The Intelligent Investor: The Definitive Book On Value part 48 docx

published figures date only to 1961, in which year it earned $83,000 on revenues of $610,000. But eight years later, on our comparison date, its revenues had soared to $53.6 million and its net to $6.3 million. At that time the stock market’s attitude toward this fine performer appeared nothing less than ecstatic. The price of 55 at the close of 1969 was more than 100 times the last reported 12- months’ earnings—which of course were the largest to date. The aggregate market value of $300 million for the stock issue was nearly 30 times the tangible assets behind the shares.* This was almost unheard of in the annals of serious stock-market valuations. (At that time IBM was selling at about 9 times and Xerox at 11 times book value.) Our Table 18-4 sets forth in dollar figures and in ratios the extraordinary discrepancy in the comparative valuations of Block and Blue Bell. True, Block showed twice the profitability of Blue Bell per dollar of capital, and its percentage growth in earnings over the past five years (from practically nothing) was much higher. But as a stock enterprise Blue Bell was selling for less than one-third the total value of Block, although Blue Bell was doing four times as much business, earning 2 1 ⁄2 times as much for its stock, had 5 1 ⁄2 times as much in tangible investment, and gave nine times the dividend yield on the price. I NDICATED CONCLUSIONS: An experienced analyst would have conceded great momentum to Block, implying excellent prospects for future growth. He might have had some qualms about the dan- gers of serious competition in the income-tax-service field, lured by the handsome return on capital realized by Block. 1 But mindful of the continued success of such outstanding companies as Avon Products in highly competitive areas, he would have hesitated to predict a speedy flattening out of the Block growth curve. His chief 456 The Intelligent Investor * “Nearly 30 times” is reflected in the entry of 2920% under “Price/book value” in the Ratios section of Table 18-4. Graham would have shaken his head in astonishment during late 1999 and early 2000, when many high- tech companies sold for hundreds of times their asset value (see the com- mentary on this chapter). Talk about “almost unheard of in the annals of serious stock-market valuations”! H & R Block remains a publicly-traded company, while Blue Bell was taken private in 1984 at $47.50 per share. concern would be simply whether the $300 million valuation for the company had not already fully valued and perhaps overvalued all that one could reasonably expect from this excellent business. By contrast the analyst should have had little difficulty in recom- mending Blue Bell as a fine company, quite conservatively priced. S EQUEL TO MARCH 1971. The 1970 near-panic lopped one-quarter off the price of Blue Bell and about one-third from that of Block. Both then joined in the extraordinary recovery of the general mar- A Comparison of Eight Pairs of Companies 457 TABLE 18-4. Pair 4. H & R Block Blue Bell 1969 1969 Price, December 31, 1969 55 49 3 ⁄4 Number of shares of common 5,426,000 1,802,000 a Market value of common $298,000,000 $89,500,000 Debt — 17,500,000 Total capitalization at market 298,000,000 107,000,000 Book value per share $1.89 $34.54 Sales $53,600,000 $202,700,000 Net income 6,380,000 7,920,000 Earned per share, 1969 $.51 (October) $4.47 Earned per share, 1964 .07 2.64 Earned per share, 1959 — 1.80 Current dividend rate .24 1.80 Dividends since 1962 1923 Ratios: Price/earnings 108.0 ϫ 11.2 ϫ Price/book value 2920 % 142 % Dividend yield 0.4 % 3.6 % Net/sales 11.9 % 3.9 % Earnings/book value 27 % 12.8 % Current assets/liabilities 3.2 ϫ 2.4 ϫ Working capital/debt no debt 3.75 ϫ Growth in per-share earnings 1969 versus 1964 +630% +68% 1969 versus 1959 — +148% a Assuming conversion of preferred stock. ket. The price of Block rose to 75 in February 1971, but Blue Bell advanced considerably more—to the equivalent of 109 (after a three-for-two split). Clearly Blue Bell proved a better buy than Block as of the end of 1969. But the fact that Block was able to advance some 35% from that apparently inflated value indicates how wary analysts and investors must be to sell good companies short—either by word or deed—no matter how high the quotation may seem.* Pair 5: International Flavors & Fragrances (flavors, etc., for other businesses) and International Harvester Co. (truck manufacturer, farm machinery, construction machinery) This comparison should carry more than one surprise. Everyone knows of International Harvester, one of the 30 giants in the Dow Jones Industrial Average.† How many of our readers have even heard of International Flavors & Fragrances, next-door neighbor to Harvester on the New York Stock Exchange list? Yet, mirabile dictu, IFF was actually selling at the end of 1969 for a higher aggregate market value than Harvester—$747 million versus $710 million. This is the more amazing when one reflects that Harvester had 17 times the stock capital of Flavors and 27 times the annual sales. In 458 The Intelligent Investor * Graham is alerting readers to a form of the “gambler’s fallacy,” in which investors believe that an overvalued stock must drop in price purely because it is overvalued. Just as a coin does not become more likely to turn up heads after landing on tails for nine times in a row, so an overvalued stock (or stock market!) can stay overvalued for a surprisingly long time. That makes short- selling, or betting that stocks will drop, too risky for mere mortals. † International Harvester was the heir to McCormick Harvesting Machine Co., the manufacturer of the McCormick reaper that helped make the mid- western states the “breadbasket of the world.” But International Harvester fell on hard times in the 1970s and, in 1985, sold its farm-equipment busi- ness to Tenneco. After changing its name to Navistar, the remaining com- pany was booted from the Dow in 1991 (although it remains a member of the S & P 500 index). International Flavors & Fragrances, also a constituent of the S & P 500, had a total stock-market value of $3 billion in early 2003, versus $1.6 billion for Navistar. fact, only three years before, the net earnings of Harvester had been larger than the 1969 sales of Flavors! How did these extraordinary disparities develop? The answer lies in the two magic words: prof- itability and growth. Flavors made a remarkable showing in both categories, while Harvester left everything to be desired. The story is told in Table 18-5. Here we find Flavors with a sen- sational profit of 14.3% of sales (before income tax the figure was 23%), compared with a mere 2.6% for Harvester. Similarly, Flavors A Comparison of Eight Pairs of Companies 459 TABLE 18-5. Pair 5. International Flavors International & Fragrances 1969 Harvester 1969 Price, December 31, 1969 65 1 ⁄2 24 3 ⁄4 Number of shares of common 11,400,000 27,329,000 Market value of common $747,000,000 $710,000,000 Debt 4,000,000 313,000,000 Total capitalization at market 751,000,000 1,023,000,000 Book value per share $6.29 $41.70 Sales $94,200,000 $2,652,000,000 Net income 13,540,000 63,800,000 Earned per share, 1969 $1.19 $2.30 Earned per share, 1964 .62 3.39 Earned per share, 1959 .28 2.83 Current dividend rate .50 1.80 Dividends since 1956 1910 Ratios: Price/earnings 55.0 ϫ 10.7 ϫ Price/book value 1050.0% 59.0% Dividend yield 0.9% 7.3% Net/sales 14.3% 2.6% Earnings/book value 19.7% 5.5% Current assets/liabilities 3.7 ϫ 2.0 ϫ Working capital/debt large 1.7 ϫ Interest earned — (before tax) 3.9 ϫ Growth in per-share earnings 1969 versus 1964 +93% +9% 1969 versus 1959 +326% +39% had earned 19.7% on its stock capital against an inadequate 5.5% earned by Harvester. In five years the net earnings of Flavors had nearly doubled, while those of Harvester practically stood still. Between 1969 and 1959 the comparison makes similar reading. These differences in performance produced a typical stock-market divergence in valuation. Flavors sold in 1969 at 55 times its last reported earnings, and Harvester at only 10.7 times. Correspond- ingly, Flavors was valued at 10.4 times its book value, while Har- vester was selling at a 41% discount from its net worth. C OMMENT AND CONCLUSIONS: The first thing to remark is that the market success of Flavors was based entirely on the development of its central business, and involved none of the corporate wheel- ing and dealing, acquisition programs, top-heavy capitalization structures, and other familiar Wall Street practices of recent years. The company has stuck to its extremely profitable knitting, and that is virtually its whole story. The record of Harvester raises an entirely different set of questions, but these too have nothing to do with “high finance.” Why have so many great companies become relatively unprofitable even during many years of general prosper- ity? What is the advantage of doing more than $2 1 ⁄2 billion of busi- ness if the enterprise cannot earn enough to justify the shareholders’ investment? It is not for us to prescribe the solution of this problem. But we insist that not only management but the rank and file of shareholders should be conscious that the problem exists and that it calls for the best brains and the best efforts possi- ble to deal with it.* From the standpoint of common-stock selec- tion, neither issue would have met our standards of sound, reasonably attractive, and moderately priced investment. Flavors was a typical brilliantly successful but lavishly valued company; 460 The Intelligent Investor * For more of Graham’s thoughts on shareholder activism, see the commen- tary on Chapter 19. In criticizing Harvester for its refusal to maximize share- holder value, Graham uncannily anticipated the behavior of the company’s future management. In 2001, a majority of shareholders voted to remove Navistar’s restrictions against outside takeover bids—but the board of direc- tors simply refused to implement the shareholders’ wishes. It’s remarkable that an antidemocratic tendency in the culture of some companies can endure for decades. Harvester’s showing was too mediocre to make it really attractive even at its discount price. (Undoubtedly there were better values available in the reasonably priced class.) S EQUEL TO 1971: The low price of Harvester at the end of 1969 protected it from a large further decline in the bad break of 1970. It lost only 10% more. Flavors proved more vulnerable and declined to 45, a loss of 30%. In the subsequent recovery both advanced, well above their 1969 close, but Harvester soon fell back to the 25 level. Pair 6: McGraw Edison (public utility and equipment; housewares) McGraw-Hill, Inc. (books, films, instruction systems; magazine and newspaper publishers; information services) This pair with so similar names—which at times we shall call Edison and Hill—are two large and successful enterprises in vastly different fields. We have chosen December 31, 1968, as the date of our comparison, developed in Table 18-6. The issues were selling at about the same price, but because of Hill’s larger capitalization it was valued at about twice the total figure of the other. This differ- ence should appear somewhat surprising, since Edison had about 50% higher sales and one-quarter larger net earnings. As a result, we find that the key ratio—the multiplier of earnings—was more than twice as great for Hill as for Edison. This phenomenon seems explicable chiefly by the persistence of a strong enthusiasm and partiality exhibited by the market toward shares of book- publishing companies, several of which had been introduced to public trading in the later 1960s.* Actually, by the end of 1968 it was evident that this enthusiasm had been overdone. The Hill shares had sold at 56 in 1967, more than 40 times the just-reported record earnings for 1966. But a small decline had appeared in 1967 and a further decline in 1968. Thus the current high multiplier of 35 was being applied to a company that A Comparison of Eight Pairs of Companies 461 * McGraw-Hill remains a publicly-traded company that owns, among other operations, BusinessWeek magazine and Standard & Poor’s Corp. McGraw–Edison is now a division of Cooper Industries. had already shown two years of receding profits. Nonetheless the stock was still valued at more than eight times its tangible asset backing, indicating a good-will component of not far from a billion dollars! Thus the price seemed to illustrate—in Dr. Johnson’s famous phrase—“The triumph of hope over experience.” By contrast, McGraw Edison seemed quoted at a reasonable price in relation to the (high) general market level and to the company’s overall performance and financial position. 462 The Intelligent Investor TABLE 18-6. Pair 6. McGraw McGraw-Hill Edison 1968 1968 Price, December 31, 1968 37 5 ⁄8 39 3 ⁄4 Number of shares of common 13,717,000 24,200,000 a Market value of common $527,000,000 $962,000,000 Debt 6,000,000 53,000,000 Total capitalization at market 533,000,000 1,015,000,000 Book value per share $20.53 $5.00 Sales $568,600,000 $398,300,000 Net income 33,400,000 26,200,000 Earned per share, 1968 $2.44 $1.13 Earned per share, 1963 1.20 .66 Earned per share, 1958 1.02 .46 Current dividend rate 1.40 .70 Dividends since 1934 1937 Ratios: Price/earnings 15.5 ϫ 35.0 ϫ Price/book value 183.0% 795.0% Dividend yield 3.7% 1.8% Net/sales 5.8% 6.6% Earnings/book value 11.8% 22.6% Current assets/liabilities 3.95 ϫ 1.75 ϫ Working capital/debt large 1.75 ϫ Growth in per-share earnings 1968 versus 1963 +104% +71% 1968 versus 1958 +139% +146% a Assuming conversion of preferred stock. SEQUEL TO EARLY 1971: The decline of McGraw-Hill’s earnings continued through 1969 and 1970, dropping to $1.02 and then to $.82 per share. In the May 1970 debacle its price suffered a devas- tating break to 10—less than a fifth of the figure two years before. It had a good recovery thereafter, but the high of 24 in May 1971 was still only 60% of the 1968 closing price. McGraw Edison gave a bet- ter account of itself—declining to 22 in 1970 and recovering fully to 41 1 ⁄2 in May 1971.* McGraw-Hill continues to be a strong and prosperous company. But its price history exemplifies—as do so many other cases—the speculative hazards in such stocks created by Wall Street through its undisciplined waves of optimism and pessimism. Pair 7: National General Corp. (a large conglomerate) and National Presto Industries (diverse electric appliances, ordnance) These two companies invite comparison chiefly because they are so different. Let us call them “General” and “Presto.” We have selected the end of 1968 for our study, because the write-offs taken by General in 1969 made the figures for that year too ambiguous. The full flavor of General’s far-flung activities could not be savored the year before, but it was already conglomerate enough for anyone’s taste. The condensed description in the Stock Guide read “Nation-wide theatre chain; motion picture and TV production, savings and loan assn., book publishing.” To which could be added, then or later, “insurance, investment banking, records, music publishing, computerized services, real estate—and 35% of Performance Systems Inc. (name recently changed from Minnie Pearl’s Chicken System Inc.).” Presto had also followed a diversifi- cation program, but in comparison with General it was modest indeed. Starting as the leading maker of pressure cookers, it had branched out into various other household and electric appliances. Quite differently, also, it took on a number of ordnance contracts for the U.S. government. A Comparison of Eight Pairs of Companies 463 * In “the May 1970 debacle” that Graham refers to, the U.S. stock market lost 5.5%. From the end of March to the end of June 1970, the S & P 500 index lost 19% of its value, one of the worst three-month returns on record. Our Table 18-7 summarizes the showing of the companies at the end of 1968. The capital structure of Presto was as simple as it could be—nothing but 1,478,000 shares of common stock, selling in the market for $58 million. Contrastingly, General had more than twice as many shares of common, plus an issue of convertible pre- ferred, plus three issues of stock warrants calling for a huge amount of common, plus a towering convertible bond issue (just given in exchange for stock of an insurance company), plus a goodly sum of nonconvertible bonds. All this added up to a market capitalization of $534 million, not counting an impending issue of convertible bonds, and $750 million, including such issue. Despite National General’s enormously greater capitalization, it had actu- ally done considerably less gross business than Presto in their fiscal years, and it had shown only 75% of Presto’s net income. The determination of the true market value of General’s common- stock capitalization presents an interesting problem for security analysts and has important implications for anyone interested in the stock on any basis more serious than outright gambling. The relatively small $4 1 ⁄2 convertible preferred can be readily taken care of by assuming its conversion into common, when the latter sells at a suitable market level. This we have done in Table 18-7. But the warrants require different treatment. In calculating the “full dilu- tion” basis the company assumes exercise of all the warrants, and the application of the proceeds to the retirement of debt, plus use of the balance to buy in common at the market. These assumptions actually produced virtually no effect on the earnings per share in calendar 1968—which were reported as $1.51 both before and after allowance for dilution. We consider this treatment illogical and unrealistic. As we see it, the warrants represent a part of the “com- mon-stock package” and their market value is part of the “effective market value” of the common-stock part of the capital. (See our discussion of this point on p. 415 above.) This simple technique of adding the market price of the warrants to that of the common has a radical effect on the showing of National General at the end of 1968, as appears from the calculation in Table 18-7. In fact the “true market price” of the common stock turns out to be more than twice the quoted figure. Hence the true multiplier of the 1968 earnings is more than doubled—to the inherently absurd figure of 69 times. The total market value of the “common-stock equivalents” then 464 The Intelligent Investor A Comparison of Eight Pairs of Companies 465 TABLE 18-7. Pair 7. National General National Presto 1968 Industries 1968 Price, December 31, 1968 44 1 ⁄4 38 5 ⁄8 Number of shares of common 4,330,000 a 1,478,000 Market value of common $192,000,000 $58,000,000 Add market value of 3 issues of warrants 221,000,000 — Total value of common and warrants 413,000,000 — Senior issues 121,000,000 — Total capitalization at market 534,000,000 58,000,000 Market price of common stock adjusted for warrants 98 — Book value of common $31.50 $26.30 Sales and revenues $117,600,000 $152,200,000 Net income 6,121,000 8,206,000 Earned per share, 1968 $1.42 (December) $5.61 Earned per share, 1963 .96 (September) 1.03 Earned per share, 1958 .48 (September) .77 Current dividend rate .20 .80 Dividends since 1964 1945 Ratios: Price/earnings 69.0 ϫ b 6.9 ϫ Price/book value 310.0% 142.0% Dividend yield .5% 2.4% Net/sales 5.5% 5.4% Earnings/book value 4.5% 21.4% Current assets/liabilities 1.63 ϫ 3.40 ϫ Working capital/debt .21 ϫ no debt Growth in per-share earnings 1968 versus 1963 +48% +450% 1968 versus 1960 +195% +630% a Assuming conversion of preferred stock. b Adjusted for market price of warrants. . savored the year before, but it was already conglomerate enough for anyone’s taste. The condensed description in the Stock Guide read “Nation-wide theatre chain; motion picture and TV production, savings. dilution. We consider this treatment illogical and unrealistic. As we see it, the warrants represent a part of the “com- mon-stock package” and their market value is part of the “effective market value . 5.5%. From the end of March to the end of June 1970, the S & P 500 index lost 19% of its value, one of the worst three-month returns on record. Our Table 18-7 summarizes the showing of the companies