability, and this must be very difficult to deter- mine with assurance. But it may not be denied that devious and question- able means were frequently employed to secure these large bonuses to the management without full disclosure of their extent to the stockholders.
7 See Appendix Note 55, p. 792 on accompanying CD, relative to investors’ experience with brewery-stock flotations of 1933.
Stock-option warrants (or long-term subscription rights) to buy shares at low prices, proved an excellent instrument for this purpose—as we have already pointed out in our discussion of stockholder-management rela- tionships. In this field complete and continued publicity is not only the- oretically desirable but of practical utility as well. The legislation of 1933–1934 marks an undeniable forward step in this regard, since the major facts of managerial compensation must now be disclosed in regis- tration statements and in annual supplements thereto (Form 10-K). With publicity given to this compensation, we believe that the self-interest of stockholders may be relied on fairly well to prevent it from passing all reasonable limits.
Chapter 48
SOME ASPECTS O |
ity is not only the- oretically desirable but of practical utility as well. The legislation of 1933–1934 marks an undeniable forward step in this regard, since the major facts of managerial compensation must now be disclosed in regis- tration statements and in annual supplements thereto (Form 10-K). With publicity given to this compensation, we believe that the self-interest of stockholders may be relied on fairly well to prevent it from passing all reasonable limits.
Chapter 48
SOME ASPECTS OF
CORPORATE PYRAMIDING
PYRAMIDING IN CORPORATE finance is the creation of a speculative capital structure by means of a holding company or a series of holding compa- nies. Usually the predominating purpose of such an arrangement is to enable the organizers to control a large business with the investment of little or no capital and also to secure to themselves the major part of its surplus profits and increased going-concern value. The device is most often utilized by dominant interests to “cash in” speculative profits on their holdings and at the same time to retain control. With the funds so provided, these successful captains of finance generally endeavor to extend their control over additional operating enterprises. The technique of pyramiding is well illustrated by the successive maneuvers of O. P. and
M. J. Van Sweringen, which started with purchase of control of the then relatively unimportant New York, Chicago, and St. Louis Railroad and rapidly developed into a far-flung railroad “empire.”1
Example: The Van Sweringen Pyramid. The original transaction of the Van Sweringens in the railroad field took place in 1916. It consisted of the
1 The complete story of how this pyramiding was effected is told in the Hearings before the Committee on Banking and Currency, United States Senate, 73d Congress, 1st Session, on Senate Resolution 84 of the 72d Congress and Senate Resolution 56 of the 73d Congress, Part 2, pp. 563–777, June 5 to 8, 1933—on “Stock Exchange Practices.” |
ilroad “empire.”1
Example: The Van Sweringen Pyramid. The original transaction of the Van Sweringens in the railroad field took place in 1916. It consisted of the
1 The complete story of how this pyramiding was effected is told in the Hearings before the Committee on Banking and Currency, United States Senate, 73d Congress, 1st Session, on Senate Resolution 84 of the 72d Congress and Senate Resolution 56 of the 73d Congress, Part 2, pp. 563–777, June 5 to 8, 1933—on “Stock Exchange Practices.” The story is also set forth in greater detail and with graphic portrayal in Regulation of Stock Ownership in Rail- roads, Part 2, pp. 820–1173 (House Report No. 2789, 71st Congress, 3d Session), especially the inserts at p. 878 thereof. For graphic and other presentation of the effects of pyramiding in the public-utility field see Utility Corporations (Sen. Doc. 92, 70th Congress, 1st Session, pt. 72-A), pp. 154–166.
The most notorious pyramided structure of recent years was the Insull set-up. An inter- esting example of a different type is presented by the United States and Foreign Securities Corporation—United States and International Securities Corporation relationship. These two situations are briefly described in Note 64 at p. 817 of the Appendix on accompanying CD.
[644]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
purchase from the New York Central Railroad Company, for the sum of
$8,500,000, of common and preferred stock constituting control of the New York, Chicago, and St. Louis Railroad Company (known as the “Nickel Plate”). This purchase was financed by giving a note to the seller for
$6,500,000 and by a cash payment of $2,000,000, which in turn was bor- rowed from a Cleveland bank. Subsequent acquisitions of control of many other companies were effected by various means, including the following:
1. The formation of a private corporation for the purpose (e.g., West- ern Corporation to acquire cont |
rred stock constituting control of the New York, Chicago, and St. Louis Railroad Company (known as the “Nickel Plate”). This purchase was financed by giving a note to the seller for
$6,500,000 and by a cash payment of $2,000,000, which in turn was bor- rowed from a Cleveland bank. Subsequent acquisitions of control of many other companies were effected by various means, including the following:
1. The formation of a private corporation for the purpose (e.g., West- ern Corporation to acquire control of Lake Erie and Western Railroad Company, and Clover Leaf Corporation to acquire control of Toledo, St. Louis and Western Railroad Company—both in 1922).
2. The use of the resources of one controlled railroad to acquire con- trol of others (e.g., the New York, Chicago and St. Louis Railroad Com- pany purchased large amounts of stock of Chesapeake and Ohio Railway and Pere Marquette Railway Company during 1923–1925).
3. The formation of a holding company to control an individual road, with sale of the holding company’s securities to the public (e.g., Chesapeake Corporation, which took over control of Chesapeake and Ohio Railway Company and sold its own bonds and stock to the public, in 1927).
4. Formation of a general holding company (e.g., Alleghany Corpora- tion, chartered in 1929. This ambitious project took over control of many railroad, coal, and miscellaneous enterprises).
The report on the “Van Sweringen Holding Companies” made to the House of Representatives in 19302 includes an interesting chart showing the contrast between the control exercised by the Van Sweringens and their relatively small equity or financial interest in the capital of the enter- prises controlled. On page 646 we append a summary of these data. The figures in Column A show the percentage of voting securities held or con- trolled by the Van Sweringens; the figures in Column B show the propor- tion of the “contributed capital” (bonds, stock, and surplus) actually owned directly or indirectly by |
es an interesting chart showing the contrast between the control exercised by the Van Sweringens and their relatively small equity or financial interest in the capital of the enter- prises controlled. On page 646 we append a summary of these data. The figures in Column A show the percentage of voting securities held or con- trolled by the Van Sweringens; the figures in Column B show the propor- tion of the “contributed capital” (bonds, stock, and surplus) actually owned directly or indirectly by them.
It is worth recalling that similar use of the holding company for pyra- miding control of railroad properties had been made before the war— notably in the case of the Rock Island Company. This enterprise was organized in 1902. Through an intermediate subsidiary it acquired nearly
2 House Report 2789, 71st Congress, 3d Session, Part 2, pp. 820–1173.
all the common stock of the Chicago, Rock Island and Pacific Railway Company and about 60% of the capital stock of the St. Louis and San Francisco Railway Company. Against these shares the two holding com- panies issued large amounts of collateral trust bonds, preferred stock and common stock. In 1909 the stock of the St. Louis and San Francisco was sold. In 1915 the Rock Island Company and its intermediate subsidiary both went into bankruptcy; the stock of the operating company was taken over by the collateral trust bondholders; and the holding company stock issues were wiped out completely.
Companies A. Control, % B. Equity, %
Holding companies:
The Vaness Co. 80.0 27.7
General Securities Corp. 90.0 51.8
Geneva Corp. 100.0 27.7
Alleghany Corp. 41.8 8.6
The Chesapeake Corp. 71.0 4.1
The Pere Marquette Corp. 100.0 0.7
Virginia Transportation Corp. 100.0 0.8
The Pittston Co. 81.8 4.3
Railroad Companies:
The New York, Chicago and St. Louis R.R. Co. 49.6 0.7
The Chesapeake and Ohio Railway Co. 54.4 1.0
Pere Marquette Railway Co. 48.3 0.6
Erie Railroad Co. 30.8 0.6
Missouri Pacific Railroad Co. 50.5 1.7
The Hocking Valle |
olding companies:
The Vaness Co. 80.0 27.7
General Securities Corp. 90.0 51.8
Geneva Corp. 100.0 27.7
Alleghany Corp. 41.8 8.6
The Chesapeake Corp. 71.0 4.1
The Pere Marquette Corp. 100.0 0.7
Virginia Transportation Corp. 100.0 0.8
The Pittston Co. 81.8 4.3
Railroad Companies:
The New York, Chicago and St. Louis R.R. Co. 49.6 0.7
The Chesapeake and Ohio Railway Co. 54.4 1.0
Pere Marquette Railway Co. 48.3 0.6
Erie Railroad Co. 30.8 0.6
Missouri Pacific Railroad Co. 50.5 1.7
The Hocking Valley Railway Co. 81.0 0.2
The Wheeling and Lake Erie Railway Co. 53.3 0.3
Kansas City Southern Railway Co. 20.8 0.9
The ignominious collapse of this venture was accepted at the time as marking the end of “high finance” in the railroad field. Yet some ten years later the same unsound practices were introduced once again, but on a larger scale and with correspondingly severer losses to investors. It remains to add that the Congressional investigation of railroad hold- ing companies instituted in 1930 had its counterpart in a similar inquiry into the finances of the Rock Island Company made by the Interstate
Commerce Commission in 1914. The memory of the financial commu- nity is proverbially and distressingly short.
Evils of Corporate Pyramiding. The pyramiding device is harmful to the security-buying public from several standpoints. It results in the creation and sale to investors of large amounts of unsound senior secu- rities. It produces common stocks of holding companies which are sub- ject to deceptively rapid increases in earning power in favorable years and which are invariably made the vehicle of wild and disastrous public spec- ulation. The possession of control by those who have no real capital investment (or a relatively minor one) is inequitable3 and makes for irre- sponsible and unsound managerial policies. Finally the holding company device permits of financial practices that exaggerate the indicated earn- ings, dividend return, or “book value,” during boom times, |
- ject to deceptively rapid increases in earning power in favorable years and which are invariably made the vehicle of wild and disastrous public spec- ulation. The possession of control by those who have no real capital investment (or a relatively minor one) is inequitable3 and makes for irre- sponsible and unsound managerial policies. Finally the holding company device permits of financial practices that exaggerate the indicated earn- ings, dividend return, or “book value,” during boom times, and thus intensify speculative fervor and facilitate market manipulation. Of these four objections to corporate pyramiding, the first three are plainly evi- dent, but the last one requires a certain amount of analytical treatment in order to present its various implications.
Overstatement of Earnings. Holding companies can overstate their apparent earning power by valuing at an unduly high price the stock div- idends they receive from subsidiaries or by including in their income profits made from the sale of stock of subsidiary companies.
Examples: The chief asset of Central States Electric Corporation was a large block of North American Company common on which regular stock dividends were paid. Prior to the end of 1929, these stock dividends were reported as income by Central States at the market value then cur- rent. As explained in our chapter on stock dividends, such market prices averaged far in excess of the value at which North American charged the stock dividends against its surplus and also far in excess of the distrib- utable earnings on North American common. Hence the income account of Central States Electric gave a misleading impression of the earnings accruing to the company.
A transaction of somewhat different character but of similar effect to the foregoing was disclosed by the report of American Founders Trust for 1927. In November 1927 American Founders offered its shareholders the privi- lege of buying about 88,400 shares of International Securities Corpora |
rplus and also far in excess of the distrib- utable earnings on North American common. Hence the income account of Central States Electric gave a misleading impression of the earnings accruing to the company.
A transaction of somewhat different character but of similar effect to the foregoing was disclosed by the report of American Founders Trust for 1927. In November 1927 American Founders offered its shareholders the privi- lege of buying about 88,400 shares of International Securities Corporation
3 See Appendix Note 65, p. 820 on accompanying CD, for examples on this point.
of America Class B Common at $16 per share. International Securities Cor- poration was a subsidiary of American Founders, and the latter had acquired the Class B stock of the former at a cash cost of $3.70 per share in 1926. American Founders reported net earnings for common stock in 1927 amounting to $1,316,488, most of which was created by its own stockhold- ers through their purchase of shares of the subsidiary as indicated above.4
Distortion of Dividend Return. Just as a holding company’s income may be exaggerated by reason of stock dividends received, so the div- idend return on its shares may be distorted in the public’s mind by pay- ment of periodic stock dividends with a market value exceeding current earnings. People are readily persuaded also to regard the value of frequent subscription rights as equivalent to an income return on the common stock. Pyramided enterprises are prodigal with subscrip- tion rights, for they flow naturally from the succession of new acqui- sitions and new financing which both promote the ambitions of those in control and maintain speculative interest at fever heat—until the inevitable collapse.
The issuance of subscription rights sometimes gives the stock market an opportunity to indulge in that peculiar circular reasoning which is the joy of the manipulator and the despair of the analyst. Company A’s stock is apparently worth no more than 25. Speculatio |
scrip- tion rights, for they flow naturally from the succession of new acqui- sitions and new financing which both promote the ambitions of those in control and maintain speculative interest at fever heat—until the inevitable collapse.
The issuance of subscription rights sometimes gives the stock market an opportunity to indulge in that peculiar circular reasoning which is the joy of the manipulator and the despair of the analyst. Company A’s stock is apparently worth no more than 25. Speculation or pool activity has advanced it to 75. Rights are offered to buy additional shares at 25, and the rights have a market value of, say, $10 each. To the speculative frater- nity these rights are practically equivalent to a special dividend of $10. It is a bonus that not only justifies the rise to 75 but warrants more opti- mism and a still higher price. To the analyst the whole proceeding is a delusion and a snare. Whatever value the rights command is manufac- tured solely out of speculators’ misguided enthusiasm, yet this chimeri- cal value is accepted as tangible income and as vindication of the enthusiasm that gave it birth. Thus, with the encouragement of the manipulator, the speculative public pulls itself up by its bootstraps to dizzier heights of irrationality.
4 In the three years 1928–1930 the American Founders group reported total net investment profits of about $43,300,000; but all of this sum and more was derived from profits on inter- company transactions of the kind described above. See the S.E.C.’s Over-all Report on Investment Trusts, Part III, Chapter VI, Sections II and III, released February 12, 1940.
Example: Between August 1928 and February 1929 American and Foreign Power Company common stock advanced from 33 to 1387/8, although paying no dividend. Rights were offered to the common stock- holders (and other security holders) to buy second preferred stock with detached stock-purchase warrants. The offering of these rights, which had an initial market v |
cribed above. See the S.E.C.’s Over-all Report on Investment Trusts, Part III, Chapter VI, Sections II and III, released February 12, 1940.
Example: Between August 1928 and February 1929 American and Foreign Power Company common stock advanced from 33 to 1387/8, although paying no dividend. Rights were offered to the common stock- holders (and other security holders) to buy second preferred stock with detached stock-purchase warrants. The offering of these rights, which had an initial market value of about $3 each, was construed by many as the equivalent of a dividend on the common stock.
Exaggeration of Book Value. The exaggeration of book value may be effected in cases where a holding company owns most of the shares of a subsidiary and where consequently an artificially high quotation may readily be established for the subsidiary issue by manipulating the small amount of stock remaining in the market. This high quotation is then taken as the basis of figuring the book value (sometimes called the “break-up value”) of the share of the holding company. For an early example of these practices we may point to Tobacco Products Corpo- ration (Va.) which owned about 80% of the common stock of United Cigar Stores Company of America. An unduly high market price seems to have been established in 1927 for the small amount of Cigar Stores stock available in the market, and this high price was used to make Tobacco Products shares appear attractive to the unwary buyer. The thoroughly objectionable accounting and stock dividend policies of United Cigar Stores, which we have previously discussed, were adjuncts to this manipulative campaign.
The most extraordinary example of such exaggeration of the book value is found, perhaps, in the case of Electric Bond and Share Company and was founded on its ownership of most of the American and Foreign Power Company warrants. The whole set-up seems to have been con- trived to induce the public to pay absolutely fantastic prices without the |
jectionable accounting and stock dividend policies of United Cigar Stores, which we have previously discussed, were adjuncts to this manipulative campaign.
The most extraordinary example of such exaggeration of the book value is found, perhaps, in the case of Electric Bond and Share Company and was founded on its ownership of most of the American and Foreign Power Company warrants. The whole set-up seems to have been con- trived to induce the public to pay absolutely fantastic prices without their complete absurdity being too apparent. A brief review of the various steps in this phantasmagoria of inflated values should be illuminating to the student of security analysis.
First, American and Foreign Power Company issued in all 1,600,000 shares of common and warrants to buy 7,100,000 more shares at $25. This permitted a price to be established for the common stock that generously capitalized its earnings and prospects but paid no attention to the exis- tence of the warrants. The quotation of the common was aided by the issuance of rights, as explained above.
Second, the high price registered for the relatively small common- stock issue automatically created a correspondingly high value for the millions of warrants.
Third, Electric Bond and Share could apply these high values to its large holdings of American and Foreign Power common and its enor- mous block of warrants, thus setting up a correspondingly inflated value for its own common stock.
Exploitation of the Stock-purchase-warrant Device. The result of this process, at its farthest point in 1929, was almost incredible. The earnings available for American and Foreign Power common stock had shown the following rising trend (due in good part, however, to continuous new acquisitions):
Year Earnings for common Number of shares Earned per share
1926 $216,000 1,243,988 0.17
1927 856,000 1,244,388 0.69
1928 1,528,000 1,248,930 1.22
1929 6,510,000 1,624,357 4.01
On the theory that a “good public-utility stock is worth |
se-warrant Device. The result of this process, at its farthest point in 1929, was almost incredible. The earnings available for American and Foreign Power common stock had shown the following rising trend (due in good part, however, to continuous new acquisitions):
Year Earnings for common Number of shares Earned per share
1926 $216,000 1,243,988 0.17
1927 856,000 1,244,388 0.69
1928 1,528,000 1,248,930 1.22
1929 6,510,000 1,624,357 4.01
On the theory that a “good public-utility stock is worth up to 50 times its current earnings,” a price of 1991/4 per share was recorded for Amer- ican and Foreign Power common. This produced in turn a price of 174 for the warrants. Hence, by the insane magic of Wall Street, earnings of
$6,500,000 were transmuted into a market value of $320,000,000 for the common shares and $1,240,000,000 for the warrants, a staggering total of $1,560,000,000.
Since over 80% of the warrants were owned by Electric Bond and Share Company, the effect of these absurd prices for American and Foreign Power junior securities was to establish a correspondingly absurd break- up value for Electric Bond and Share common. This break-up value was industriously exploited to justify higher and higher quotations for the lat- ter issue. In March 1929 attention was called to the fact that the market value of this company’s portfolio was equivalent to about $108 per share (of new stock), against a range of 91 to 97 for its own market quotation. The implication was that Electric Bond and Share stock was “underval- ued.” In September 1929 the price had advanced to 1841/2. It was then computed that the “break-up value” amounted to about 150, “allowing no
value for the company’s supervisory and construction business.” The pub- lic did not stop to reflect that a considerable part of this “book value” was based upon an essentially fictitious market quotation for an asset that the company had received for nothing only a few years before (as a bonus with American and Foreig |
Bond and Share stock was “underval- ued.” In September 1929 the price had advanced to 1841/2. It was then computed that the “break-up value” amounted to about 150, “allowing no
value for the company’s supervisory and construction business.” The pub- lic did not stop to reflect that a considerable part of this “book value” was based upon an essentially fictitious market quotation for an asset that the company had received for nothing only a few years before (as a bonus with American and Foreign Power Second Preferred stock).
This exploitation of the warrants had a peculiar vitality which made itself felt even in the depth of the depression in 1932–1933. Time having brought its usual revenge, the once dazzling American and Foreign Power Company had trembled on the brink of receivership, as shown by a price of only 151/4 for its 5% bonds. Nevertheless, in November 1933 the highly unsubstantial warrants still commanded an aggregate market quotation of nearly $50,000,000, a figure that bore a ridiculous relationship to the exceedingly low values placed upon the senior securities. The following table shows how absurd this situation was, the more so since it existed in a time of deflated stock prices, when relative values are presumably sub- jected to more critical appraisal.
(000 OMITTED IN MARKET VALUE)
Issue
Amount outstanding
Price Nov. 1933 Total market value, 1933 Price Dec. 31,
1938 Total market value, 1938
5% Debentures $50,000 40 $20,000 53 26,500
$7 First Preferred shares 480 21 10,100 197/8 9,300
$6 First Preferred shares 387 15 5,800 15 5,800
$7 Second Preferred shares 2,655 12 31,900 91/4 24,900
Common shares 1,850 10 18,500 31/2 6,500
Warrants shares 6,874 7 48,100 1 6,900
By the end of 1938, as the table indicates, a good part of the absurd- ity had been corrected.
Some Holding Companies Not Guilty of Excessive Pyramiding. To avoid creating a false impression, we must point out that, although pyramiding is usually effected by means of holding compan |
shares 480 21 10,100 197/8 9,300
$6 First Preferred shares 387 15 5,800 15 5,800
$7 Second Preferred shares 2,655 12 31,900 91/4 24,900
Common shares 1,850 10 18,500 31/2 6,500
Warrants shares 6,874 7 48,100 1 6,900
By the end of 1938, as the table indicates, a good part of the absurd- ity had been corrected.
Some Holding Companies Not Guilty of Excessive Pyramiding. To avoid creating a false impression, we must point out that, although pyramiding is usually effected by means of holding companies, it does not follow that all holding companies are created for this purpose and are therefore reprehensible. The holding company is often utilized for entirely legitimate purposes, e.g., to permit unified and economical operations of
separate units, to diversify investment and risk and to gain certain tech- nical advantages of flexibility and convenience. Many sound and impor- tant enterprises are in holding company form.
Examples: United States Steel Corporation is entirely a holding com- pany; although originally there was some element of pyramiding in its capital set-up, this defect disappeared in later years. American Telephone and Telegraph Company is preponderantly a holding company, but its financial structure has never been subject to serious criticism. General Motors Corporation is largely a holding company.
A holding-company exhibit must therefore be considered on its mer- its. American Light and Traction Company is a typical example of the holding company organized entirely for legitimate purposes. On the other hand the acquisition of control of this enterprise by United Light and Railways Company (Del.) must be regarded as a pyramiding move on the part of the United Light and Power interests.
Speculative Capital Structure May Be Created in Other Ways. It may be pointed out also that a speculative capital structure can be cre- ated without the use of a holding company.
Examples: The Maytag Company recapitalization, discussed in an ear- lier chapter, yielded r |
irely for legitimate purposes. On the other hand the acquisition of control of this enterprise by United Light and Railways Company (Del.) must be regarded as a pyramiding move on the part of the United Light and Power interests.
Speculative Capital Structure May Be Created in Other Ways. It may be pointed out also that a speculative capital structure can be cre- ated without the use of a holding company.
Examples: The Maytag Company recapitalization, discussed in an ear- lier chapter, yielded results usually attained by the formation of a holding company and the sale of its senior securities. In the case of Continental Baking Corporation—to cite another example—the holding company form was not an essential part of the pyramided result there attained. The spec- ulative structure was due entirely to the creation of large preferred issues by the parent company, and it would still have existed if Continental Bak- ing had acquired all its properties directly, eliminating its subsidiaries. (As it happened, in 1938 this company took steps to acquire the assets of its chief subsidiaries, thus largely eliminating the holding-company form but retaining the speculative capital structure.)
Legislative Restraints on Pyramiding. So spectacular were the dis- astrous effects of the public-utility pyramiding of the 1920’s that Congress was moved to drastic action. The Public Utility Holding Company Act of 1935 includes the so-called “death sentence” for many of the existing sys- tems, requiring them ultimately to simplify their capital structures and to dispose of subsidiaries operating in noncontiguous territory. Forma- tion of new pyramids is effectively blocked by requiring Commission
approval for all acquisitions and all new financing. Similar steps are in prospect to regulate present railroad holding companies and to prevent creation of new ones.5
We may say with some confidence that the spectacle of the Van Sweringen debacle succeeding the Rock Island Company debacle is not |
ing them ultimately to simplify their capital structures and to dispose of subsidiaries operating in noncontiguous territory. Forma- tion of new pyramids is effectively blocked by requiring Commission
approval for all acquisitions and all new financing. Similar steps are in prospect to regulate present railroad holding companies and to prevent creation of new ones.5
We may say with some confidence that the spectacle of the Van Sweringen debacle succeeding the Rock Island Company debacle is not likely to be duplicated in the future. The industrial field never offered the same romantic possibilities for high finance as were found among the rails and utilities, but it may well be that the ingenious talents of promoters and financial wizards will be directed towards the industrials in the future. The investor and the analyst should be on their guard against such new dazzlements.
5 See Senate Resolution 71 of the 74th Congress and 21 volumes of hearings thereon which have appeared to date (December 1939). See also Senate Report No. 180, 75th Congress, 1st Session, and Senate Report No. 25, pts. 1, 4 and 5, 76th Congress, 1st Session.
Chapter 49
COMPARATIVE ANALYSIS OF COMPANIES
IN THE SAME FIELD
STATISTICAL COMPARISONS of groups of concerns operating in a given industry are a more or less routine part of the analyst’s work. Such tabu- lations permit each company’s showing to be studied against a back- ground of the industry as a whole. They frequently bring to light instances of undervaluation or overvaluation or lead to the conclusion that the securities of one enterprise should be replaced by those of another in the same field.
In this chapter we shall suggest standard forms for such comparative analyses, and we shall also discuss the significance of the various items included therein. Needless to say, these forms are called “standard” only in the sense that they can be used generally to good advantage; no claim of perfection is made for |
ly bring to light instances of undervaluation or overvaluation or lead to the conclusion that the securities of one enterprise should be replaced by those of another in the same field.
In this chapter we shall suggest standard forms for such comparative analyses, and we shall also discuss the significance of the various items included therein. Needless to say, these forms are called “standard” only in the sense that they can be used generally to good advantage; no claim of perfection is made for them, and the student is free to make any changes that he thinks will serve his particular purpose.
FORM I. RAILROAD COMPARISON
A. Capitalization:
1. Fixed charges.*
2. Effective debt (fixed charges* multiplied by 22).
3. Preferred stock at market (number of shares X market price).
4. Common stock at market (number of shares X market price).
5. Total capitalization.
6. Ratio of effective debt to total capitalization.
7. Ratio of preferred stock to total capitalization.
8. Ratio of common stock to total capitalization.
B. Income Account:
9. Gross revenues.
10. Ratio of maintenance to gross.
[654]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
11. Ratio of railway operating income (net after taxes) to gross.
12. Ratio of fixed charges* to gross.
13. Ratio of preferred dividends to gross.
14. Ratio of balance for common to gross.
C. Calculations:
15. Number of times fixed charges* earned.
15. I.P.† Number of times fixed charges* plus preferred dividends earned.
16. Earned on common stock, per share.
17. Earned on common stock, % of market price.
18. Ratio of gross to aggregate market value of common stock (9 --- 4).
16. S.P.‡ Earned on preferred stock, per share.
17. S.P. Earned on preferred stock, % of market price.
18. S.P. Ratio of gross to aggregate market value of preferred stock (9 --- 3).
19. Credit or debit to earnings for undistributed profit or loss of subsidiaries (if important).
D. Seven-year aver |
d charges* plus preferred dividends earned.
16. Earned on common stock, per share.
17. Earned on common stock, % of market price.
18. Ratio of gross to aggregate market value of common stock (9 --- 4).
16. S.P.‡ Earned on preferred stock, per share.
17. S.P. Earned on preferred stock, % of market price.
18. S.P. Ratio of gross to aggregate market value of preferred stock (9 --- 3).
19. Credit or debit to earnings for undistributed profit or loss of subsidiaries (if important).
D. Seven-year average figures:
20. Earned on common stock, per share.
21. Earned on common stock, % of current market price of common.
20. S.P. Earned on preferred stock, per share.
21. S.P. Earned on preferred stock, % of current market price of preferred.
22. Number of times net deductions earned.
23. Number of times fixed charges earned.
22. I.P. Number of times net deductions plus preferred dividends earned.
23. I.P. Number of times fixed charges plus preferred dividends earned.
E. Trend figure:
24 to 30. Earned per share on common stock each year for past seven years. (Where necessary, earnings should be adjusted to present capitalization.)
24. S.P. to 30. S.P. Same data for speculative preferred stock, if wanted.
F. Dividends:
31. Dividend rate on common.
32. Dividend yield on common.
31. P. Dividend rate on preferred.
32. P. Dividend yield on preferred.
* Or net deductions if larger.
† I.P. = for studying an investment preferred stock.
‡ S.P. = for studying a speculative preferred stock.
Observations on the Railroad Comparison.1 It has formerly been the custom to base earnings studies on the figures for the previous calen- dar years, with certain references to later interim reports. But since com- plete figures are now available month by month, it is more logical and effective practice to ignore the calendar-year division and to use instead the results for the twelve months to the latest date available. The simplest way to arrive at such a twelve months’ figure is to apply the change |
ations on the Railroad Comparison.1 It has formerly been the custom to base earnings studies on the figures for the previous calen- dar years, with certain references to later interim reports. But since com- plete figures are now available month by month, it is more logical and effective practice to ignore the calendar-year division and to use instead the results for the twelve months to the latest date available. The simplest way to arrive at such a twelve months’ figure is to apply the change shown for the current year to date to the results of the previous calendar year.
Example:
GROSS EARNINGS OF PENNSYLVANIA RAILROAD SYSTEM FOR
12 MONTHS ENDED JUNE, 1939
(1) 6 months to June 1939 (as reported) . . . . . . . . . . . . . . . . . . . . . . . . . . . $189,623,000
(2) 6 months to June 1938 (as reported) . . . . . . . . . . . . . . . . . . . . . . . . . . . 167,524,000
(3) Difference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +22,099,000
(4) Calender year 1938 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,384,000
12 months to June 1939 (4 plus 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . $382,483,000
Our table includes a few significant calculations based on the seven- year average. In an intensive study, average results should be scrutinized in more detail. To save time, it is suggested that additional average fig- ures be computed only for those roads which the analyst selects for fur- ther investigation after he has studied the exhibits in the “standard form.” Whether the period of averaging should cover seven years or a longer or shorter time is largely a matter for individual judgment. In theory it should be just long enough to cover a full cyclical fluctuation but not so long as to include factors or results that are totally out of date. The six years 1934–1939 might well be regarded as a somewhat better criterion, for example, than the longer period 1 |
yst selects for fur- ther investigation after he has studied the exhibits in the “standard form.” Whether the period of averaging should cover seven years or a longer or shorter time is largely a matter for individual judgment. In theory it should be just long enough to cover a full cyclical fluctuation but not so long as to include factors or results that are totally out of date. The six years 1934–1939 might well be regarded as a somewhat better criterion, for example, than the longer period 1933–1939.
Figures relating to preferred stocks fall into two different classes, depending on whether the issue is considered for fixed-value investment or as a speculative commitment. (Usually the market price will indicate
1 Reference is made to earlier chapters for explanation of the terminology and the critical tests referred to in this discussion.
clearly enough in which category a particular issue belongs.) The items marked “I.P.” are to be used in studying an investment preferred stock, and those marked “S.P.” in studying a speculative preferred. Where there are junior income bonds, the simplest and most satisfactory procedure will be to treat them in all respects as a preferred stock issue, with a foot- note referring to their actual title. Such contingent bond interest will therefore be excluded from the net deductions or the fixed charges.
In this tabular comparison we follow the suggestion previously offered that the effective debt be computed by capitalizing the larger of net deduc- tions or fixed charges. In using the table as an aid to the selection of sen- ior issues for investment, chief attention will be paid to items 22 and 23 (or 22 “I.P.” and 23 “I.P.”), showing the average margin above interest (and pre- ferred dividend) requirements. Consideration should be given also to items 6, 7 and 8, showing the division of total capitalization between senior secu- rities and junior equity. (In dealing with bonds, the preferred stock is part of the junior equity; |
net deduc- tions or fixed charges. In using the table as an aid to the selection of sen- ior issues for investment, chief attention will be paid to items 22 and 23 (or 22 “I.P.” and 23 “I.P.”), showing the average margin above interest (and pre- ferred dividend) requirements. Consideration should be given also to items 6, 7 and 8, showing the division of total capitalization between senior secu- rities and junior equity. (In dealing with bonds, the preferred stock is part of the junior equity; in considering a preferred stock for investment, it must be included with the effective debt.) Items 10 and 19 should also be exam- ined to see if the earnings have been overstated by reason of inadequate maintenance or by the inclusion of unearned dividends from subsidiaries. Speculative preferred stocks will ordinarily be analyzed in much the same way as common stocks, and the similarity becomes greater as the price of the preferred stock is lower. It should be remembered, however, that a preferred stock is always less attractive, logically considered, than a common stock making the same showing. For example, a $6 preferred earning $5 per share is intrinsically less desirable than a common stock earning $5 per share (and with the same prior charges), since the latter is entitled to all the present and future equity, whereas the preferred stock is
strictly limited in its claim upon the future.
In comparing railroad common stocks (and preferred shares equiva- lent thereto), the point of departure is the percentage earned on the mar- ket price. This may be qualified, to an extent more or less important, by consideration of items 10 and 19. Items 12 and 18 will indicate at once whether the company is speculatively or conservatively capitalized, rela- tively speaking. A speculatively capitalized road will show a large ratio of net deductions to gross and (ordinarily) a small ratio of common stock at market value to gross. The converse will be true for a conservatively capitalize |
f departure is the percentage earned on the mar- ket price. This may be qualified, to an extent more or less important, by consideration of items 10 and 19. Items 12 and 18 will indicate at once whether the company is speculatively or conservatively capitalized, rela- tively speaking. A speculatively capitalized road will show a large ratio of net deductions to gross and (ordinarily) a small ratio of common stock at market value to gross. The converse will be true for a conservatively capitalized road.
Limitation upon Comparison of Speculatively and Conserva- tively Capitalized Companies in the Same Field. The analyst must beware of trying to draw conclusions as to the relative attractive- ness of two railroad common stocks when one is speculatively and the other is conservatively capitalized. Two such issues will respond quite dif- ferently to changes for the better or the worse, so that an advantage pos- sessed by one of them under current conditions may readily be lost if conditions should change.
Example: The example shown on p. 681 illustrates in a twofold fash- ion the fallacy of comparing a conservatively capitalized with a specula- tively capitalized common stock. In 1922 the earnings of Union Pacific common were nearly four times as high in relation to market price as were those of Rock Island common. A conclusion that Union Pacific was “cheaper,” based on these figures, would have been fallacious, because the relative capitalization structures were so different as to make the two companies noncomparable. This fact is shown graphically by the much larger expansion of the earnings and the market price of Rock Island common that accompanied the moderate rise in gross business during the five years following.
The situation in 1927 was substantially the opposite. At that time Rock Island common was earning proportionately more than Union Pacific common. But it would have been equally fallacious to conclude that Rock Island common was “intrinsically cheaper.” |
to make the two companies noncomparable. This fact is shown graphically by the much larger expansion of the earnings and the market price of Rock Island common that accompanied the moderate rise in gross business during the five years following.
The situation in 1927 was substantially the opposite. At that time Rock Island common was earning proportionately more than Union Pacific common. But it would have been equally fallacious to conclude that Rock Island common was “intrinsically cheaper.” The speculative capitalization structure of the latter road made it highly vulnerable to unfavorable devel- opment, so that it was unable to withstand the post-1929 depression.
Other Illustrations in Appendix. The practical approach to compar- ative analysis of railroad stocks (and bonds) may best be illustrated by the reproduction of several such comparisons made by one of the authors a number of years ago and published as part of the service rendered to clients by a New York Stock Exchange firm. These will be found in Appendix Note 66 on accompanying CD. It will be observed that the comparisons were made between roads in approximately the same class as regards capitaliza- tion structure, with the exception of the comparison between Atchison and New York Central, in which instance special reference was made to the greater sensitivity of New York Central to changes in either direction.
COMPARISON OF UNION PACIFIC AND ROCK ISLAND COMMON STOCKS
Item
Union Pacific R.R. Chicago, Rock Island, & Pacific Ry.
A. Showing the effect of general improvement:
Average price of common, 1922 Earned per share, 1922
% earned on market price, 1922
Fixed charges and preferred dividends earned, 1922
Ratio of gross to market value of common, 1922
Increase in gross, 1927 over 1922 Earned per share of common, 1927 Increase in earnings on common,
1927 over 1922
Average price of common, 1927
Increase in average price, 1927 over 1922
B. Showing the effect of a general decline in business:
Earned |
Island, & Pacific Ry.
A. Showing the effect of general improvement:
Average price of common, 1922 Earned per share, 1922
% earned on market price, 1922
Fixed charges and preferred dividends earned, 1922
Ratio of gross to market value of common, 1922
Increase in gross, 1927 over 1922 Earned per share of common, 1927 Increase in earnings on common,
1927 over 1922
Average price of common, 1927
Increase in average price, 1927 over 1922
B. Showing the effect of a general decline in business:
Earned on average price, 1927
Fixed charges and preferred dividends earned, 1927
Ratio of gross to market value of common, 1927
Decrease in gross, 1933 below 1927 Earned on common, 1933
Decrease in earnings for common, 1933 below 1927
Average price of common, 1933 Decrease in average price, 1933
below 1927
140
40
$12.76 $0.96
9.1% 2.4%
2.39 times 1.05 times
62% 419%
5.7% 12.9%
$16.05 $12.08
26% 1,158%
179 92
28% 130%
9.0%
13.1%
2.64 times 1.58 times
51% 204%
46% 54%
$7.88 $20.40(d)
51% 269%
97 6
46% 93%
Note: In June 1933 trustees in bankruptcy were appointed for the Rock Island.
FORM II. PUBLIC-UTILITY COMPARISON
The public-utility comparison form is practically the same as that for rail- roads. The only changes are the following: Fixed charges (as mentioned in line 1 and elsewhere) should include subsidiary-preferred dividends. Line 2 should be called “Funded debt and subsidiary preferred stock,” and these should be taken from the balance sheet. Items 22 and 22 I.P., relat- ing to net deductions, are not needed. Item 10 becomes “ratio of depre- ciation to gross.” An item, 10M, may be included to show “ratio of maintenance to gross” for the companies which publish this information.
Our observations regarding the use of the railroad comparison apply as well to the public-utility comparison. Variations in the depreciation rate are fully as important as variations in the railroad maintenance ratios. When a wide difference appears, it should not be taken for |
P., relat- ing to net deductions, are not needed. Item 10 becomes “ratio of depre- ciation to gross.” An item, 10M, may be included to show “ratio of maintenance to gross” for the companies which publish this information.
Our observations regarding the use of the railroad comparison apply as well to the public-utility comparison. Variations in the depreciation rate are fully as important as variations in the railroad maintenance ratios. When a wide difference appears, it should not be taken for granted that one property is unduly conservative or the other not conservative enough, but a presumption to this effect does arise, and the question should be investigated as thoroughly as possible. A statistical indication that one utility stock is more attractive than another should not be acted upon until (among other qualitative matters) some study has been made of the rate situation and the relative prospects for favorable or unfavorable changes therein. In view of experience since 1933, careful attention should also be given to the dangers of municipal or federal competition.
FORM III. INDUSTRIAL COMPARISON (FOR
COMPANIES IN THE SAME FIELD)
Since this form differs in numerous respects from the two preceding, it is given in full herewith:
A. Capitalization:
1. Bonds at par.
2. Preferred stock at market value (number of shares X market price).
3. Common stock at market value (number of shares X market price).
4. Total capitalization.
5. Ratio of bonds to capitalization.
6. Ratio of aggregate market value of preferred to capitalization.
7. Ratio of aggregate market value of common to capitalization.
B. Income Account (most recent year):
8. Gross sales.
9. Depreciation.
10. Net available for bond interest.
11. Bond interest.
12. Preferred dividend requirements.
13. Balance for common.
14. Margin of profit (ratio of 10 to 8).
15. % earned on total capitalization (ratio of 10 to 4).
C. Calculations:
16. Number of times interest charges earned.
16. I.P. Number of times int |
of aggregate market value of preferred to capitalization.
7. Ratio of aggregate market value of common to capitalization.
B. Income Account (most recent year):
8. Gross sales.
9. Depreciation.
10. Net available for bond interest.
11. Bond interest.
12. Preferred dividend requirements.
13. Balance for common.
14. Margin of profit (ratio of 10 to 8).
15. % earned on total capitalization (ratio of 10 to 4).
C. Calculations:
16. Number of times interest charges earned.
16. I.P. Number of times interest charges plus preferred dividends earned.
17. Earned on common, per share.
18. Earned on common, % of market price.
17. S.P. Earned on preferred, per share.
18. S.P. Earned on preferred, % of market price.
19. Ratio of gross to aggregate market value of common.
19. S.P. Ratio of gross to aggregate market value of preferred.
D. Seven-year average:
20. Number of times interest charges earned.
21. Earned on common stock per share.
22. Earned on common stock, % of current market price.
(20 I.P., 21 S.P. and 22 S.P.—Same calculation for preferred stock if wanted).
E. Trend figure:
23. Earned per share of common stock each year for past seven years (adjustments in number of shares outstanding to be made where necessary).
23. S.P. Same data for speculative preferred issues, if wanted.
F. Dividends:
24. Dividend rate on common.
25. Dividend yield on common.
24. P. Dividend rate on preferred.
25. P. Dividend yield on preferred.
G. Balance sheet:
26. Cash assets.
27. Receivables (less reserves).
28. Inventories (less proper reserves).
29. Total current assets.
30. Total current liabilities.
30. N. Notes Payable (Including “Bank Loans” and “Bills Payable”)
31. Net current assets.
32. Ratio of current assets to current liabilities.
33. Ratio of inventory to sales.
34. Ratio of receivables to sales.
35. Net tangible assets available for total capitalization.
36. Cash-asset-value of common per share (deducting all prior obligations).
37. Net-current-asset-value of common per share ( |
erves).
28. Inventories (less proper reserves).
29. Total current assets.
30. Total current liabilities.
30. N. Notes Payable (Including “Bank Loans” and “Bills Payable”)
31. Net current assets.
32. Ratio of current assets to current liabilities.
33. Ratio of inventory to sales.
34. Ratio of receivables to sales.
35. Net tangible assets available for total capitalization.
36. Cash-asset-value of common per share (deducting all prior obligations).
37. Net-current-asset-value of common per share (deducting all prior obligations).
38. Net-tangible-asset-value of common per share (deducting all prior obligations).
(36 S.P., 37 S.P., 38 S.P.—Same data for speculative preferred issues, if wanted).
H. Supplementary data (when available):
1. Physical output:
Number of units; receipts per unit; cost per unit; profit per unit; total capitalization per unit; common stock valuation per unit.
2. Miscellaneous:
For example: number of stores operated; sales per store; profit per store; ore reserves; life of mine at current (or average) rate of production.
Observations on the Industrial Comparison. Some remarks regarding the use of this suggested form may be helpful. The net earn- ings figure must be corrected for any known distortions or omissions, including adjustments for undistributed earnings or losses of subsidiaries. If it appears to be misleading and cannot be adequately corrected, it should not be used as a basis of comparisons. (Inferences drawn from unreliable figures must themselves be unreliable.) No attempt should be
made to subject the depreciation figures to exact comparisons; they are useful only in disclosing wide and obvious disparities in the rates used. The calculation of bond-interest-coverage is subject to the qualification discussed in Chap. 17, with respect to companies that may have impor- tant rental obligations equivalent to interest charges.
Whereas the percentage earned on the market price of the common (item 18) is a leading figure in all comparison |
ves be unreliable.) No attempt should be
made to subject the depreciation figures to exact comparisons; they are useful only in disclosing wide and obvious disparities in the rates used. The calculation of bond-interest-coverage is subject to the qualification discussed in Chap. 17, with respect to companies that may have impor- tant rental obligations equivalent to interest charges.
Whereas the percentage earned on the market price of the common (item 18) is a leading figure in all comparisons, almost equal attention must be given to item 15, showing the percentage earned on total capi- talization. These figures, together with items 7 and 19 (ratio of aggregate market value of common stock to sales and to capitalization), will indi- cate the part played by conservative or speculative capitalization struc- tures among the companies compared. (The theory of capitalization structure was considered in Chap. 40.)
As a matter of practical procedure it is not safe to rely upon the fact that the earnings ratio for the common stock (item 18) is higher than the average for the industry, unless the percentage earned on the total capi- talization (item 15) is also higher. Furthermore, if the company with the poorer earnings exhibit shows much larger sales-per-dollar-of-common- stock (item 19), it may have better speculative possibilities in the event of general business improvement.
The balance-sheet computations do not have primary significance unless they indicate either definite financial weakness or a substantial excess of current-asset-value over the market price. The division of importance as between the current results, the seven-year average and the trend is something entirely for the analyst’s judgment to decide. Nat- urally, he will have the more confidence in any suggested conclusion if it is confirmed on each of these counts.
Example of the Use of Standard Forms. An example of the use of the standard form to reach a conclusion concerning comparative values should |
nancial weakness or a substantial excess of current-asset-value over the market price. The division of importance as between the current results, the seven-year average and the trend is something entirely for the analyst’s judgment to decide. Nat- urally, he will have the more confidence in any suggested conclusion if it is confirmed on each of these counts.
Example of the Use of Standard Forms. An example of the use of the standard form to reach a conclusion concerning comparative values should be of interest. A survey of the common stocks of the listed steel pro- ducers in July 1938 indicated that Continental Steel had made a better exhibit than the average, whereas Granite City Steel had shown much smaller earning power. The two companies operated to some extent in the same branches of the steel industry; they were very similar in size, and the price of their common stocks was identical. In the tabulation presented on page 666 we supply comparative figures for these two enterprises, omitting some of the items on our standard form as immaterial to this analysis.
Comments on the Comparison. The use of five-year average figures for each item, presented along with those of the most recent twelve months, is suggested here because the subnormal business conditions in the year ended June 30, 1938 made it inadvisable to lay too great emphasis on the results for this single period. Granite City reports on calendar-year basis, whereas Continental used both a June 30 and a December 31 fiscal year during 1934–1938. However, the availability of quarterly or semiannual figures makes it a simple matter for the analyst to construct his average and 12 months’ figures to end in the middle of the year.
Analysis of the data reveals only one point of superiority for Granite City Steel—the smaller amount of senior securities. But even this is not necessarily an advantage, since the relatively fewer shares of Continental common make them more sensitive to favorable as well as unfavor |
31 fiscal year during 1934–1938. However, the availability of quarterly or semiannual figures makes it a simple matter for the analyst to construct his average and 12 months’ figures to end in the middle of the year.
Analysis of the data reveals only one point of superiority for Granite City Steel—the smaller amount of senior securities. But even this is not necessarily an advantage, since the relatively fewer shares of Continental common make them more sensitive to favorable as well as unfavorable developments. The exhibit for the June 1938 year, and five-year average, show a statistical superiority for Continental on each of the following important points:
Earnings on market price of common stock. Earnings on total capitalization.
Ratio of gross to market value of common. Margin of profit.
Depreciation in relation to plant account. Working-capital position.
Tangible asset values. Dividend return.
Trend of earnings.
If the comparison is carried back prior to 1934, Granite City is found to have enjoyed a marked advantage in the depression years from mid- 1930 to mid-1933. During this time it earned and paid dividends while Continental Steel was reporting moderate losses. It is curious to observe that in the more recent recession the tables were exactly turned, and Con- tinental Steel did very well while Granite City fared badly. Obviously the 1937–1938 results would command more attention than those in the longer past. Nevertheless, the thorough analyst would endeavor to learn as much as possible about the basic reasons underlying the change in the relative performance of the two companies.
Study of Qualitative Factors Also Necessary. Our last observation leads to the more general remark that conclusions suggested by compar- ative tabulations of this sort should not be accepted until careful thought has been given to the qualitative factors. When one issue seems to be sell- ing much too low on the basis of the exhibit in relation to that of another in the same fi |
rn as much as possible about the basic reasons underlying the change in the relative performance of the two companies.
Study of Qualitative Factors Also Necessary. Our last observation leads to the more general remark that conclusions suggested by compar- ative tabulations of this sort should not be accepted until careful thought has been given to the qualitative factors. When one issue seems to be sell- ing much too low on the basis of the exhibit in relation to that of another in the same field, there may be adequate reasons for this disparity that the statistics do not disclose. Among such valid reasons may be a defi- nitely poorer outlook or a questionable management. A lower dividend return for a common stock should not ordinarily be considered as a strong offsetting factor, since the dividend is usually adjusted to the earn- ing power within a reasonable time.
Although overconservative dividend policies are sometimes followed for a considerable period (a subject referred to in Chap. 29), there is a well-defined tendency even in these cases for the market price to reflect the earning power sooner or later.
Relative popularity and relative market activity are two elements not connected with intrinsic value that nevertheless exert a powerful and often a continuing effect upon the market quotation. The analyst must give these factors respectful heed, but his work would be stultified if he always favored the more active and the more popular issue.
The recommendation of an exchange of one security for another seems to involve a greater personal accountability on the part of the analyst than the selection of an issue for original purchase. The reason is that holders of securities for investment are loath to make changes, and thus they are particularly irritated if the subsequent market action makes the move appear to have been unwise. Speculative holders will naturally gage all advice by the test of market results—usually immediate results. Bearing these human-natu |
Subsets and Splits
No community queries yet
The top public SQL queries from the community will appear here once available.