Benjamin Graham

Chapter 17 – Four Extremely Instructive Case Histories

Summary and Discussion – Chapter 17 – Four Extremely Instructive Case Histories
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created July 26th, 2014
Last updated August 12th, 2014
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

One of the central premises of the value investing tradition is that the stock market is not perfectly efficient, and in fact is frequently prone to the mispricing of securities. This chapter provides examples of some of the more egregious examples of market mispricing from the late 1960s.

Graham draws one example from each of four categories: A prominent but overpriced business which investors failed to realize was on its last legs (despite numerous indications to that effect); a reckless business whose strategy of aggressive acquisitions caused dramatic speculative appreciation in the price of its shares; an absurd hostile takeover in which the acquired company was many multiples larger than its acquirer; and an ethically questionable initial public offering of a trendy corporation.

Case History I: 

Overpriced business on its last legs:
the Penn Central Railroad Corporation

In 1968, the Pennsylvania and New York Central railroads merged to form what was then the United States’ largest railroad company and sixth-largest publicly traded company: the Penn Central Railroad Corporation. [1] Shockingly, by 1970 Penn Central had entered bankruptcy proceedings and defaulted on the majority of its bonds, precipitating a collapse in its stock price from $86.50 to $5.50/share. [2] Graham refers to this incident as “An extreme example of the neglect of the most elementary warning signals of financial weakness, by all those who had bonds or shares of this system under their supervision,” lambasting its $86.50 price as “[a] crazily high market price for the stock of a tottering giant.” [3] So what were the warnings signs?

With the benefit of hindsight, the problems facing Penn Central Railroad Co. are clear as day. Competition from personal automobiles and truck-based freight services were applying pressure to the railroad industry even prior to the creation of Penn Central in 1968. The creation by Congress of the Federal-Aid Highway Act in 1956, coupled with the restrictions to cost-cutting by railroad companies imposed by the Interstate Commerce Commission, are just two of the root causes which are popularly considered to have been factors in the calamitous decline of Penn Central. [4] In addition to these industry-level headwinds, however, a number of additional red flags were also evident at the company level. These can be summarized as follows:

  1. Inadequate interest coverage. In their 1934 masterpiece Security Analysis, Benjamin Graham and David Dodd prescribed a minimum interest coverage rate of 5 times (using pre-tax figures) and 2.9 times (using after-tax figures) for bonds issued by railroad corporations. In 1968, the interest coverage on Penn Central’s bonds was only 1.98 times based on pre-tax figures. [5] Investors employing the framework of Graham and Dodd’s Security Analysis would never have bought railroad bonds with such a hopelessly inadequate rate of interest coverage.
  2. Suspicious earnings. Penn Central’s 1968 earnings per share were $3.80, resulting in a price-earnings ratio of 24 based on its price of $86.50/share. At the same time, the company was at that time not paying any federal income tax. [6] This was as good a red flag as any that the earnings reported by the company may not have been what they seemed.
  3. Overpriced bonds relative to similar alternatives. An investor holding Penn Central bonds in 1968 or 1969 could have exchanged them, “at no sacrifice of price or income,” for bonds with significantly higher rates of interest coverage—a clear indication that market participants were underestimating the true risk of Penn Central’s bonds. [7]
  4. Low profitability relative to competitors. Penn Central’s 1968 operating profit of 52.5%—while impressive by today’s standards—paled in comparison to the 64.8% profit margin of Norfolk & Western, one of its main regional competitors. [8]
  5. Accounting anomalies. Extraordinary “special charges” and other unusual accounting maneuvers would have aroused the suspicion of prudent Penn Central shareholders. As it happens, however, the vast majority of the investing community was caught completely off-guard by the company’s bankruptcy. Graham’s scathing conclusion to the Penn Central story is one to keep readily in mind:

Moral: Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.” [9]

Case History II:

“Serial acquirer”: Ling-Temco-Vought Inc.

In Ling-Temco-Vought Inc., we have a “[a]n extreme example of quick and unsound “empire building,” with ultimate collapse practically guaranteed.” [10]. Founded in 1955 by then-electrician James L. Ling, the company embarked on a dramatic series of acquisitions which brought the conglomerate’s revenues to a peak of $3.75 billion in 1969, before collapsing to $374 million the very next year. The following charts, derived from Table 17-1, page 427, illustrate the extreme rapidity of the company’s rise and fall, while also shedding light on some of Ling-Temco-Vought Inc’s underlying weaknesses:

LTV Inc - Sales vs Interest Charges

LTV Inc - Market Price vs Shareholders' Equity vs EPS

In essence, Ling-Temco-Vought Inc’s dramatic rise and fall was enabled by recklessness on the part of shareholders and lending institutions. With the benefit of hindsight, it is painfully clear that the corporation’s debt-based expansion could not have been sustained. Yet even at the time, several warning signs were visible and—for the most part—ignored:

1. Accounting anomalies. Through a variety of “creative accounting” techniques, Ling-Temco-Vought Inc. concentrated operating losses into its 1961 annual report, thereby positioning themselves to report record earnings in the following year. [11] Even more blatant was the company’s inclusion of several questionable assets (including substantial goodwill and a nebulous “bond-discount asset”) on its balance sheet, in the absence of which its true EPS would have been substantially below that which was reported (and uncritically accepted) by shareholders. [12]

2. Overpriced secondary offering. As Graham notes on page 9 of chapter 6, “most new issues are sold under “favorable market conditions”—which means favorable for the seller and consequently less favorable for the buyer.” Bearing that in mind, one is all too prepared to hear that, less than three years after being sold to the public at $111 per share, Ling-Temco-Vought’s stock plummeted to $7.13/share. [13] Here again, Graham’s comments from chapter 6 (page 11) are worth repeating:

“The heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result—price collapse. In many cases the new issues lose 75% or more of their offering price. The situation is worsened by the aforementioned fact that, at bottom, the public has a real aversion to the very kind of small issue that it bought so readily in its careless moments.”

3. Massive debt overhang. The dramatic expansion of Ling-Temco-Vought’s liabilities, as illustrated in the chart below, should at the very least have elicited serious concern among the company’s shareholders. As it happens, Ling-Temco-Vought was in part a victim of its own success: between 1966 and 1968, the company received close to $400 million in bank loans. [14]

LTV Inc - Short-term debt vs Long-term debt vs Interest charges

Case History III: 

Absurd hostile takeover:
Acquisition of Sharon Steel Corporation by The NVF Company

The story of the NVF Company’s acquisition of Sharon Steel is a textbook example of creative accounting brought to a comical extreme. Before proceeding any further in this example, a side-by-side look at the two companies’ financial condition c. 1968 will prove informative for what’s to come: [15]

NVF Company

Sharon Steel

Sales $31 million
Stock capital $17.4 million
Long-term debt $4.6 million
Net income $502,000
Sales $219 million
Stock capital $101 million
Long-term debt $43 million
Net income $2,929,000

As these tables make clear, Sharon Steel dwarfed NVF Company with respect to revenue, profit, stock/share capital (the amount of money raised from shareholders by the firm by way of primary and secondary share offerings), and long-term debts. Nonetheless, the management of NVF company successfully acquired Sharon Steel despite their obvious “financial disproportions.” [16] How did they do it? The short answer is that NVF’s offer was highly levered, involving the issuance of a vast amount of bonds and stock warrants. As might be imagined, the consolidated financial statements resulting from this lopsided acquisition were a veritable circus of accounting gimmickry. Graham provides a detailed treatment of the acquisition offer and its bizarre treatment in the company’s accounts (particularly detailed treatment of the latter is provided in Appendix 6). For our purposes, it is sufficient to cite one example which is indicative of the rest: post-acquisition, the company’s consolidated assets included a $58,600,000 item which the company’s accountants cryptically described as a “deferred debt expense.” As Graham notes, “[t]his sum is greater than the entire ‘stockholders’ equity, placed at $40,200,000”! [17]

As far as morals of the story go, this example illustrates the extent to which shareholders must do their homework when considering whether or not to accept a hostile takeover attempt, particularly under conditions where the financial strength of the acquiring firm is very much in doubt, and/or when extreme leverage is relied upon for the acquisition offer.

Case History IV: The Questionable IPO of AAA Enterprises

This last case history illustrates just how poor the quality of initial public offerings can sometimes be, and just how uncritical the ‘investing public” can be in receiving them. Incorporated in 1965 by then-college student Jackie G. Williams, AAA Enterprises made $61,000 of pre-tax profit in its first year. [18] By 1969, one of the US’ “largest stock-exchange houses” had agreed to market Williams’s business to the public through an initial public offering, after which the newly-public AAA Enterprises promptly ballooned to 115 times its earnings per share. [19] What on Earth could have compelled AAA’s shareholders to have paid so high a price for a stake in an unproven and largely unprofitable enterprise? At any given time, it is never difficult to find widely-shared rationalizations for the price level of highly popular securities. Such rationalizations notwithstanding, the fact remains that AAA Enterprises filed for bankruptcy less than two years later. [20] Graham’s reflection on this particular case of IPO madness requires no further commentary:

“The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising,” computers, electronics, science, technology, or what have you, when the particular fashion is raging…

Should not responsible investment houses be honor-bound to refrain from identifying themselves with such enterprises, nine out of ten of which may be foredoomed to ultimate failure?” [21]

 

Footnotes

[1] 423.
[2] 423.
[3] 422.
[4] For details on the Federal-Aid Highway act and its impact on the railroad industry, see Charles R. Geist, Encyclopedia of American Business History (New York: Infobase Publishing, 2006), 226. For details on the regulation of the railroad industry by the Interstate Commerce Commission, see George H. Drury, The Historical Guide to North American Railroads: Histories, Figures, and Features of More than 160 Railroads Abandoned or Merged since 1930 (Waukesha: Kalmbach Publishing, 1994), 215, 248-251. For an overview of the company’s origins and bankruptcy, visit its Wikipedia page at http://en.wikipedia.org/wiki/Penn_Central_Transportation_Company#Pre-merger, where you will find the above citations as well as suggestions for further reading.
[5] 423.
[6] 424.
[7] 424.
[8] 425.
[9] 425.
[10] 422.
[11] 428.
[12] 428.
[13] 428.
[14] 429.
[15] Tables derived from pages 431-432.
[16] 430.
[17] 431.
[18] 434.
[19] 434.
[20] 436.
[21] 436-437.

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