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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-nature factors in mind, the analyst must avoid suggesting common-stock exchanges to speculators (except possibly if accompanied by an emphatic disclaimer of responsibility for subsequent market action), and he must hesitate to suggest such exchanges to holders for investment unless the statistical superiority of the issue recommended is quite impres- sive. As an arbitrary rule, we might say that there should be good reason to believe that by making the exchange the investor would be getting at least 50% more for his money. Variations in Homogeneity Affect the Values of Comparative Analysis. The dependability of industrial comparisons will vary with COMPARISON OF CONTINENTAL STEEL AND GRANITE CITY STEEL (000 OMITTED, EXCEPT THOSE PER SHARE) Item Continental Steel Granite City Steel Market price of common, July 1938 1. Bonds at par 2. Preferred stock at market 3. Common stock at market 4. Total capitalization 5. Ratio of common to total capitalization 8. Gross sales 9. Depreciation 10. Net available for bond interest 11. Bond interest 12. Preferred dividends 13. Balance for common 14. Margin of profit 15. % earned on total capitalization 16. Interest charges earned 17. Earned on common, per share 18. Earned on common, % of market price 19. Ratio of gross to market value of common Trend figures: 23. Earned per share by years: Year ended June 30, 1938 Year ended June 30, 1937 Year ended June 30, 1936 Year ended June 30, 1935 Year ended June 30, 1934 Dividends: 24. Dividend rate

Net available for bond interest 11. Bond interest 12. Preferred dividends 13. Balance for common 14. Margin of profit 15. % earned on total capitalization 16. Interest charges earned 17. Earned on common, per share 18. Earned on common, % of market price 19. Ratio of gross to market value of common Trend figures: 23. Earned per share by years: Year ended June 30, 1938 Year ended June 30, 1937 Year ended June 30, 1936 Year ended June 30, 1935 Year ended June 30, 1934 Dividends: 24. Dividend rate on common 25. Dividend yield on common Financial position (dates): 29. Total current assets 30. Total current liabilities 31. Net current assets 35. Net tangible assets for total capitalization 17 $1,202 2,450 3,410 7,062 48.3% 17 $1,618 6,494 8,112 80.0% Average of 5 years ended 6/30/38 Year ended 6/30/38 Average of 5 years ended 6/30/38 Year ended 6/30/38 $15,049 500 704 81 179 444 4.7% 10.0 8.7 times $2.29 13.5 441.5% $1.60 3.83 2.67 1.69 1.66 $13,989 445 559 67 171 321 4.0% 7.9% 8.3 times $1.60 9.4 409.8% 1.31 $1.00 5.9% 6/30/38 $6,467 1,198 5,269 13,498 $8,715 390 336 (Est.) 18 318 3.9% 4.1% 18.7 times $1.20 7.1 134.3% $0.89(d) 1.49 1.45 2.65 $8,554 459 287(d) (Est.) 54 341(d) (def.) (def.) (def.) $0.89(d) (d) 131.8% None 12/31/37 $4,179 1,164 3,015 13,556 the nature of the industry considered. The basic question, of course, is whether future developments are likely to affect all the companies in the group similarly or dissimilarly. If similarly, then substantial weight may be accorded to the relative performance in the past, as shown by the sta- tistical exhibit. An industrial group of this type may be called “homoge- neous.” But, if the individual companies in the field are likely to respond quite variously to new conditions, then the relative showing must be regarded as a much less reliable guide. A group of this kind may be termed “heterogeneous.” With certain exceptions for traffic and geographical variations, e.g., in particular, the Pocohantas so

weight may be accorded to the relative performance in the past, as shown by the sta- tistical exhibit. An industrial group of this type may be called “homoge- neous.” But, if the individual companies in the field are likely to respond quite variously to new conditions, then the relative showing must be regarded as a much less reliable guide. A group of this kind may be termed “heterogeneous.” With certain exceptions for traffic and geographical variations, e.g., in particular, the Pocohantas soft-coal carriers, the railroads must be consid- ered a highly homogeneous group. The same is true of the larger light, heat and power utilities. In the industrial field the best examples of homogeneous groups are afforded by the producers of raw materials and of other standard- ized products in which the trade name is a minor factor. These would include producers of sugar, coal, metals, steel products, cement, cotton print cloths, etc. The larger oil companies may be considered as fairly homoge- neous; the smaller concerns are not well suited to comparison because they are subject to sudden important changes in production, reserves and rela- tive price received. The larger baking, dairy and packing companies fall into fairly homogeneous groups. The same is true of the larger chain-store enter- prises when compared with other units in the same subgroups, e.g., grocery, five-and-ten-cent, restaurant, etc. Department stores are less homogeneous, but comparisons in this field are by no means far-fetched. Makers of manufactured goods sold under advertised trade-marks must generally be regarded as belonging to heterogeneous groups. In these fields one concern frequently prospers at the expense of its com- petitors, so that the units in the industry do not improve or decline together. Among automobile manufactures, for example, there have been continuous and pronounced variations in relative standing. Producers of all the various classes of machinery and equipment are subject to som

ns far-fetched. Makers of manufactured goods sold under advertised trade-marks must generally be regarded as belonging to heterogeneous groups. In these fields one concern frequently prospers at the expense of its com- petitors, so that the units in the industry do not improve or decline together. Among automobile manufactures, for example, there have been continuous and pronounced variations in relative standing. Producers of all the various classes of machinery and equipment are subject to some- what the same conditions. This is true also of the proprietary drug man- ufacturers. Intermediate positions from this point of view are occupied by such groups as the larger makers of tires, of tobacco products, of shoes, wherein changes of relative position are not so frequent.2 2 But significant changes do occur, of course. Note, for example, the phenomenal growth of Philip Morris, relative to its large competitors, the somewhat less spectacular development of The analyst must be most cautious about drawing comparative con- clusions from the statistical data when dealing with companies in a het- erogeneous group. No doubt preference may properly be accorded in these fields to the companies making the best quantitative showing (if not offset by known qualitative factors)—for this basis of selection would seem sounder than any other—but the analyst and the investor should be fully aware that such superiority may prove evanescent. As a general rule, the less homogeneous the group the more attention must be paid to the qualitative factors in making comparisons. More General Limitations on the Value of Comparative Analy- sis. It may be well once again to caution the student against being deluded by the mathematical exactitude of his comparative tables into believing that their indicated conclusions are equally exact. We have men- tioned the need of considering qualitative factors and of allowing for lack of homogeneity. But beyond these points lie all the various obstacles

the more attention must be paid to the qualitative factors in making comparisons. More General Limitations on the Value of Comparative Analy- sis. It may be well once again to caution the student against being deluded by the mathematical exactitude of his comparative tables into believing that their indicated conclusions are equally exact. We have men- tioned the need of considering qualitative factors and of allowing for lack of homogeneity. But beyond these points lie all the various obstacles to the success of the analyst that we presented in some detail in our first chapter. The technique of comparative analysis may lessen some of the hazards of his work, but it can never exempt him from the vicissitudes of the future or the stubborness of the stock market itself or the conse- quences of his own failure—often unavoidable—to learn all the impor- tant facts. He must expect to appear wrong often and to be wrong on occasion; but with intelligence and prudence his work should yield bet- ter over-all results than the guesses or the superficial judgments of the typical stock buyer. General Shoe and the exceptional comparative showing of Lee Tire, in the three fields men- tioned. All three of these were relatively small enterprises. Chapter 50 DISCREPANCIES BETWEEN PRICE AND VALUE OUR EXPOSITION OF THE TECHNIQUE of security analysis has included many different examples of overvaluation and undervaluation. Evidently the processes by which the securities market arrives at its appraisals are fre- quently 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 or sell. The mistakes of the market are thus the mistakes of groups or masses of individuals. Most of them can be traced to one or more of three basic causes: exaggeration, oversimplification or neglect. In this chapter and the next we shall attempt a concise review of the various

ives at its appraisals are fre- quently 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 or sell. The mistakes of the market are thus the mistakes of groups or masses of individuals. Most of them can be traced to one or more of three basic causes: exaggeration, oversimplification or neglect. In this chapter and the next we shall attempt a concise review of the various aberrations of the securities market. We shall approach the sub- ject from the standpoint of the practical activities of the analyst, seeking in each case to determine the extent to which it offers an opportunity for profitable action on his part. This inquiry will thus constitute an ampli- fication of our early chapter on the scope and limitations of security analysis, drawing upon the material developed in the succeeding discus- sions, to which a number of references will be made. General Procedure of the Analyst. 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 pro- ceed to make his discoveries? Mainly by hard and systematic work. There are two broad methods that he may follow. The first consists of a series of comparative analyses by industrial groups along the lines described in the previous chapter. Such studies will give him a fair idea of the standard or usual characteristics of each group and also point out those companies which deviate widely from the modal exhibit. If, for example, he discovers [669] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. that a certain steel common stock has been earning about twice as much on its market price as the industry as a whole, he has a clue to work on— or rather a

previous chapter. Such studies will give him a fair idea of the standard or usual characteristics of each group and also point out those companies which deviate widely from the modal exhibit. If, for example, he discovers [669] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. that a certain steel common stock has been earning about twice as much on its market price as the industry as a whole, he has a clue to work on— or rather a suggestion to be pursued by dint of a thoroughgoing investiga- tion of all the important qualitative and quantitative factors relating to the enterprise. The same type of methodical inquiry may be applied to the field of bonds and preferred stocks. The wide area of receivership railroad bonds can best be explored by means of a comparative analysis of the showing of the bonds of roughly the same rank issued by, say, a dozen of the major carriers in trusteeship. Or a large number of public-utility preferred stocks could be listed according to: (1) their over-all dividend and inter- est coverage, (2) their stock-value ratio and (3) their price and yield. Such a simple grouping might indicate a few issues that either were well secured and returned more than the average or else were clearly selling too high in view of their inadequate statistical protection. And so on. The second general method consists in scrutinizing corporate reports as they make their appearance and relating their showing to the market price of their bonds or stocks. These reports can be seen—in summary form, at least—in various daily papers; a more comprehensive presenta- tion can be found in the daily corporation-report sheets of the financial services or weekly in the Commercial and Financial Chronicle. A quick glance at a hundred of such reports may reveal between five and ten that look interesting enough from the earnings or current-asset standpoint to warrant more intensive study. Can Cyclical Swings of

ng to the market price of their bonds or stocks. These reports can be seen—in summary form, at least—in various daily papers; a more comprehensive presenta- tion can be found in the daily corporation-report sheets of the financial services or weekly in the Commercial and Financial Chronicle. A quick glance at a hundred of such reports may reveal between five and ten that look interesting enough from the earnings or current-asset standpoint to warrant more intensive study. Can Cyclical Swings of Prices Be Exploited? The best understood disparities between price and value are those which accompany the recur- rent broad swings of the market through boom and depression. It is a mere truism that stocks sell too high in a bull market and too low in a bear mar- ket. For at bottom this is simply equivalent to saying that any upward or downward movement of prices must finally reach a limit, and since prices do not remain at such limits (or at any other level) permanently, it must turn out in retrospect that prices will have advanced or declined too far. Can the analyst exploit successfully the repeated exaggerations of the general market? Experience suggests that a procedure somewhat like the following should turn out to be reasonably satisfactory: 1. Select a diversified list of leading common stocks, e.g., those in the “Dow-Jones Industrial Average.” 2. Determine an indicated “normal” value for this group by applying a suitable multiplier to average earnings. The multiplier might be equiv- alent to capitalizing the earnings at, say, twice the current interest rate on highest grade industrial bonds. The period for averaging earnings would ordinarily be seven to ten years, but exceptional conditions such as occurred in 1931–1933 might suggest a different method, e.g., basing the average on the period beginning in 1934, when operating in 1939 or later. 3. Make composite purchases of the list when the shares can be bought at a substantial discount from normal value, say, at

be equiv- alent to capitalizing the earnings at, say, twice the current interest rate on highest grade industrial bonds. The period for averaging earnings would ordinarily be seven to ten years, but exceptional conditions such as occurred in 1931–1933 might suggest a different method, e.g., basing the average on the period beginning in 1934, when operating in 1939 or later. 3. Make composite purchases of the list when the shares can be bought at a substantial discount from normal value, say, at 2/3 such value. Or purchases may be made on a scale downwards, beginning say, at 80% of normal value. 4. Sell out such purchases when a price is reached substantially above normal value, say, 1/3 higher, or from 20% to 50% higher on a scale basis. This was the general scheme of operations developed by Roger Babson many years ago. It yielded quite satisfactory results prior to 1925. But—as we pointed out in Chap. 37—during the 1921–1933 cycle (measuring from low point to low point) it would have called for purchasing during 1921, selling out probably in 1926, thus requiring complete abstinence from the market during the great boom of 1927–1929, and repurchasing in 1931, to be followed by a severe shrinkage in market values. A program of this character would have made far too heavy demands upon human fortitude. The behavior of the market since 1933 has offered difficulties of a dif- ferent sort in applying these mechanical formulas—particularly in deter- mining normal earnings from which to compute normal values. It is scarcely to be expected that an idea as basically simple as this one can be utilized with any high degree of accuracy in catching the broad market swings. But for those who realize its inherent limitations it may have con- siderable utility, for at least it is likely on the average to result in purchases at intrinsically attractive levels—which is more than half the battle in common-stock investment. “Catching the Swings” on a Marginal Basis Impracticable. From t

to compute normal values. It is scarcely to be expected that an idea as basically simple as this one can be utilized with any high degree of accuracy in catching the broad market swings. But for those who realize its inherent limitations it may have con- siderable utility, for at least it is likely on the average to result in purchases at intrinsically attractive levels—which is more than half the battle in common-stock investment. “Catching the Swings” on a Marginal Basis Impracticable. From the ordinary speculative standpoint, involving purchases on mar- gin and short sales, this method of operation must be set down as imprac- ticable. The outright owner can afford to buy too soon and to sell too soon. In fact he must expect to do both and to see the market decline far- ther after he buys and advance farther after he sells out. But the margin trader is necessarily concerned with immediate results; he swims with the tide, hoping to gage the exact moment when the tide will turn and to reverse his stroke the moment before. In this he rarely succeeds, so that his typical experience is temporary success ending in complete disaster. It is the essential character of the speculator that he buys because he thinks stocks are going up not because they are cheap, and conversely when he sells. Hence there is a fundamental cleavage of viewpoint between the speculator and the securities analyst, which militates strongly against any enduringly satisfactory association between them. Bond prices tend undoubtedly to swing through cycles in somewhat the same way as stocks, and it is frequently suggested that bond investors follow the policy of selling their holdings near the top of these cycles and repurchasing them near the bottom. We are doubtful if this can be done with satisfactory results in the typical case. There are no well-defined standards as to when high-grade bond prices are cheap or dear corre- sponding to the earnings-ratio test for common stocks, and the opera- tion

prices tend undoubtedly to swing through cycles in somewhat the same way as stocks, and it is frequently suggested that bond investors follow the policy of selling their holdings near the top of these cycles and repurchasing them near the bottom. We are doubtful if this can be done with satisfactory results in the typical case. There are no well-defined standards as to when high-grade bond prices are cheap or dear corre- sponding to the earnings-ratio test for common stocks, and the opera- tions have to be guided chiefly by a technique of gaging market moves that seems rather far removed from “investment.” The loss of interest on funds between the time of sale and repurchase is a strong debit factor, and in our opinion the net advantage is not sufficient to warrant incurring the psychological dangers that inhere in any placing of emphasis by the investor upon market movements. Opportunities in “Secondary” or Little-known Issues. Return- ing to common stocks, although overvaluation or undervaluation of lead- ing issues occurs only at certain points in the stock-market cycle, the large field of “nonrepresentative” or “secondary” issues is likely to yield instances of undervaluation at all times. When the market leaders are cheap, some of the less prominent common stocks are likely to be a good deal cheaper. During 1932–1933, for example, stocks such as Plymouth Cordage, Pepperell Manufacturing, American Laundry Machinery and many others, sold at unbelievably low prices in relation to their past records and current financial exhibits. It is probably a matter for individ- ual preference whether the investor should purchase an outstanding issue like General Motors at about 50% of its conservative valuation or a less prominent stock like Pepperell at about 25% of such value. The Impermanence of Leadership. The composition of the market- leader group has varied greatly from year to year, especially in view of the recent shift of attention from past performance to assumed

tion to their past records and current financial exhibits. It is probably a matter for individ- ual preference whether the investor should purchase an outstanding issue like General Motors at about 50% of its conservative valuation or a less prominent stock like Pepperell at about 25% of such value. The Impermanence of Leadership. The composition of the market- leader group has varied greatly from year to year, especially in view of the recent shift of attention from past performance to assumed prospects. If we examine the list during the decline of 1937–1938, we shall find quite a number of once outstanding issues that sold at surprisingly low prices in relation to their statistical exhibits. Example: A startling example of this sort is provided by Great Atlantic and Pacific Tea Company common, which in 1929 sold as high as 494 and in 1938 as low as 36. Salient data on this issue are as follows: Year1 Sales (000 omitted) Net (000 omitted) Earned per share of common Dividend paid on common Price range of common 1938 $ 878,972 $15,834 $ 6.71 $4.00 72–36 1937 881,703 9,119 3.50 6.25 1171/2–451/4 1936 907,371 17,085 7.31 7.00 1301/2–1101/2 1935 872,244 16,593 7.08 7.00 140 –121 1934 842,016 16,709 7.13 7.00 150–122 1933 819,617 20,478 8.94 7.00 1811/2–115 1932 863,048 22,733 10.02 7.00 168–1031/2 1931 1,008,325 29,793 13.40 6.50 260–130 1930 1,065,807 30,743 13.86 5.25 260–155 1929 1,053,693 26,220 11.77 4.50 494–162 1 Year ended following Jan. 31, except price range. The balance sheet of January 31, 1938, showed cash assets of 85 mil- lions and net current assets of 134 millions. At the 1938 low prices, the preferred and common together were selling for 126 millions. Here, then, was a company whose spectacular growth was one of the great romances of American business, a company that was without doubt the largest retail enterprise in America and perhaps in the world, that had an uninter- rupted record of earnings and dividends for many years—and yet was selling

e balance sheet of January 31, 1938, showed cash assets of 85 mil- lions and net current assets of 134 millions. At the 1938 low prices, the preferred and common together were selling for 126 millions. Here, then, was a company whose spectacular growth was one of the great romances of American business, a company that was without doubt the largest retail enterprise in America and perhaps in the world, that had an uninter- rupted record of earnings and dividends for many years—and yet was selling for less than its net current assets alone. Thus one of the outstand- ing businesses of the country was considered by Wall Street in 1938 to be worth less as a going concern than if it were liquidated. Why? First, because of chain-store tax threats; second, because of a recent decline in earnings; and, third, because the general market was depressed. We doubt that a better illustration can be found of the real nature of the stock market, which does not aim to evaluate businesses with any exactitude but rather to express its likes and dislikes, its hopes and fears, in the form of daily changing quotations. There is indeed enough sound sense and selective judgment in the market’s activities to create on most occasions some degree of correspondence between market price and ascertainable or intrinsic value. In particular, as was pointed out in Chap. 4, when we are dealing with something as elusive and nonmathematical as the evaluation of future prospects, we are generally led to accept the market’s verdict as better than anything that the analyst can arrive at. But, on enough occasions to keep the analyst busy, the emotions of the stock market carry it in either direction beyond the limits of sound judgment. Opportunities in Normal Markets. During the intermediate period, when average prices show no definite signs of being either too low or too high, common stocks may usually be found that seem definitely under- valued on a statistical basis. These generally fall into two clas

the market’s verdict as better than anything that the analyst can arrive at. But, on enough occasions to keep the analyst busy, the emotions of the stock market carry it in either direction beyond the limits of sound judgment. Opportunities in Normal Markets. During the intermediate period, when average prices show no definite signs of being either too low or too high, common stocks may usually be found that seem definitely under- valued on a statistical basis. These generally fall into two classes: (1) Those showing high current and average earnings in relation to market price and (2) those making a reasonably satisfactory exhibit of earnings and selling at a low price in relation to net-current-asset value. Obviously, such companies will not be large and well known, or else the trend of GROUP A. COMMON STOCKS SELLING AT THE END OF 1938 OR 1939 AT LESS THAN 7 TIMES PAST YEAR’S EARNINGS AND ALSO AT LESS THAN NET CURRENT ASSET VALUE Company Year taken Price Dec. 31 Earnings for year per share Average earnings 1934–1938 or 1934–1939 per share Net current asset value per share Net tangible asset value per share J. D. Adams Mfg. 1938 8 $1.15 $1.20 $12.07 $14.38 American Seating 1939 101/4 1.82 1.75 11.42 23.95 Bunte Bros. 1938 10 2.10 2.14 12.84 27.83 Grand Union 1939 10 1.80 1.25 13.60† 20.00† International Silver 1939 263/4 4.98 def 0.10 39.67 97.50 I. B. Kleinert 1938 81/2 1.27 0.80 11.04 16.90 New Idea 1939 121/8 2.18 1.78 13.44 16.02 *N. Y. Merchandise 1939 73/4 1.44 1.44 11.66 14.05 *Pacific Commercial 1938 111/2 2.31 2.77 24.18 27.74 Seton Leather 1938 61/4 1.38 0.94 8.38 11.27 * These stocks belong also in Group B. † Partly estimated. earnings will not have been encouraging. In the appended table are given a number of companies falling in each group as of the end of 1938 or 1939, at which times the market level for industrial stocks did not appear to be especially high or especially low. GROUP B. COMMON STOCKS SELLING AT THE END OF 1938 OR 1939 AT

1.44 1.44 11.66 14.05 *Pacific Commercial 1938 111/2 2.31 2.77 24.18 27.74 Seton Leather 1938 61/4 1.38 0.94 8.38 11.27 * These stocks belong also in Group B. † Partly estimated. earnings will not have been encouraging. In the appended table are given a number of companies falling in each group as of the end of 1938 or 1939, at which times the market level for industrial stocks did not appear to be especially high or especially low. GROUP B. COMMON STOCKS SELLING AT THE END OF 1938 OR 1939 AT TWO-THIRDS, OR LESS, OF NET CURRENT ASSET VALUE AND ALSO AT LESS THAN 12 TIMES EITHER PAST YEAR’S OR AVERAGE EARNINGS Company Year taken Price Dec. 31 Earnings for year per share Average earnings 1934–1938 or 1934–1939 per share Net current asset value per share Net tangible asset value per share Butler Bros. 1939 7 $0.83 $0.27 $12.75 $19.59 Ely & Walker 1939 18 2.30 1.83 41.60 48.51 Gilchrist 1939 43/4 0.70* 0.85* 13.85 17.39 Hale Bros. Stores 1939 14 1.81 2.00 22.13 28.14 Intertype 1939 83/4 0.55 0.82 19.77 22.35 Lee & Cady 1939 6 0.77 0.73 11.35 12.61 H. D. Lee Mercantile 1938 14 0.87 1.35 25.00 31.56 Manhattan Shirt 1938 111/2 0.73 1.06 19.36 23.62 Reliance Mfg. 1939 12 1.69 0.94 18.97 22.21 S. Stroock 1939 91/4 1.21 1.39 14.90 26.61 * Years ended following Jan 31. It is not difficult for the assiduous analyst to find interesting statisti- cal exhibits such as those presented in our table. Much more difficult is the task of determining whether or not the qualitative factors will justify following the quantitative indications—in other words, whether or not the investor may have sufficient confidence in the company’s future to consider its shares a real bargain at the apparently subnormal price. On this question the weight of financial opinion appears inclined to a generally pessimistic conclusion. The investment trusts, with all their facil- ities for discovering opportunities of this type, have paid little attention to them—partly, it is true, because they a

actors will justify following the quantitative indications—in other words, whether or not the investor may have sufficient confidence in the company’s future to consider its shares a real bargain at the apparently subnormal price. On this question the weight of financial opinion appears inclined to a generally pessimistic conclusion. The investment trusts, with all their facil- ities for discovering opportunities of this type, have paid little attention to them—partly, it is true, because they are difficult to buy and sell in the large quantities that the trusts prefer, but also because of their conviction that however good the statistical exhibit of a secondary company may be it is not likely to prove a profitable purchase unless there is specific ground for optimism regarding its future. The main drawback of a typical smaller sized company is its vulnera- bility to a sudden and perhaps permanent loss of its earning power. Undoubtedly such adverse developments occur in a larger proportion of cases in this group than among the larger enterprises. As an offset to this we have the fact that the successful small company can multiply its value far more impressively than those which are already of enormous size. For example, the growth of Philip Morris, Inc., in market value from 5 millions in 1934 to 90 millions in 1939, accompanying a 1,200% increase in net earn- ings, would have been quite inconceivable in the case of American Tobacco. Similarly, the growth of Pepsi-Cola has far outstripped in percentage that of Coca-Cola; the same is true of General Shoe vs. International Shoe; etc. But most students will try to locate the potential Philip Morris oppor- tunities, by gaging future possibilities with greater or less care, and will then buy their shares even at a fairly high price—rather than make their commitments in a diversified group of “bargain issues” with only ordi- nary prospects. Our own experience leads us to favor the latter technique, although we cannot gu

far outstripped in percentage that of Coca-Cola; the same is true of General Shoe vs. International Shoe; etc. But most students will try to locate the potential Philip Morris oppor- tunities, by gaging future possibilities with greater or less care, and will then buy their shares even at a fairly high price—rather than make their commitments in a diversified group of “bargain issues” with only ordi- nary prospects. Our own experience leads us to favor the latter technique, although we cannot guarantee brilliant results therefrom under present- day conditions. Yet judging from observations made over a number of years, it would seem that investment in apparently undervalued common stocks can be carried on with a very fair degree of over-all success, pro- vided average alertness and good judgment are used in passing on the future-prospect question—and provided also that commitments are avoided at times when the general market is statistically much too high. Two older examples of this type of opportunity are given here, to afford the reader some notion of former stock markets. Florence Stove Common Firestone Tire & Rubber Common Price in Jan. 1935 . . . . . . . . . . . . . . .35 Price in Nov. 1925 120 Dividend . . . . . . . . . . . . . . . . . . . . . . .$2 Dividend $6 Earned per share: Earned per share year ended Oct.: 1934 . . . . . . . . . . . . . . . . . . . . . .$7.93 1925 $32.57* 1933 . . . . . . . . . . . . . . . . . . . . . . .7.98 1924 16.92 1932 . . . . . . . . . . . . . . . . . . . . . . .3.33 1923 14.06 1931 . . . . . . . . . . . . . . . . . . . . . . .2.27 1922 17.08 * Earnings before contingency reserves were $40.95 per share. In these cases the market price had failed to reflect adequately the indicated earning power. Market Behavior of Standard and Nonstandard Issues. A close study of the market action of common stocks suggests the following fur- ther general observations: 1. Standard or leading issues almost always respond rapidly to changes in their

. . . . . . . . . . .3.33 1923 14.06 1931 . . . . . . . . . . . . . . . . . . . . . . .2.27 1922 17.08 * Earnings before contingency reserves were $40.95 per share. In these cases the market price had failed to reflect adequately the indicated earning power. Market Behavior of Standard and Nonstandard Issues. A close study of the market action of common stocks suggests the following fur- ther general observations: 1. Standard or leading issues almost always respond rapidly to changes in their reported profits—so much so that they tend regularly to exaggerate marketwise the significance of year-to-year fluctuations in earnings. 2. The action of the less familiar issues depends largely upon what atti- tude is taken towards them by professional market operators. If interest is lacking, the price may lag far behind the statistical showing. If interest is attracted to the issue, either manipulatively or more legitimately, the opposite result can readily be attained, and the price will respond in extreme fashion to changes in the company’s exhibit. Examples of Behavior of Nonstandard Issues. The following two examples will illustrate this diversity of behavior of nonrepresentative common stocks. BUTTE AND SUPERIOR COPPER (ACTUALLY ZINC) COMPANY COMMON Period Earnings per share Dividend per share Price range Year, 1914 $ 5.21 $ 2.25 44–24 1st quarter, 1915 4.27 0.75 50–36 2d quarter, 1915 7.73 3.25 80–45 3d quarter, 1915 10.13 5.75 73–57 4th quarter, 1915 11.34 8.25 75–59 Year 1915 $33.47 $18.00 80–36 Year 1916 30.58 34.00 105–42 These were extraordinarily large earnings and dividends. Even allow- ing for the fact that they were due to wartime prices for zinc, the market price showed none the less a striking disregard of the company’s spectac- ular exhibit. The reason was lack of general interest or of individual market sponsorship. Contrast the foregoing with the appended showing of the common stock of Mullins Body (later Mullins Manufacturing) Corporation. Betwe

1915 $33.47 $18.00 80–36 Year 1916 30.58 34.00 105–42 These were extraordinarily large earnings and dividends. Even allow- ing for the fact that they were due to wartime prices for zinc, the market price showed none the less a striking disregard of the company’s spectac- ular exhibit. The reason was lack of general interest or of individual market sponsorship. Contrast the foregoing with the appended showing of the common stock of Mullins Body (later Mullins Manufacturing) Corporation. Between 1924 and 1926 we note the characteristic market swings of a low-priced “secondary” common-stock issue. At the beginning of 1927 the shares were undoubtedly attractive, speculatively, at about 10, for the price was low in relation to the earnings of the three years previously. A substantial, but by no means spectacular, rise in profits during 1927–1928 resulted in a typical stock-market exploitation. The price advanced from 10 in 1927 to 95 in 1928 and fell back again to 10 in 1929. Year Earned per share Dividend Price range 1924 $1.91 None 18–9 1925 2.47 None 22–13 1926 1.97 None 20–8 1927 5.13 None 79–10 1928 6.53 None 95–69 1929 2.67 None 82–10 A contrast of another kind is afforded by the behavior of the aircraft- manufacturing stocks in 1938–1939, as compared with that of war ben- eficiaries in 1915–1918. The two following examples will illustrate the relationship between market price in 1938 and 1939 and actual perform- ance at the time. Boeing Airplane Co. Glenn L. Martin Co. Date December 1938 November 1939 Market value of company $25,270,000 $49,413,000 (722,000 sh. @ 35) (1,092,000 sh. @ 451/4) Sales 1938 2,006,000 12,417,000 Net 1938 555,000(d) 2,349,000 Sales, 9 months 1939 6,566,000 8,506,000 Net, 9 months 1939 2,606,000(d) 1,514,000 Tangible assets, Sept. 30, 1939 4,527,000 15,200,000 In these cases the market was evidently capitalizing the as yet unreal- ized profits from war orders as if they supplied a permanent basis of future earnings. The contras

Co. Date December 1938 November 1939 Market value of company $25,270,000 $49,413,000 (722,000 sh. @ 35) (1,092,000 sh. @ 451/4) Sales 1938 2,006,000 12,417,000 Net 1938 555,000(d) 2,349,000 Sales, 9 months 1939 6,566,000 8,506,000 Net, 9 months 1939 2,606,000(d) 1,514,000 Tangible assets, Sept. 30, 1939 4,527,000 15,200,000 In these cases the market was evidently capitalizing the as yet unreal- ized profits from war orders as if they supplied a permanent basis of future earnings. The contrast between the Butte and Superior price-earnings ratio in 1915–1916 and that of these aircraft concerns in 1938–1939 is very striking. Relationship of the Analyst to Such Situations. The analyst can deal intelligently and fairly successfully with situations such as Wright Aero- nautical, Bangor and Aroostook, Firestone and Butte and Superior at the periods referred to. He could even have formed a worth-while opinion about Mullins early in 1927. But once this issue fell into market opera- tors’ hands it passed beyond the pale of analytical judgment. As far as Wall Street was concerned, Mullins had ceased to be a business and had become a symbol on the ticker tape. To buy it or to sell it was equally haz- ardous; the analyst could warn of the hazard, but he could have no idea of the limits of its rise or fall. (As it happened, however, the company issued a convertible preferred stock in 1928 which made possible a prof- itable hedging operation, consisting of the purchase of the preferred and the sale of the common.) Similarly with the airplane issues in 1939, the analyst could go no further than to indicate the obvious hazard that lay in treating as permanent a source of business that the whole world must necessarily hope was essentially temporary. When the general market appears dangerously high to the analyst, he must be hesitant about recommending unfamiliar common stocks, even though they may seem to be of the bargain type. A severe decline in the general market will affect

and the sale of the common.) Similarly with the airplane issues in 1939, the analyst could go no further than to indicate the obvious hazard that lay in treating as permanent a source of business that the whole world must necessarily hope was essentially temporary. When the general market appears dangerously high to the analyst, he must be hesitant about recommending unfamiliar common stocks, even though they may seem to be of the bargain type. A severe decline in the general market will affect all stock prices adversely, and the less active issues may prove especially vulnerable to the effects of necessi- tous selling. Market Exaggerations Due to Factors Other than Changes in Earnings: Dividend Changes. The inveterate tendency of the stock mar- ket to exaggerate extends to factors other than changes in earnings. Overemphasis is laid upon such matters as dividend changes, stock split- ups, mergers and segregations. An increase in the cash dividend is a favor- able development, but it is absurd to add $20 to the price of a stock just because the dividend rate is advanced from $5 to $6 annually. The buyer at the higher price is paying out in advance all the additional dividends that he will receive at the new rate over the next 20 years. The excited responses often made to stock dividends are even more illogical, since they are in essence nothing more than pieces of paper. The same is true of split-ups, which create more shares but give the stockholder nothing he did not have before—except the minor advantage of a possibly broader market due to the lower price level.1 Mergers and Segregations. Wall Street becomes easily enthusiastic over mergers and just as ebullient over segregations, which are the exact oppo- site. Putting two and two together frequently produces five in the stock market, and this five may later be split up into three and three. Such inductive studies as have been made of the results following mergers seem to cast considerable doubt upon the effic

before—except the minor advantage of a possibly broader market due to the lower price level.1 Mergers and Segregations. Wall Street becomes easily enthusiastic over mergers and just as ebullient over segregations, which are the exact oppo- site. Putting two and two together frequently produces five in the stock market, and this five may later be split up into three and three. Such inductive studies as have been made of the results following mergers seem to cast considerable doubt upon the efficacy of consolidation as an aid to earning power.2 There is also reason to believe that the personal element in corporate management often stands in the way of really advantageous consolidations and that those which are consummated are due sometimes to knowledge by those in control of unfavorable conditions ahead. The exaggerated response made by the stock market to developments that seem relatively unimportant in themselves is readily explained in terms of the psychology of the speculator. He wants “action,” first of all; and he is willing to contribute to this action if he can be given any pre- text for bullish excitement. (Whether through hypocrisy or self-decep- tion, brokerage-house customers generally refuse to admit they are merely gambling with ticker quotations and insist upon some ostensible “reason” for their purchases.) Stock dividends and other “favorable devel- opments” of this character supply the desired pretexts, and they have been exploited by the professional market operators, sometimes with the con- nivance of the corporate officials. The whole thing would be childish if it were not so vicious. The securities analyst should understand how these absurdities of Wall Street come into being, but he would do well to avoid any form of contact with them. 1 In the Atlas Tack manipulation of 1933 an effort was made to attract public buying by promising a split-up of the stock, 3 shares for 1. Obviously, such a move could make no real difference of any kind in the c

perators, sometimes with the con- nivance of the corporate officials. The whole thing would be childish if it were not so vicious. The securities analyst should understand how these absurdities of Wall Street come into being, but he would do well to avoid any form of contact with them. 1 In the Atlas Tack manipulation of 1933 an effort was made to attract public buying by promising a split-up of the stock, 3 shares for 1. Obviously, such a move could make no real difference of any kind in the case of an issue selling in the 30s. The circumstances surround- ing the rise of Atlas Tack from 11/2 to 343/4 in 1933 and its precipitous fall to 10 are worth studying as a perfect example of the manipulative pattern. It is illuminating to compare the price-earnings and the price-assets relationships of the same stock prior to 1929. 2 See, for example, Arthur S. Dewing, “A Statistical Test of the Success of Consolidations,” published in Quarterly Journal of Economics, November 1921 and reprinted in his Financial Policy of Corporations, pp. 885–898, New York, 1926. But see Henry R. Seager and Charles A. Gullick, Trust and Corporation Problems, pp. 659–661, New York, 1929, and Report of the Committee on Recent Economic Changes, Vol. I, pp. 194 ff., New York, 1929. Litigation. The tendency of Wall Street to go to extremes is illustrated in the opposite direction by its tremendous dislike of litigation. A lawsuit of any significance casts a damper on the securities affected, and the extent of the decline may be out of all proportion to the merits of the case. Developments of this kind may offer real opportunities to the analyst, though of course they are of a specialized nature. The aspect of broadest importance is that of receivership. Since the undervaluations resulting therefrom are almost always confined to bond issues, we shall discuss this subject later in the chapter in connection with senior securities. Example: A rather striking example of the effect of litigation on c

nt of the decline may be out of all proportion to the merits of the case. Developments of this kind may offer real opportunities to the analyst, though of course they are of a specialized nature. The aspect of broadest importance is that of receivership. Since the undervaluations resulting therefrom are almost always confined to bond issues, we shall discuss this subject later in the chapter in connection with senior securities. Example: A rather striking example of the effect of litigation on com- mon-stock values is afforded by the Reading Company case. In 1913 the United States government brought suit to compel separation of the com- pany’s railroad and coal properties. The stock market, having its own ideas of consistency, considered this move as a dangerous attack on Reading, despite the fact that the segregation would in itself ordinarily be considered as “bullish.” A plan was later agreed upon (in 1921) under which the coal subsidiary’s stock was in effect to be distributed pro rata among the Read- ing Company’s common and preferred shareholders. This was hailed in turn as a favorable development, although in fact it constituted a victory for the government against the company. Some common stockholders, however, objected to the participation of the preferred stock in the coal company “rights.” Suit was brought to restrict these rights to the common stock. Amusingly, but not surprisingly, the effect of this move was to depress the price of Reading common. In logic, the common should have advanced, since, if the suit were successful, there would be more value for the junior shares, and, if it failed (as it did), there would be no less value than before. But the stock market reasoned merely that here was some new litigation and hence Reading common should be “let alone.” Situations involving litigation frequently permit the analyst to pursue to advantage his quantitative approach in contrast with the qualitative attitude of security holders in general. Assume th

common should have advanced, since, if the suit were successful, there would be more value for the junior shares, and, if it failed (as it did), there would be no less value than before. But the stock market reasoned merely that here was some new litigation and hence Reading common should be “let alone.” Situations involving litigation frequently permit the analyst to pursue to advantage his quantitative approach in contrast with the qualitative attitude of security holders in general. Assume that the assets of a bank- rupt concern have been turned into cash and there is available for distri- bution to its bondholders the sum of, say, 50% net. But there is a suit pending, brought by others, to collect a good part of this money. It may be that the action is so far-fetched as to be almost absurd; it may be that it has been defeated in the lower courts, and even on appeal, and that it has now but a microscopic chance to be heard by the United States Supreme Court. Nevertheless, the mere pendency of this litigation will severely reduce the market value of the bonds. Under the conditions named, they are likely to sell as low as 35 instead of 50 cents on the dol- lar. The anomaly here is that a remote claim, which the plaintiff can regard as having scarcely any real value to him, is made the equivalent in the market to a heavy liability on the part of the defendant. We thus have a mathematically demonstrable case of undervaluations, and, taking these as a class, they lend themselves exceedingly well to exploitation by the securities analyst. Examples: Island Oil and Transport 8% Notes. In June 1933 these notes were selling at 18. The receiver held a cash fund equivalent to about 45% on the issue, from which were deductible certain fees and allowances, indi- cating a net distributable balance of about 30 for the notes. The distribu- tion was being delayed by a suit for damages that had been repeatedly unsuccessful in its various legal stages and was now approaching final

ves exceedingly well to exploitation by the securities analyst. Examples: Island Oil and Transport 8% Notes. In June 1933 these notes were selling at 18. The receiver held a cash fund equivalent to about 45% on the issue, from which were deductible certain fees and allowances, indi- cating a net distributable balance of about 30 for the notes. The distribu- tion was being delayed by a suit for damages that had been repeatedly unsuccessful in its various legal stages and was now approaching final deter- mination. This suit was exerting an adverse effect upon the market value of the notes out of all proportion to its merits, a statement that is demon- strable from the fact that the litigation could have been settled by payment of a relatively small amount. After the earlier decisions were finally sus- tained by the higher courts, the noteholders received a distribution of $290 per $1,000 in April 1934. A small additional distribution was indicated.3 A similar situation arose in the case of United Shipyards Corporation stock after ratification of the sale of its properties to Bethlehem Steel Com- pany in 1938. Dissenting holders brought suit to set the sale aside on the ground that the price was grossly inadequate. The effect of this litigation was to hold down the price of the Class B common to 11/4 in January 1939, as against a realizable value of between 21/2 to 3 if the sale was upheld. Obviously, if the suit had any merit, the stock should have been worth more rather than less than 21/2; alternatively, if it had no merit, as seemed 3 A very similar situation existed in 1938 in connection with the various bond issues of National Bondholders Corporation, which was engaged in liquidating various properties and claims. These securities were selling at considerably less than the amount realizable for them in liquidation, chiefly because of certain suits involving a substantial cash fund. As in the Island Oil example, this litigation was in the last stages of appeal, a

ess than 21/2; alternatively, if it had no merit, as seemed 3 A very similar situation existed in 1938 in connection with the various bond issues of National Bondholders Corporation, which was engaged in liquidating various properties and claims. These securities were selling at considerably less than the amount realizable for them in liquidation, chiefly because of certain suits involving a substantial cash fund. As in the Island Oil example, this litigation was in the last stages of appeal, and the decisions theretofore had all been favorable to the bondholders. Following the final decision the value of a typical issue advanced from 26 bid in 1938 to the equivalent of 41 bid in 1939. clear, then the shares were clearly worth twice their selling price. (A sim- ilar disparity existed in connection with the price of the Class A stock.) Undervalued Investment Issues. Undervalued bonds and preferred stocks of investment caliber may be discovered in any period by means of assiduous search. In many cases the low price of a bond or preferred stock is due to a poor market, which in turn results from the small size of the issue, but this very small size may make for greater inherent secu- rity. The Electric Refrigeration Building Corporation 6s, due 1936, described in Chap. 26, are a good example of this paradox. At times some specific development greatly strengthens the position of a senior issue, but the price is slow to reflect this improvement, and thus a bargain situation is created. These developments relate usually to the capitalization structure or to corporate relationships. Several exam- ples will illustrate our point. Examples: In 1923 Youngstown Sheet and Tube Company purchased the properties of Steel and Tube Company of America and assumed lia- bility for the latter’s General Mortgage 7s, due 1951. Youngstown sold a 6% debenture issue at 99 to supply funds for this purchase. The follow- ing price relationship obtained at the time: Company Price Yield, % You

created. These developments relate usually to the capitalization structure or to corporate relationships. Several exam- ples will illustrate our point. Examples: In 1923 Youngstown Sheet and Tube Company purchased the properties of Steel and Tube Company of America and assumed lia- bility for the latter’s General Mortgage 7s, due 1951. Youngstown sold a 6% debenture issue at 99 to supply funds for this purchase. The follow- ing price relationship obtained at the time: Company Price Yield, % Youngstown Sheet and Tube Debenture 6s 99 6.02 Steel and Tube General 7s 102 6.85 The market failed to realize the altered status of the Steel and Tube bonds, and thus they sold illogically at a higher yield than the unsecured issue of the same obligor company. This presented a clear-cut opportu- nity to the analyst to recommend a purchase or an exchange. In 1922 the City of Detroit purchased the urban lines of Detroit United Railway Company and agreed to pay therefor sums sufficient to retire the Detroit United Railway First 41/2s, due 1932. Unusually strong protective provisions were inserted in the purchase contract which prac- tically, if not technically, made the City of Detroit liable for the bonds. But, after the deal was consummated, the bonds sold at 82, yielding more than 7%. The bond market failed to recognize their true status as virtual obligations of the City of Detroit. In 1924 Congoleum Company had outstanding $1,800,000 of 7% pre- ferred stock junior to $2,890,000 of bonds and followed by 960,000 shares of common stock having an average market value of some $48,000,000. In October of that year the company issued 681,000 additional shares of common for the business of the Nairn Linoleum Company, a large unit in the same field, with $15,000,000 of tangible assets. The enormous equity thus created for the small senior issues made them safe beyond question, but the price of the preferred stock remained under par. In 1927 Electric Refrigeration Corporation (now Ke

onds and followed by 960,000 shares of common stock having an average market value of some $48,000,000. In October of that year the company issued 681,000 additional shares of common for the business of the Nairn Linoleum Company, a large unit in the same field, with $15,000,000 of tangible assets. The enormous equity thus created for the small senior issues made them safe beyond question, but the price of the preferred stock remained under par. In 1927 Electric Refrigeration Corporation (now Kelvinator Corpo- ration) sold 373,000 shares of common stock for $6,600,000, making a total of 1,000,000 shares of common stock, with average market value of about $21,000,000, coming behind only $2,880,000 of 6% notes, due in 1936. The notes sold at 74, however, to yield 11%. The low price was due to a large operating deficit incurred in 1927, but the market failed to take into account the fact that the receipt of a much greater amount of new cash from the sale of additional stock had established a very strong back- ing for the small note issue. These four senior issues have all been paid off at par or higher. (The Congoleum-Nairn Preferred was called for payment at 107 in 1934.) Examples of this kind are convenient for the authors since they do not involve the risk of some later mischance casting doubt upon their judg- ment. To avoid loading the dice too heavily in our favor, we add another illustration which is current as this chapter is written. A Current Example. Choctaw and Memphis Railroad Company First 5s, due 1949, were selling in 1939 at about 35, carrying more than 5 years’ unpaid interest. They were a first lien on underlying mileage of the Chicago, Rock Island and Pacific System. The Rock Island had been reporting poor earnings since 1930, and all its obligations were in default. However, a segregation of the 1937 earnings by mortgage divisions showed that the Choctaw and Memphis mileage was very profitable and that its interest charges had been covered 2.6 times

s Railroad Company First 5s, due 1949, were selling in 1939 at about 35, carrying more than 5 years’ unpaid interest. They were a first lien on underlying mileage of the Chicago, Rock Island and Pacific System. The Rock Island had been reporting poor earnings since 1930, and all its obligations were in default. However, a segregation of the 1937 earnings by mortgage divisions showed that the Choctaw and Memphis mileage was very profitable and that its interest charges had been covered 2.6 times in that year even though the company had earned only $2,700,000 toward total interest of $14,080,000. Furthermore, the several reorganization plans presented up to 1939, including that of the I.C.C. examiner, had all provided for prin- cipal and back interest on this issue in full, although virtually the entire remaining bond structure was to be drastically cut down, and total inter- est charges were to be reduced to less than $2,500,000 annually. Assuming, as seemed inevitable, that the company was to be reorgan- ized along the lines proposed, it was clear that these Choctaw and Mem- phis bonds would enjoy a very strong position, whether they were to be left undisturbed with their lien on a valuable mileage and their back inter- est paid off, or were to be given par for par in a new, small first mortgage on the entire system. This conclusion would be inescapable unless it were true that a railroad with minimum gross earnings of 65 millions could not be counted on to meet charges of 21/2 millions annually—less than one-fifth its former burden. Thus all the quantitative factors would seem to indicate strongly that the Choctaw and Memphis 5s were greatly undervalued at 35 and that once the recapitalization was completed the entrenched position of this issue should become manifest.4 Price-value Discrepancies in Receiverships. In Chap. 18, deal- ing with reorganization procedure, we gave two diverse examples of disparities arising under a receivership: the Fisk Rubber case, in

21/2 millions annually—less than one-fifth its former burden. Thus all the quantitative factors would seem to indicate strongly that the Choctaw and Memphis 5s were greatly undervalued at 35 and that once the recapitalization was completed the entrenched position of this issue should become manifest.4 Price-value Discrepancies in Receiverships. In Chap. 18, deal- ing with reorganization procedure, we gave two diverse examples of disparities arising under a receivership: the Fisk Rubber case, in which the obligations sold at a ridiculously low price compared with the cur- rent assets available for them; and the Studebaker case, in which the price of the 6% notes was clearly out of line with that of the stock. A general statement may fairly be made that in cases where substantial values are ultimately realized out of a receivership, the senior securities will be found to have sold at much too low a price. This characteristic has a twofold consequence. It has previously led us to advise strongly against buying at investment levels any securities of a company that is likely to fall into financial difficulties; it now leads us to suggest that after these difficulties have arisen they may produce attractive analytical opportunities. This will be true not only of issues so strongly entrenched as to come through reorganization unscathed (e.g., Brooklyn Union Elevated 5s, as described in Chap. 2) but also of senior securities which are “scaled down” or otherwise affected in a readjustment plan. It seems to hold most 4 See Appendix Note 67, p. 835 on accompanying CD, for text of the material in the 1934 edition relating to the Fox Film 6% Notes, due 1936, which in 1933 were selling at 75 to yield 20% to maturity. Further Example: In 1938 Tung Sol Lamp Company 4% Notes, due 1941, were selling at 50. The very small size of this issue, in relation to the company’s resources and earnings, made payment apparently certain. (In fact they were called in 1939 in advance of maturity.)

ment plan. It seems to hold most 4 See Appendix Note 67, p. 835 on accompanying CD, for text of the material in the 1934 edition relating to the Fox Film 6% Notes, due 1936, which in 1933 were selling at 75 to yield 20% to maturity. Further Example: In 1938 Tung Sol Lamp Company 4% Notes, due 1941, were selling at 50. The very small size of this issue, in relation to the company’s resources and earnings, made payment apparently certain. (In fact they were called in 1939 in advance of maturity.) consistently in cases where liquidation or a sale to outside interests results ultimately in a cash distribution or its equivalent. Examples: Three typical examples of such a consummation are given herewith. 1. Ontario Power Service Corporation First 51/2s, Due 1950. This issue defaulted interest payment on July 1, 1932. About this time the bonds sold as low as 21. The Hydro-Electric Commission of Ontario purchased the property soon afterwards, on a basis that gave $900 of new debentures, fully guaranteed by the Province of Ontario, for each $1,000 Ontario Power Service bond. The new debentures were quoted at 90 in December 1933, equivalent to 81 for the old bonds. The small number of bondhold- ers not making the exchange received 70% in cash. 2. Amalgamated Laundries, Inc., 61/2s, Due 1936. Receivers were appointed in February 1932. The bonds were quoted at 4 in April 1932. In June 1932 the properties were sold to outside interests, and liquidat- ing dividends of 121/2% and 2% were paid in August 1932 and March 1933. In December 1933 the bonds were still quoted at 4, indicating expectation of at least that amount in further distributions. 3. Fisk Rubber Company First 8s and Debenture 51/2s, Due 1941 and 1931. Information regarding these issues was given in Chap. 18. Receivership was announced in January 1931. In 1932 the 8s and 51/2s sold as low as 16 and 101/2 respectively. In 1933 a reorganization was effected, which distributed 40% in cash on the 8s and 37% on the 51/2

paid in August 1932 and March 1933. In December 1933 the bonds were still quoted at 4, indicating expectation of at least that amount in further distributions. 3. Fisk Rubber Company First 8s and Debenture 51/2s, Due 1941 and 1931. Information regarding these issues was given in Chap. 18. Receivership was announced in January 1931. In 1932 the 8s and 51/2s sold as low as 16 and 101/2 respectively. In 1933 a reorganization was effected, which distributed 40% in cash on the 8s and 37% on the 51/2s, together with securities of two successor companies. The aggregate val- ues of the cash and the new securities at the close of 1933 came close to 100% for the 8% bonds and 70% for the debenture 51/2s. Price Patterns Produced by Insolvency. Certain price patterns are likely to be followed during receivership or bankruptcy proceedings, especially if they are protracted. In the first place, there is often a ten- dency for the stock issues to sell too high, not only in relation to the price of the bond issues but also absolutely, i.e., in relation to their probable ultimate value. This is due to the incidence of speculative interest, which is attracted by a seemingly low price range. In the case of senior issues, popular interest steadily decreases, and the price tends to decline accord- ingly, as the proceedings wear on. Consequently, the lowest levels are likely to be reached a short time before a reorganization plan is ready to be announced. A profitable field of analytical activity should be found therefore in keeping in close touch with such situations, endeavoring to discover secu- rities that appear to be selling far under their intrinsic value and to deter- mine approximately the best time for making a commitment in them. But in these, as in all analytical situations, we must warn against an endeavor to gage too nicely the proper time to buy. An essential characteristic of security analysis, as we understand it, is that the time factor is a subordi- nate consideratio

y should be found therefore in keeping in close touch with such situations, endeavoring to discover secu- rities that appear to be selling far under their intrinsic value and to deter- mine approximately the best time for making a commitment in them. But in these, as in all analytical situations, we must warn against an endeavor to gage too nicely the proper time to buy. An essential characteristic of security analysis, as we understand it, is that the time factor is a subordi- nate consideration. Hence our use of the qualifying word “approximately,” which is intended to allow a leeway of several months and sometimes even longer, in judging the “right time” to enter upon the operation. Opportunities in Railroad Trusteeships. In the years following 1932 a large part of the country’s railroad mileage went into the hands of trustees. At the close of 1938 a total of 111 railway companies operating 78,016 miles (31% of the total railway mileage in the United States) were in the hands of receivers or trustees. This is the greatest mileage ever in the hands of the courts at any one time. Reorganization in every case has been long delayed, owing on the one hand to the complicated capital structures to be dealt with and on the other to the uncertainty as to future normal earnings. As a result the price of a great many issues fell to extremely low levels—which would undoubtedly have presented excel- lent opportunities for the shrewd investor, had it not been that the earn- ings of the railroads as a whole continued for some years to make disappointing showings as compared with general business. Viewing the situation about the end of 1939, it appeared that many of the first-mortgage liens on important mileage had fallen to lower levels than were warranted by anything but a most pessimistic view of the future of the carriers. Certainly, these issues were cheaper than the bonds and stocks of solvent roads, which sold for the most part at liberal prices in relation to their curre

railroads as a whole continued for some years to make disappointing showings as compared with general business. Viewing the situation about the end of 1939, it appeared that many of the first-mortgage liens on important mileage had fallen to lower levels than were warranted by anything but a most pessimistic view of the future of the carriers. Certainly, these issues were cheaper than the bonds and stocks of solvent roads, which sold for the most part at liberal prices in relation to their current exhibits and which in many cases would be in danger of insolvency if future conditions turned out as badly as the low price of trusteeships issues seemed to anticipate. The technique of ana- lyzing issues of the latter group is covered on accompanying CD in Chap. 12 and in Appendix Note 66, page 821. Chapter 51 DISCREPANCIES BETWEEN PRICE AND VALUE (Continued) THE PRACTICAL DISTINCTIONS drawn in our last chapter between leading and secondary common stocks have their counterpart in the field of sen- ior securities as between seasoned and unseasoned issues. A seasoned issue may be defined as an issue of a company long and favorably known to the investment public. (The security itself may be of recent creation so long as the company has a high reputation among investors.) Seasoned and unseasoned issues tend at times to follow divergent patterns of con- duct in the market, viz.: 1. The price of seasoned issues is often maintained despite a considerable weakening of their investment position. 2. Unseasoned issues are very sensitive to adverse developments of any nature. Hence they often fall to prices far lower than seem to be warranted by their statistical exhibit. Price Inertia of Seasoned Issues. These opposite characteristics are due, in part at least, to the inertia and lack of penetration of the typical investor. He buys by reputation rather than by analysis and he holds tena- ciously to what he has bought. Hence holders of long-established issues do not sell them

nt position. 2. Unseasoned issues are very sensitive to adverse developments of any nature. Hence they often fall to prices far lower than seem to be warranted by their statistical exhibit. Price Inertia of Seasoned Issues. These opposite characteristics are due, in part at least, to the inertia and lack of penetration of the typical investor. He buys by reputation rather than by analysis and he holds tena- ciously to what he has bought. Hence holders of long-established issues do not sell them readily, and even a small decline in price attracts buyers long familiar with the security. Example: This trait of seasoned issues is well illustrated by the market history of the United States Rubber Company 8% Noncumulative Preferred. The issue received full dividends between 1905 and 1927. In each year of this period except 1924 there were investors who paid higher than par for this stock. Its popularity was based entirely upon its reputation and its dividend record, for the statistical exhibit of the company during most of the period was anything but impressive, even for an industrial bond, and [688] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. hence ridiculously inadequate to justify the purchase of a noncumulative industrial preferred stock. Between the years 1922 and 1927, the following coverage was shown for interest charges and preferred dividends combined: 1922 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.20 times 1923 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.18 times 1924 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.32 times 1925 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.79 times 1926 . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.20 times 1923 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.18 times 1924 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.32 times 1925 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.79 times 1926 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.00 times 1927 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.01 times In 1928 the stock sold as high as 109. During that year the company sustained an enormous loss, and the preferred dividend was discontin- ued. Despite the miserable showing and the absence of any dividend, the issue actually sold at 921/2 in 1929. (In 1932 it sold at 31/8.)1 Vulnerability of Unseasoned Issues. Turning to unseasoned issues, we may point out that these belong almost entirely to the industrial field. The element of seasoning plays a very small part as between the various senior issues of the railroads; and in the public-utility group proper (i.e., electric, manufactured gas, telephone and water companies) price varia- tions will be found to follow the statistical showing fairly closely, without being strongly influenced by the factor of popularity or familiarity— except in the case of very small concerns. Industrial financing has brought into the market a continuous stream of bond and preferred stock issues of companies new to the investment list. Investors have been persuaded to buy these offerings largely through the appeal of a yield moderately higher than the standard rate for sea- soned securities of comparable grade. If the earning power is maintained uninterruptedly after issuance, the new security naturally proves a s

f popularity or familiarity— except in the case of very small concerns. Industrial financing has brought into the market a continuous stream of bond and preferred stock issues of companies new to the investment list. Investors have been persuaded to buy these offerings largely through the appeal of a yield moderately higher than the standard rate for sea- soned securities of comparable grade. If the earning power is maintained uninterruptedly after issuance, the new security naturally proves a satis- factory commitment. But any adverse development will ordinarily induce a severe decline in the market price. This vulnerability of unseasoned issues gives rise to the practical conclusion that it is unwise to buy a new industrial bond or preferred stock for straight investment. 1 A more recent example of the same kind is presented by Curtis Publishing 7% Preferred, which sold at 114 in 1936 and 1091/2 in 1937, despite an exceedingly inadequate showing of earnings (and tangible assets). The high price of many railroad bonds in those years, notwithstanding their unsatisfactory earnings exhibit, illustrates this point more broadly. Since such issues are unduly sensitive to unfavorable developments, it would seem that the price would often fall too low and in that case they would afford attractive opportunities to purchase. This is undoubtedly true, but there is great need of caution in endeavoring to take advantage of these disparities. In the first place, the disfavor accorded to unseasoned securities in the market is not merely a subjective matter, due to lack of knowledge. Seasoning is usually defined as an objective quality, arising from a demonstrated ability to weather business storms. Although this definition is not entirely accurate, there is enough truth in it to justify in good part the investor’s preference for seasoned issues. More important, perhaps, is the broad distinction of size and promi- nence that can be drawn between seasoned and unseasoned securiti

o unseasoned securities in the market is not merely a subjective matter, due to lack of knowledge. Seasoning is usually defined as an objective quality, arising from a demonstrated ability to weather business storms. Although this definition is not entirely accurate, there is enough truth in it to justify in good part the investor’s preference for seasoned issues. More important, perhaps, is the broad distinction of size and promi- nence that can be drawn between seasoned and unseasoned securities. The larger companies are generally the older companies, having senior issues long familiar to the public. Hence unseasoned bonds and preferred stocks are for the most part issues of concerns of secondary importance. But we have pointed out, in our discussion of industrial investments (Chap. 7), that in this field dominant size may reasonably be considered a most desirable trait. It follows, therefore, that in this respect unseasoned issues must suffer as a class from a not inconsiderable disadvantage. Unseasoned Industrial Issues Rarely Deserve an Investment Rating. The logical and practical result is that unseasoned industrial issues can very rarely deserve an investment rating, and consequently they should only be bought on an admittedly speculative basis. This requires in turn that the market price be low enough to permit of a substantial rise; e.g., the price must ordinarily be below 70. It will be recalled that in our treatment of speculative senior issues (Chap. 26), we referred to the price sector of about 70 to 100 as the “range of subjective variation,” in which an issue might properly sell because of a legitimate difference of opinion as to whether or not it was sound. It seems, however, that in the case of unseasoned industrial bonds or pre- ferred stocks the analyst should not be attracted by a price level within this range, even though the quantitative showing be quite satisfactory. He should favor such issues only when they can be bought at a frankly specula

red to the price sector of about 70 to 100 as the “range of subjective variation,” in which an issue might properly sell because of a legitimate difference of opinion as to whether or not it was sound. It seems, however, that in the case of unseasoned industrial bonds or pre- ferred stocks the analyst should not be attracted by a price level within this range, even though the quantitative showing be quite satisfactory. He should favor such issues only when they can be bought at a frankly speculative price. Exception may be made to this rule when the statistical exhibit is extraordinarily strong, as perhaps in the case of the Fox Film 6% notes men- tioned in the preceding chapter and described in Appendix Note 67, page 835 on accompanying CD. We doubt if such exceptions can prudently include any unseasoned industrial preferred stocks, because of the contrac- tual weakness of such issues. (In the case of Congoleum preferred, described above, the company was of dominant size in its field, and the preferred stock was not so much “unseasoned” as it was inactive marketwise.) Discrepancies in Comparative Prices. Comparisons may or may not be odious, but they hold a somewhat deceptive fascination for the ana- lyst. It seems a much simpler process to decide that issue A is preferable to issue B than to determine that issue A is an attractive purchase in its own right. But in our chapter on comparative analysis we have alluded to the particular responsibility that attaches to the recommendation of secu- rity exchanges, and we have warned against an overready acceptance of a purely quantitative superiority. The future is often no respecter of statis- tical data. We may frame this caveat in another way by suggesting that the analyst should not urge a security exchange unless either (1) the issue to be bought is attractive, regarded by itself, or (2) there is a definite contrac- tual relationship between the two issues in question. Let us illustrate con- sideration (1) by two

ommendation of secu- rity exchanges, and we have warned against an overready acceptance of a purely quantitative superiority. The future is often no respecter of statis- tical data. We may frame this caveat in another way by suggesting that the analyst should not urge a security exchange unless either (1) the issue to be bought is attractive, regarded by itself, or (2) there is a definite contrac- tual relationship between the two issues in question. Let us illustrate con- sideration (1) by two examples of comparisons taken from our records. Examples: I. Comparison Made in March 1932. Item Ward Baking First 6s, due 1937. Price 851/4, yield 9.70% Bethlehem Steel First & Ref. 5s, due 1942. Price 93, yield 5.90% Total interest charges earned: 1931 1930 1929 1928 1927 1926 1925 Seven-year average Amount of bond issues Market value of stock issues (March ’32 average) Cash assets Net working capital 8.1 times 8.2 times 11.0 times 11.2 times 14.0 times 14.5 times 12.6 times 1.0 times 4.3 times 4.8 times 2.7 times 2.3 times 2.6 times 2.1 times 11.4 times $ 4,546,000 12,200,000 3,438,000 3,494,000 2.8 times $145,000,000* 116,000,000 50,300,000 116,300,000 * Including guaranteed stock. In this comparison the Ward Baking issue made a far stronger statis- tical showing than the Bethlehem Steel bonds. Furthermore, it appeared sufficiently well protected to justify an investment rating, despite the high return. The qualitative factors, although not impressive, did not suggest any danger of collapse of the business. Hence the bonds could be recom- mended either as an original purchase or as an advantageous substitute for the Bethlehem Steel 5s. II. Comparison Made in March 1929. Item Spear & Co. (Furniture Stores) 7% First Preferred. Price 77, yielding 9.09% Republic Iron & Steel 7% Preferred. Price 112, yielding 6.25% (Interest and) preferred dividends earned: 1928 2.4 times 1.9 times 1927 4.0 times 1.5 times 1926 3.0 times 2.1 times 1925 2.5 times 1.7 times 1924 4.7

nger of collapse of the business. Hence the bonds could be recom- mended either as an original purchase or as an advantageous substitute for the Bethlehem Steel 5s. II. Comparison Made in March 1929. Item Spear & Co. (Furniture Stores) 7% First Preferred. Price 77, yielding 9.09% Republic Iron & Steel 7% Preferred. Price 112, yielding 6.25% (Interest and) preferred dividends earned: 1928 2.4 times 1.9 times 1927 4.0 times 1.5 times 1926 3.0 times 2.1 times 1925 2.5 times 1.7 times 1924 4.7 times 1.1 times 1923 6.5 times 2.5 times 1922 4.3 times 0.5 times Seven-year average 3.9 times 1.6 times Amount of bond issues None $32,700,000 Amount of (1st) preferred issue $ 3,900,000 25,000,000 Market value of junior issues 3,200,000* 62,000,000 Net working capital 10,460,000 21,500,000 * Includes Second Preferred estimated at 50. In this comparison the Spear and Company issue undoubtedly made a better statistical showing than Republic Iron and Steel Preferred. Taken by itself, however, its exhibit was not sufficiently impressive to carry con- viction of investment merit, considering the type of business and the fact that we were dealing with a preferred stock. The price of the issue was not low enough to warrant recommendation on a fully speculative basis, i.e., with prime emphasis on the opportunity for enhancement of princi- pal. This meant in turn that it could not consistently be recommended in exchange for another issue, such as Republic Iron and Steel Preferred. Comparison of Definitely Related Issues. When the issues exam- ined are definitely related, a different situation obtains. An exchange can then be considered solely from the standpoint of the respective merits within the given situation; the responsibility for entering into or remain- ing in the situation need not be assumed by the analyst. In our previous chapters we have considered a number of cases in which relative prices were clearly out of line, permitting authoritative recommendations of exchange

on of Definitely Related Issues. When the issues exam- ined are definitely related, a different situation obtains. An exchange can then be considered solely from the standpoint of the respective merits within the given situation; the responsibility for entering into or remain- ing in the situation need not be assumed by the analyst. In our previous chapters we have considered a number of cases in which relative prices were clearly out of line, permitting authoritative recommendations of exchange. These disparities arise from the frequent failure of the general market to recognize the effect of contractual provisions and often also from a tendency for speculative markets to concentrate attention on the common stocks and to neglect the senior securities. Examples of the first type were given in our discussion of price discrepancies involving guaranteed issues in Chap. 17. The price discrepancies between various Interborough Rapid Transit Company issues, discussed in Appendix Note 56 on accompanying CD, and between Brooklyn Union Elevated Rail- road 5s and Brooklyn-Manhattan Transit Corporation 6s, referred to in Chap. 2, are other illustrations in this category.2 The illogical price relationships between a senior convertible issue and the common stock, discussed in Chap. 25 on accompanying CD, are exam- ples of opportunities arising from the concentration of speculative interest on the more active junior shares. A different manifestation of the same gen- eral tendency is shown by the spread of 7 points existing in August 1933 between the price of American Water Works and Electric Company “free” common and the less active voting trust certificates for the same issue. Such phenomena invite not only direct exchanges but also hedging operations. A similar comparison could be made in July 1933 between Southern Railway 5% Noncumulative Preferred, paying no dividend and selling at 49, and the Mobile and Ohio Stock Trust Certificates, which were an obli- gation of the same ro

by the spread of 7 points existing in August 1933 between the price of American Water Works and Electric Company “free” common and the less active voting trust certificates for the same issue. Such phenomena invite not only direct exchanges but also hedging operations. A similar comparison could be made in July 1933 between Southern Railway 5% Noncumulative Preferred, paying no dividend and selling at 49, and the Mobile and Ohio Stock Trust Certificates, which were an obli- gation of the same road, bearing a perpetual guaranty of a 4% dividend and selling concurrently at 393/4. Even if the preferred dividend had been immediately resumed and continued without interruption, the yield 2 The student is invited to consider the price relationships between Pierce Petroleum and Pierce Oil preferred and common in 1929; between Central States Electric Corporation 51/2% bonds and North American Company common in 1934; between the common issues of Advance-Rumely Corporation and Allis-Chalmers Manufacturing Company in 1933; between Ventures, Ltd., and Falconbridge Nickel, and between Chesapeake Corporation and Chesapeake and Ohio Railway common stocks in 1939—as examples of disparities arising from ownership by one company of securities in another. thereon would have been no higher than that obtainable from the senior fixed-interest obligation. (In 1939 Southern Railway Preferred, still pay- ing no dividend, sold at 35 against a price of about 40 for the Mobile and Ohio 4% certificates. At these prices the advantage still appeared clearly on the side of the guaranteed issue.) Other and Less Certain Discrepancies. In the foregoing examples the aberrations are mathematically demonstrable. There is a larger class of disparities between senior and junior securities that may not be proved quite so conclusively but are sufficiently certain for practical purposes. As an example of these, consider Colorado Industrial Company 5s, due August 1, 1934, guaranteed by Colorado Fuel and Iro

. At these prices the advantage still appeared clearly on the side of the guaranteed issue.) Other and Less Certain Discrepancies. In the foregoing examples the aberrations are mathematically demonstrable. There is a larger class of disparities between senior and junior securities that may not be proved quite so conclusively but are sufficiently certain for practical purposes. As an example of these, consider Colorado Industrial Company 5s, due August 1, 1934, guaranteed by Colorado Fuel and Iron Company, which in May 1933 sold at 43, while the Colorado Fuel and Iron 8% Preferred, paying no dividend, sold at 45. The bond issue had to be paid off in full within 14 months’ time, or else the preferred stock was faced with the possibility of complete extinction through receivership. In order that the preferred stock might prove more valuable than the bonds bought at the same price, it would be necessary not only that the bonds be paid off at par in little over a year but that preferred dividends be resumed and back dividends discharged within that short time. This was almost, if not quite, inconceivable. In comparing nonconvertible preferred stocks with common stocks of the same company, we find the same tendency for the latter to sell too high, relatively, when both issues are on a speculative basis. Comparisons of this kind can be safely drawn, however, only when the preferred stock bears cumulative dividends. (The reason for this restriction should be clear from our detailed discussion of the disabilities of noncumulative issues in Chap. 15.) A price of 10 for American and Foreign Power Com- pany common when the $7 Cumulative Second Preferred was selling at 11 in April 1933 was clearly unwarranted. A similar remark may be made of the price of 211/2 for Chicago Great Western Railroad Company com- mon in February 1927, against 321/2 for the 4% preferred stock on which dividends of $44 per share had accumulated. It is true that if extraordinary prosperity should develop

iscussion of the disabilities of noncumulative issues in Chap. 15.) A price of 10 for American and Foreign Power Com- pany common when the $7 Cumulative Second Preferred was selling at 11 in April 1933 was clearly unwarranted. A similar remark may be made of the price of 211/2 for Chicago Great Western Railroad Company com- mon in February 1927, against 321/2 for the 4% preferred stock on which dividends of $44 per share had accumulated. It is true that if extraordinary prosperity should develop in situations of this kind, the common shares might eventually be worth substantially more than the preferred. But even if this should occur, the company is bound to pass through an intermediate period during which the improved situation permits it to resume preferred dividends and then to discharge the accumulations. Since such developments benefit the pre- ferred stock directly, they are likely to establish (for a while at least) a mar- ket value for the senior issues far higher than that of the common stock. Hence, assuming any appreciable degree of improvement, a purchase of the preferred shares at the low levels should fare better than one made in the common stock. Discrepancies Due to Special Supply and Demand Factors. The illogical relationships that we have been considering grow out of supply and demand conditions that are, in turn, the product of unthinking spec- ulative purchases. Sometimes discrepancies are occasioned by special and temporary causes affecting either demand or supply. Examples: In the illogical relationship between the prices of Interboro Rapid Transit Company 5s and 7s in 1933, the operations of a substan- tial sinking fund, which purchased the 5s and not the 7s, were undoubt- edly instrumental in raising the price of the former disproportionately. An outstanding example of this kind is found in the market action of United States Liberty 41/4s during the postwar readjustment of 1921–1922. Large amounts of these bonds had been bought during the w

d or supply. Examples: In the illogical relationship between the prices of Interboro Rapid Transit Company 5s and 7s in 1933, the operations of a substan- tial sinking fund, which purchased the 5s and not the 7s, were undoubt- edly instrumental in raising the price of the former disproportionately. An outstanding example of this kind is found in the market action of United States Liberty 41/4s during the postwar readjustment of 1921–1922. Large amounts of these bonds had been bought during the war for patriotic reasons and financed by bank loans. A general desire to liquidate these loans later on induced a heavy volume of sales which drove the price down. This special selling pressure actually resulted in establishing a lower price basis for Liberty Bonds than for high-grade rail- road issues, which were, of course, inferior in security and at a greater disadvantage also in the matter of taxation. Compare the following simul- taneous prices in September 1920. Issue Price Yield United States Liberty Fourth 41/4s, due 1938 841/2 5.64%* Union Pacific First 4s, due 1947 80 5.42% * Not allowing for tax exemption. This situation supplied an excellent opportunity for the securities ana- lyst to advise exchanges from the old-line railroad issues into Liberty Bonds. A less striking disparity appeared a little later between the price of these Liberty Bonds and of United States Victory 43/4s, due 1923. This state of affairs is discussed in a circular, prepared by one of the authors and issued at that time, a copy of which is given in Appendix Note 68 on accompanying CD, as an additional example of “practical security analysis.” United States Savings Bonds Offer Similar Opportunity. For the investor of moderate means the disparity between United States government and corporate obligations has reappeared in recent years. The yield on United States Savings Bonds (available to any one individual to the extent of $10,000 principal amount each year) is 2.90% on the regular compo

and issued at that time, a copy of which is given in Appendix Note 68 on accompanying CD, as an additional example of “practical security analysis.” United States Savings Bonds Offer Similar Opportunity. For the investor of moderate means the disparity between United States government and corporate obligations has reappeared in recent years. The yield on United States Savings Bonds (available to any one individual to the extent of $10,000 principal amount each year) is 2.90% on the regular compound- interest basis of calculation and 3.33% on a simple-interest basis. This yield is definitely higher than that returned by best-rated public-utility and indus- trial issues.3 In addition to their safety factor, which at present must clearly be set higher than that of any corporate issue, the United States Savings Bonds have the minor advantage of exemption from normal income tax and the major advantage of being redeemable at the option of the holder at any time, thus guaranteeing him against intermediate loss in market value. 3 The average yields for such bonds for the first 3 months of 1940, carrying A1+ ratings of Standard Statistics Company, were only 2.62% and 2.44%, respectively. Chapter 52 MARKET ANALYSIS AND SECURITY ANALYSIS FORECASTING SECURITY PRICES is not properly a part of security analysis. However, the two activities are generally thought to be closely allied, and they are frequently carried on by the same individuals and organizations. Endeavors to predict the course of prices have a variety of objectives and a still greater variety of techniques. Most emphasis is laid in Wall Street upon the science, or art, or pastime, of prophesying the immediate action of the “general market,” which is fairly represented by the various aver- ages used in the financial press. Some of the services or experts confine their aim to predicting the longer term trend of the market, purporting to ignore day-to-day fluctuations and to consider the broa

eavors to predict the course of prices have a variety of objectives and a still greater variety of techniques. Most emphasis is laid in Wall Street upon the science, or art, or pastime, of prophesying the immediate action of the “general market,” which is fairly represented by the various aver- ages used in the financial press. Some of the services or experts confine their aim to predicting the longer term trend of the market, purporting to ignore day-to-day fluctuations and to consider the broader “swings” covering a period of, say, several months. A great deal of attention is given also to prophesying the market action of individual issues, as distinct from the market as a whole. Market Analysis as a Substitute for or Adjunct to Security Analysis. Assuming that these activities are carried on with sufficient seriousness to represent more than mere guesses, we may refer to all or any of them by the designation of “market analysis.” In this chapter we wish to consider the extent to which market analysis may seriously be considered as a substitute for or a supplement to security analysis. The question is important. If, as many believe, one can dependably foretell the movements of stock prices without any reference to the underlying val- ues, then it would be sensible to confine security analysis to the selection of fixed-value investments only. For, when it comes to the common-stock type of issue, it would manifestly be more profitable to master the tech- nique of determining when to buy or sell, or of selecting the issues that are going to have the greatest or quickest advance, than to devote painstaking efforts to forming conclusions about intrinsic value. Many [697] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. other people believe that the best results can be obtained by an analysis of the market position of a stock in conjunction with an analysis of its intrinsic value. If this is so, the securi

when to buy or sell, or of selecting the issues that are going to have the greatest or quickest advance, than to devote painstaking efforts to forming conclusions about intrinsic value. Many [697] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. other people believe that the best results can be obtained by an analysis of the market position of a stock in conjunction with an analysis of its intrinsic value. If this is so, the securities analyst who ventures outside the fixed-value field must qualify as a market analyst as well and be pre- pared to view each situation from both standpoints at the same time. It is not within our province to attempt a detailed criticism of the the- ories and the technique underlying all the different methods of market analysis. We shall confine ourselves to considering the broader lines of reasoning that are involved in the major premises of price forecasting. Even with this sketchy treatment it should be possible to reach some use- ful conclusions on the perplexing question of the relationship between market analysis and security analysis. Two Kinds of Market Analysis. A distinction may be made between two kinds of market analysis. The first finds the material for its predic- tions exclusively in the past action of the stock market. The second con- siders all sorts of economic factors, e.g., business conditions, general and specific; money rates; the political outlook. (The market’s behavior is itself only one of these numerous elements of study.) The underlying theory of the first approach may be summed up in the declaration that “the market is its own best forecaster.” The behavior of the market is generally studied by means of charts on which are plotted the movements of individual stocks or of “averages.” Those who devote themselves primarily to a study of these price movements are known as “chartists,” and their procedure is often called “chart reading.” But it must

s behavior is itself only one of these numerous elements of study.) The underlying theory of the first approach may be summed up in the declaration that “the market is its own best forecaster.” The behavior of the market is generally studied by means of charts on which are plotted the movements of individual stocks or of “averages.” Those who devote themselves primarily to a study of these price movements are known as “chartists,” and their procedure is often called “chart reading.” But it must be pointed out that much present-day market analysis rep- resents a combination of the two kinds described, in the sense that the mar- ket’s action alone constitutes the predominant but not the exclusive field of study. General economic indications play a subordinate but still significant role. Considerable latitude is therefore left for individual judgment, not only in interpreting the technical indications of the market’s action but also in reconciling such indications with outside factors. The “Dow theory,” how- ever, which is the best known method of market analysis, limits itself essen- tially to a study of the market’s behavior. Hence we feel justified in dealing separately with chart reading as applied exclusively to stock prices. Implication of the First Type of Market Analysis. It must be recognized that the vogue of such “technical study” has increased immensely during the past fifteen years. Whereas security analysis suffered a distinct loss of prestige beginning about 1927—from which it has not entirely recovered—chart reading apparently increased the number of its follow- ers even during the long depression and in the years thereafter. Many sceptics, it is true, are inclined to dismiss the whole procedure as akin to astrology or necromancy, but the sheer weight of its importance in Wall Street requires that its pretensions be examined with some degree of care. In order to confine our discussion within the framework of logical rea- soning, we shall purposely omi

7—from which it has not entirely recovered—chart reading apparently increased the number of its follow- ers even during the long depression and in the years thereafter. Many sceptics, it is true, are inclined to dismiss the whole procedure as akin to astrology or necromancy, but the sheer weight of its importance in Wall Street requires that its pretensions be examined with some degree of care. In order to confine our discussion within the framework of logical rea- soning, we shall purposely omit even a condensed summary of the main tenets of chart reading.1 We wish to consider only the implications of the general idea that a study confined to past price movements can be availed of profitably to foretell the movements of the future. Such consideration, we believe, should lead to the following conclusions: 1. Chart reading cannot possibly be a science. 2. It has not proved itself in the past to be a dependable method of making profits in the stock market. 3. Its theoretical basis rests upon faulty logic or else upon mere assertion. 4. Its vogue is due to certain advantages it possesses over haphazard specu- lation, but these advantages tend to diminish as the number of chart students increases. 1. Chart Reading Not a Science and Its Practice Cannot Be Continu- ously Successful. That chart reading cannot be a science is clearly demon- strable. If it were a science, its conclusions would be as a rule dependable. In that case everybody could predict tomorrow’s or next week’s price changes, and hence everyone could make money continuously by buying and selling at the right time. This is patently impossible. A moment’s thought will show that there can be no such thing as a scientific predic- tion of economic events under human control. The very “dependability” of such a prediction will cause human actions that will invalidate it. Hence thoughtful chartists admit that continued success is dependent upon keeping the successful method known to only a few people. 1 For detai

e changes, and hence everyone could make money continuously by buying and selling at the right time. This is patently impossible. A moment’s thought will show that there can be no such thing as a scientific predic- tion of economic events under human control. The very “dependability” of such a prediction will cause human actions that will invalidate it. Hence thoughtful chartists admit that continued success is dependent upon keeping the successful method known to only a few people. 1 For detailed statements concerning the theory and practice of chart reading the student is referred to: R. W. Shabacker, Stock Market Profits, B. C. Forbes, New York, 1934; Robert Rhea, “The Dow Theory,” passim, Barron’s, New York, 1932; H. M. Gartley, “Analyzing the Stock Market,” a series of articles in Barron’s beginning with the issue of Sept. 19, 1932 and ending with the issue of Dec. 5, 1932. See Appendix Note 69, p. 837 on accompanying CD, for a brief statement of the main tenets of the Dow theory. 2. Because of this fact it follows that there is no generally known method of chart reading that has been continuously successful for a long period of time.2 If it were known, it would be speedily adopted by num- berless traders. This very following would bring its usefulness to an end. 3. Theoretical Basis Open to Question. The theoretical basis of chart reading runs somewhat as follows: a. The action of the market (or of a particular stock) reflects the activities and the attitude of those interested in it. b. Therefore, by studying the record of market action, we can tell what is going to happen next in the market. The premise may well be true, but the conclusion does not necessar- ily follow. You may learn a great deal about the technical position of a stock by studying its chart, and yet you may not learn enough to permit you to operate profitably in the issue. A good analogy is provided by the “past performances” of race horses, which are so assiduously studied by the devotee

interested in it. b. Therefore, by studying the record of market action, we can tell what is going to happen next in the market. The premise may well be true, but the conclusion does not necessar- ily follow. You may learn a great deal about the technical position of a stock by studying its chart, and yet you may not learn enough to permit you to operate profitably in the issue. A good analogy is provided by the “past performances” of race horses, which are so assiduously studied by the devotees of the race track. Undoubtedly these charts afford consider- able information concerning the relative merits of the entries; they will often enable the student to pick the winner of a race; but the trouble is that they do not furnish that valuable information often enough to make betting on horse races a profitable diversion. Coming nearer home, we have a similar situation in security analysis itself. The past earnings of a company supply a useful indication of its future earnings—useful, but not infallible. Security analysis and market analysis are alike, therefore, in the fact that they deal with data that are not conclusive as to the future. The difference, as we shall point out, is that the securities analyst can protect himself by a margin of safety that is denied to the market analyst. Undoubtedly, there are times when the behavior of the market, as revealed on the charts, carries a definite and trustworthy meaning of par- ticular value to those who are skilled in its interpretation. If reliance on chart indications were confined to those really convincing cases, a more positive argument could be made in favor of “technical study.” But such 2 Adherents of the Dow theory claim that it has been continuously successful for a great many years. We believe this statement to be open to much doubt—turning, in part, on certain disputed interpretations of what the theory indicated on various key occasions. precise signals seem to occur only at wide intervals, and in the mean

ation. If reliance on chart indications were confined to those really convincing cases, a more positive argument could be made in favor of “technical study.” But such 2 Adherents of the Dow theory claim that it has been continuously successful for a great many years. We believe this statement to be open to much doubt—turning, in part, on certain disputed interpretations of what the theory indicated on various key occasions. precise signals seem to occur only at wide intervals, and in the meantime human impatience plus the exigencies of the chart reader’s profession impel him to draw more frequent conclusions from less convincing data. 4. Other Theoretical and Practical Weaknesses. The appeal of chart reading to the stock-market trader is something like that of a patent med- icine to an incurable invalid. The stock speculator does suffer, in fact, from a well-nigh incurable ailment. The cure he seeks, however, is not abstinence from speculation but profits. Despite all experience, he per- suades himself that these can be made and retained; he grasps greedily and uncritically at every plausible means to this end. The plausibility of chart reading, in our opinion, derives largely from its insistence on the sound gambling maxim that losses should be cut short and profits allowed to run. This principle usually prevents sudden large losses, and at times it permits a large profit to be taken. The results are likely to be better, therefore, than those produced by the haphazard following of “market tips.” Traders, noticing this advantage, are certain that by developing the technique of chart reading farther they will so increase its reliability as to assure themselves continued profits. But in this conclusion there lurks a double fallacy. Many players at roulette follow a similar system, which limits their losses at any one session and permits them at times to realize a substantial gain. But in the end they always find that the aggregate of small losses exceeds the few la

lowing of “market tips.” Traders, noticing this advantage, are certain that by developing the technique of chart reading farther they will so increase its reliability as to assure themselves continued profits. But in this conclusion there lurks a double fallacy. Many players at roulette follow a similar system, which limits their losses at any one session and permits them at times to realize a substantial gain. But in the end they always find that the aggregate of small losses exceeds the few large profits. (This must be so, since the mathematical odds against them are inexorable over a period of time.) The same is true of the stock trader, who will find that the expense of trading weights the dice heavily against him. A second difficulty is that, as the methods of chart reading gain in popularity, the amount of the loss taken in unprofitable trades tends to increase and the profits also tend to diminish. For as more and more people, following the same system, receive the signal to buy at about the same time, the result of this competitive buying must be that a higher average price is paid by the group. Conversely, when this larger group decides to sell out at the same time, either to cut short a loss or to protect a profit, the effect must again be that a lower average price is received. (The growth in the use of “stop- loss orders,” formerly a helpful technical device of the trader, had this very effect of detracting greatly from their value as a protective measure.) The more intelligent chart students recognize these theoretical weak- nesses, we believe, and take the view that market forecasting is an art that requires talent, judgment, intuition and other personal qualities. They admit that no rules of procedure can be laid down, the automatic follow- ing of which will insure success. Hence the widespread tendency in Wall Street circles towards a composite or eclectic approach, in which a very thorough study of the market’s performance is projected against the

re intelligent chart students recognize these theoretical weak- nesses, we believe, and take the view that market forecasting is an art that requires talent, judgment, intuition and other personal qualities. They admit that no rules of procedure can be laid down, the automatic follow- ing of which will insure success. Hence the widespread tendency in Wall Street circles towards a composite or eclectic approach, in which a very thorough study of the market’s performance is projected against the general economic background, and the whole is subjected to the appraisal of experienced judgment. The Second Type of Mechanical Forecasting. Before considering the significance of this injection of the judgment factor, let us pass on to the other type of mechanical forecasting, which is based upon factors out- side of the market itself. As far as the general market is concerned, the usual procedure is to construct indices representing various economic factors, e.g., money rates, carloadings, steel production, and to deduce impending changes in the market from an observation of a recent change in these indices.3 One of the earliest methods of the kind, and a very sim- ple one, was based upon the percentage of blast furnaces in operation. This theory was developed by Col. Leonard P. Ayres of the Cleveland Trust Company and ran to the effect that security prices usually reached a bottom when blast furnaces in operation declined through 60% of the total and that conversely they usually reached a top when blast furnaces in operation passed through the 60% mark on the upswing in use thereof.4 A companion theory of Colonel Ayres was that the high point in bond prices is reached about 14 months subsequent to the low point in pig-iron production and that the peak in stock prices is reached about two years following the low point for pig-iron production.5 This simple method is representative of all mechanical forecasting systems, in that (1) it sounds vaguely plausible on the basis of

ached a top when blast furnaces in operation passed through the 60% mark on the upswing in use thereof.4 A companion theory of Colonel Ayres was that the high point in bond prices is reached about 14 months subsequent to the low point in pig-iron production and that the peak in stock prices is reached about two years following the low point for pig-iron production.5 This simple method is representative of all mechanical forecasting systems, in that (1) it sounds vaguely plausible on the basis of a priori 3 These indices may also be plotted on charts, in which case the forecasting takes on the aspect of chart reading. Examples: The A, B, and C lines of the Harvard Economic Service which were published in weekly letters from Jan. 3, 1922, to Dec. 26, 1931 (since continued through 1939 at less frequent intervals in The Review of Economic Statistics); also the single composite Index Line in the “Investment Timing Service” offered by Independence Fund of North America, Inc., in 1939. 4 See Bulletin of the Cleveland Trust Company, July 15, 1924, cited by David F. Jordan, in Practical Business Forecasting, p. 203n, New York, 1927. 5 See Business Recovery Following Depression, a pamphlet published by the Cleveland Trust Company in 1922. The conclusions of Colonel Ayres are summarized on p. 31 of the pamphlet. reasoning and (2) it relies for its convincingness on the fact that it has “worked” for a number of years past. The necessary weakness of all these systems lies in the time element. It is easy and safe to prophesy, for exam- ple, that a period of high interest rates will lead to a sharp decline in the market. The question is, “How soon?” There is no scientific way of answer- ing this question. Many of the forecasting services are therefore driven to a sort of pseudo-science, in which they take it for granted that certain time lags or certain coincidences that happened to occur several times in the past (or have been worked out laboriously by a process of trial and e

lement. It is easy and safe to prophesy, for exam- ple, that a period of high interest rates will lead to a sharp decline in the market. The question is, “How soon?” There is no scientific way of answer- ing this question. Many of the forecasting services are therefore driven to a sort of pseudo-science, in which they take it for granted that certain time lags or certain coincidences that happened to occur several times in the past (or have been worked out laboriously by a process of trial and error), can be counted upon to occur in much the same way in the future. Broadly speaking, therefore, the endeavor to forecast security-price changes by reference to mechanical indices is open to the same objections as the methods of the chart readers. They are not truly scientific, because there is no convincing reasoning to support them and because, further- more, really scientific (i.e., entirely dependable) forecasting in the economic field is a logical impossibility. Disadvantages of Market Analysis as Compared with Security Analysis. We return in consequence to our earlier conclusion that mar- ket analysis is an art for which special talent is needed in order to pur- sue it successfully. Security analysis is also an art; and it, too, will not yield satisfactory results unless the analyst has ability as well as knowl- edge. We think, however, that security analysis has several advantages over market analysis, which are likely to make the former a more suc- cessful field of activity for those with training and intelligence. In secu- rity analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid. The underlying idea is that even if the security turns out to be less attractive than it appeared, the com- mitment might still prove a satisfactory one. In market analysis there are no margins of safety; you are either right or wrong, and, if you are wrong, yo

for those with training and intelligence. In secu- rity analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid. The underlying idea is that even if the security turns out to be less attractive than it appeared, the com- mitment might still prove a satisfactory one. In market analysis there are no margins of safety; you are either right or wrong, and, if you are wrong, you lose money.6 6 Viewing the two activities as possible professions, we are inclined to draw an analogous comparison between the law and the concert stage. A talented lawyer should be able to make a respectable living; a talented, i.e., a “merely talented,” musician faces heartbreaking obsta- cles to a successful concert career. Thus, as we see it, a thoroughly competent securities ana- lyst should be able to obtain satisfactory results from his work, whereas permanent success as a market analyst requires unusual qualities—or unusual luck. The cardinal rule of the market analyst that losses should be cut short and profits safeguarded (by selling when a decline commences) leads in the direction of active trading. This means in turn that the cost of buy- ing and selling becomes a heavily adverse factor in aggregate results. Operations based on security analysis are ordinarily of the investment type and do not involve active trading. A third disadvantage of market analysis is that it involves essentially a battle of wits. Profits made by trading in the market are for the most part realized at the expense of others who are trying to do the same thing. The trader necessarily favors the more active issues, and the price changes in these are the resultant of the activities of numerous operators of his own type. The market analyst can be hopeful of success only upon the assumption that he will be more clever or perhaps luckier than his competitors. The work of the securities analy

nvolves essentially a battle of wits. Profits made by trading in the market are for the most part realized at the expense of others who are trying to do the same thing. The trader necessarily favors the more active issues, and the price changes in these are the resultant of the activities of numerous operators of his own type. The market analyst can be hopeful of success only upon the assumption that he will be more clever or perhaps luckier than his competitors. The work of the securities analyst, on the other hand, is in no similar sense competitive with that of his fellow analysts. In the typical case the issue that he elects to buy is not sold by some one who has made an equally painstaking analysis of its value. We must emphasize the point that the security analyst examines a far larger list of securities than does the market analyst. Out of this large list, he selects the exceptional cases in which the market price falls far short of reflecting intrinsic value, either through neglect or because of undue emphasis laid upon unfavorable factors that are probably temporary. Market analysis seems easier than security analysis, and its rewards may be realized much more quickly. For these very reasons, it is likely to prove more disappointing in the long run. There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else. Prophesies Based on Near-term Prospects. A good part of the analy- sis and advice supplied in the financial district rests upon the near-term business prospects of the company considered. It is assumed that, if the out- look favors increased earnings, the issue should be bought in the expecta- tion of a higher price when the larger profits are actually reported. In this reasoning, security analysis and market analysis are made to coincide. The market prospect is thought to be identical with the business prospect. But to our mind the theory of buying stocks chiefly upon the basis of their immediate outlook mak

rests upon the near-term business prospects of the company considered. It is assumed that, if the out- look favors increased earnings, the issue should be bought in the expecta- tion of a higher price when the larger profits are actually reported. In this reasoning, security analysis and market analysis are made to coincide. The market prospect is thought to be identical with the business prospect. But to our mind the theory of buying stocks chiefly upon the basis of their immediate outlook makes the selection of speculative securities entirely too simple a matter. Its weakness lies in the fact that the current market price already takes into account the consensus of opinion as to future prospects. And in many cases the prospects will have been given more than their just need of recognition. When a stock is recommended for the reason that next year’s earnings are expected to show improve- ment, a twofold hazard is involved. First, the forecast of next year’s results may prove incorrect; second, even if correct, it may have been discounted or even overdiscounted in the current price. If markets generally reflected only this year’s earnings, then a good esti- mate of next year’s results would be of inestimable value. But the premise is not correct. Our table on page 707 shows on the one hand the annual earnings per share of United States Steel Corporation common and on the other hand the price range of that issue for the years 1902–1939. Exclud- ing the 1928–1933 period (in which business changes were so extreme as necessarily to induce corresponding changes in stock prices), it is difficult to establish any definite correlation between fluctuations in earnings and fluctuations in market quotations. In Appendix Note 70 (on accompanying CD), we reproduce signifi- cant parts of the analysis and recommendation concerning two common stocks made by an important statistical and advisory service in the latter part of 1933. The recommendations are seen to be based largely

which business changes were so extreme as necessarily to induce corresponding changes in stock prices), it is difficult to establish any definite correlation between fluctuations in earnings and fluctuations in market quotations. In Appendix Note 70 (on accompanying CD), we reproduce signifi- cant parts of the analysis and recommendation concerning two common stocks made by an important statistical and advisory service in the latter part of 1933. The recommendations are seen to be based largely upon the apparent outlook for 1934. There is no indication of any endeavor to ascertain the fair value of the business and to compare this value with the current price. A thorough-going statistical analysis would point to the conclusion that the issue of which the sale is advised was selling below its intrinsic value, just because of the unfavorable immediate prospects, and that the opposite was true of the common stock recommended as worth holding because of its satisfactory outlook. We are sceptical of the ability of the analyst to forecast with a fair degree of success the market behavior of individual issues over the near- term future—whether he base his predictions upon the technical posi- tion of the market or upon the general outlook for business or upon the specific outlook for the individual companies. More satisfactory results are to be obtained, in our opinion, by confining the positive conclusions of the analyst to the following fields of endeavor: 1. The selection of standard senior issues that meet exacting tests of safety. 2. The discovery of senior issues that merit an investment rating but that also have opportunities of an appreciable enhancement in value. 3. The discovery of common stocks, or speculative senior issues, that appear to be selling at far less than their intrinsic value. 4. The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage ope

ard senior issues that meet exacting tests of safety. 2. The discovery of senior issues that merit an investment rating but that also have opportunities of an appreciable enhancement in value. 3. The discovery of common stocks, or speculative senior issues, that appear to be selling at far less than their intrinsic value. 4. The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage operations. A SUMMARY OF OUR VIEWS ON INVESTMENT POLICIES If we transfer our attention, finally, from the analyst to the owner of secu- rities, we may briefly express our views on what he may soundly do and not do. The following résumé makes some allowance for different cate- gories of investors. A. The Investor of Small Means. 1. Investment for Income. In his case the only sensible investment for safety and accumulated income, under pres- ent conditions, is found in United States Savings Bonds. Other good invest- ments yield little if any more, and they have not equal protection against both ultimate and intermediate loss. Straight bonds and preferred stocks ostensibly offering a higher return are almost certain to involve an appre- ciable risk factor. The various types of “savings plans” and similar securi- ties offered by salesmen are full of pitfalls; the investor persuaded by their promise of liberal income to prefer them to United States Savings Bonds is very, very likely to regret his choice. 2. Investment for Profit. Four approaches are open to both the small and the large investor: a. Purchase of representative common stocks when the market level is clearly low as judged by objective, long-term standards. This policy requires patience and courage and is by no means free from the possibil- ity of grave miscalculation. Over a long period we believe that it will show good results. b. Purchase of individual issues with special growth possibilities, when these can be obtai

t his choice. 2. Investment for Profit. Four approaches are open to both the small and the large investor: a. Purchase of representative common stocks when the market level is clearly low as judged by objective, long-term standards. This policy requires patience and courage and is by no means free from the possibil- ity of grave miscalculation. Over a long period we believe that it will show good results. b. Purchase of individual issues with special growth possibilities, when these can be obtained at reasonable prices in relation to actual accomplishment. Where growth is generally expected, the price is rarely reasonable. If the basis of purchase is a confidence in future growth not held by the pub- lic, the operation may prove sound and profitable; it may also prove ill- founded and costly. c. Purchase of well-secured privileged senior issues. A combination of really adequate security with a promising conversion or similar right is a UNITED STATES STEEL COMMON, 1901–1939 Year Earned per share Range of market price High Low Average 1901 $ 9.1 55 24 40 1902 10.7 47 30 39 1903 4.9 40 10 25 1904 1.0 34 8 21 1905 8.5 43 25 34 1906 14.3 50 33 42 1907 15.6 50 22 36 1908 4.1 59 26 48 1909 10.6 95 41 68 1910 12.2 91 61 76 1911 5.9 82 50 66 1912 5.7 81 58 70 1913 11.0 69 50 60 1914 0.3(d) 67 48 58 1915 10.0 90 38 64 1916 48.5 130 80 105 1917 39.2 137 80 109 1918 22.1 117 87 102 1919 10.1 116 88 102 1920 16.6 109 76 93 1921 2.2 87 70 79 1922 2.8 112 82 97 1923 16.4 110 86 98 1924 11.8 121 94 108 1925 12.9 139 112 126 1926 18.0 161 117 139 1927* 12.3 246 155 201 1927† 8.8 176 111 144 1928 12.5 173 132 153 1929 21.2 262 150 206 1930 9.1 199 134 167 1931 1.4(d) 152 36 99 1932 11.1(d) 53 21 37 1933 7.1(d) 68 23 46 1934 5.4(d) 60 29 45 1935 2.8(d) 51 28 40 1936 2.9 80 46 63 1937 8.0 127 49 88 1938 3.8(d) 71 38 55 1939 1.84 83 41 62 * Before allowing for 40% stock dividend. † After allowing for 40% stock dividend. rare but by no means unknown phenomenon. A policy of caref

24 11.8 121 94 108 1925 12.9 139 112 126 1926 18.0 161 117 139 1927* 12.3 246 155 201 1927† 8.8 176 111 144 1928 12.5 173 132 153 1929 21.2 262 150 206 1930 9.1 199 134 167 1931 1.4(d) 152 36 99 1932 11.1(d) 53 21 37 1933 7.1(d) 68 23 46 1934 5.4(d) 60 29 45 1935 2.8(d) 51 28 40 1936 2.9 80 46 63 1937 8.0 127 49 88 1938 3.8(d) 71 38 55 1939 1.84 83 41 62 * Before allowing for 40% stock dividend. † After allowing for 40% stock dividend. rare but by no means unknown phenomenon. A policy of careful selec- tion in this field should bring good results, provided the investor has the patience and persistence needed to find his opportunities. d. Purchase of securities selling well below intrinsic value. Intrinsic value takes into account not only past earnings and liquid asset values but also future earning power, conservatively estimated—in other words, qualitative as well as quantitative elements. We think that since a large percentage of all issues nowadays are relatively unpopular, there must be many cases in which the market goes clearly and crassly astray, thus cre- ating real opportunities for the discriminating student. These may be found in bonds, preferred stocks and common stocks. In our view, the search for and the recognition of security values of the types just discussed are not beyond the competence of the small investor who wishes to practice security analysis in a nonprofessional capacity, although he will undoubtedly need better than average intelli- gence and training. But we think it should be a necessary rule that the nonprofessional investor submit his ideas to the criticism of a professional analyst, such as the statistician of a New York Stock Exchange firm. Surely modesty is not incompatible with self-confidence; and there is logic in the thought that unless a man is qualified to advise others professionally, he should not, unaided, prescribe for himself. 3. Speculation. The investor of small means is privileged, of course, to step out of his role

ining. But we think it should be a necessary rule that the nonprofessional investor submit his ideas to the criticism of a professional analyst, such as the statistician of a New York Stock Exchange firm. Surely modesty is not incompatible with self-confidence; and there is logic in the thought that unless a man is qualified to advise others professionally, he should not, unaided, prescribe for himself. 3. Speculation. The investor of small means is privileged, of course, to step out of his role and become a speculator. (He is also privileged to regret his action afterwards.) There are various types of speculation, and they offer varying chances of success: a. Buying stock in new or virtually new ventures. This we can con- demn unhesitatingly and with emphasis. The odds are so strongly against the man who buys into these new flotations that he might as well throw three-quarters of the money out of the window and keep the rest in the bank. b. Trading in the market. It is fortunate for Wall Street as an institu- tion that a small minority of people can trade successfully and that many others think they can. The accepted view holds that stock trading is like anything else; i.e., with intelligence and application, or with good profes- sional guidance, profits can be realized. Our own opinion is sceptical, per- haps jaundiced. We think that, regardless of preparation and method, success in trading is either accidental and impermanent or else due to a highly uncommon talent. Hence the vast majority of stock traders are inevitably doomed to failure. We do not expect this conclusion to have much effect on the public. (Note our basic distinction between purchas- ing stocks at objectively low levels and selling them at high levels—which we term investment—and the popular practice of buying only when the market is “expected” to advance and selling when it is “due” to decline— which we call speculation.) c. Purchase of “growth stocks” at generous prices. In calling this “spec

e the vast majority of stock traders are inevitably doomed to failure. We do not expect this conclusion to have much effect on the public. (Note our basic distinction between purchas- ing stocks at objectively low levels and selling them at high levels—which we term investment—and the popular practice of buying only when the market is “expected” to advance and selling when it is “due” to decline— which we call speculation.) c. Purchase of “growth stocks” at generous prices. In calling this “spec- ulation,” we contravene most authoritative views. For reasons previously expressed, we consider this popular approach to be inherently dangerous and increasingly so as it becomes more popular. But the chances of indi- vidual success are much brighter here than in the other forms of specu- lation, and there is a better field for the exercise of foresight, judgment and moderation. B. The Individual Investor of Large Means. Although he has obvi- ous technical advantages over the small investor, he suffers from three special handicaps: 1. He cannot solve his straight investment problem simply by buying nothing but United States Savings Bonds, since the amount that any indi- vidual may purchase is limited. Hence he must, perforce, consider the broader field of fixed-value investment. We believe that strict application of quantitative tests, plus reasonably good judgment in the qualitative area, should afford a satisfactory end result. 2. However, the extraneous problem of possible inflation is more seri- ous to him than to the small investor. Since 1932 there has been a strong common-sense argument for some common-stock holdings as a defen- sive measure. In addition, a substantial holding of common stocks corre- sponds with the traditional attitude and practice of the wealthy individual. 3. The size of his investment unit is more likely to induce the large investor to concentrate on the popular and active issues. To some extent, therefore, he is handicapped in the application of

on is more seri- ous to him than to the small investor. Since 1932 there has been a strong common-sense argument for some common-stock holdings as a defen- sive measure. In addition, a substantial holding of common stocks corre- sponds with the traditional attitude and practice of the wealthy individual. 3. The size of his investment unit is more likely to induce the large investor to concentrate on the popular and active issues. To some extent, therefore, he is handicapped in the application of the undervalued-secu- rity technique. However, we imagine that a more serious obstacle thereto will be found in his preferences and prejudices. C. Investment by Business Corporations. We believe that United States government bonds, carrying exemption from corporate income taxes, are almost the only logical medium for such business funds as may properly be invested for a term of years. (Under 1940 conditions short-time investment involves as much trouble as income.) It seems fairly evident, on the whole, that other types of investments by business enterprises—whether in bonds or in stocks—can offer an appreciably higher return only at risk of loss and of criticism. D. Institutional Investment. We shall not presume to suggest poli- cies for financial institutions whose business it is to be versed in the the- ory and practice of investment. The same might be said for philanthropic and educational institutions, since these generally have the benefit of experienced financiers in shaping their financial policies. But in order not to dodge completely a very difficult issue, we venture the following final observation: An institution that can manage to get along on the low income provided by high-grade fixed-value issues should, in our opin- ion, confine its holdings to this field. We doubt if the better performance of common-stock indexes over past periods will, in itself, warrant the heavy responsibilities and the recurring uncertainties that are insepara- ble from a common-stock

their financial policies. But in order not to dodge completely a very difficult issue, we venture the following final observation: An institution that can manage to get along on the low income provided by high-grade fixed-value issues should, in our opin- ion, confine its holdings to this field. We doubt if the better performance of common-stock indexes over past periods will, in itself, warrant the heavy responsibilities and the recurring uncertainties that are insepara- ble from a common-stock investment program. This conclusion may per- haps be modified either if there is substantial unanimity of view that inflation must be guarded against or if the insufficiency of income com- pels search for a higher return. In such case those in charge may be war- ranted in setting aside a portion of the institution’s funds for administration in other than fixed-value fields, in accordance with the canons and technique of security analysis.7 7 Yale University now follows a policy of investing part of its funds in “equities”—defined as common stocks and nonpaying senior issues. The percentage varies in accordance with a fixed formula, somewhat as follows: The initial proportion is 30% of the total fund. Whenever a rise in the market level advances this figure to 40%, one-eighth of each stock holding is switched into bonds. Conversely, whenever a decline in the market reduces the proportion to 15%, bonds are sold and one-third additional of each stock is bought. See address of Laurence G. Tighe, Associate Treasurer of Yale University entitled “Present Day Investment Problems of Endowed Institutions,” delivered on February 14, 1940 before the Trust Division of the American Bankers Association. It was summarized in the New York Sun of February 20, 1940. PART VIII GLOBAL VALUE INVESTING Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank P ar t VIII

nce G. Tighe, Associate Treasurer of Yale University entitled “Present Day Investment Problems of Endowed Institutions,” delivered on February 14, 1940 before the Trust Division of the American Bankers Association. It was summarized in the New York Sun of February 20, 1940. PART VIII GLOBAL VALUE INVESTING Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank P ar t VIII GLOBE TROT TING WITH GRAHAM AND DODD BY THOM AS A. RUSSO have the privilege of introducing the part of Security Analysis that was never written, that on global investing. This was not a grievous omis- sion by the authors. After all, other than in Great Britain and a few European countries, global securities markets were still fairly undevel- oped when the second edition was published in 1940. I first learned of global value investing from Professor Jack McDonald at Stanford Business School in the early 1980s. McDonald regaled us with “war stories” about his own experiences investing abroad. Even as recently as the 1980s, foreign investing was difficult. By U.S. standards, overseas markets were illiquid and trading costs high. Accounting prac- tices were foreign, to say the least, and disclosure was less transparent than in the United States. That was not all. Consider the challenges posed to the would-be global investor by local corporate governance and management prac- tices; restrictions on capital movements; variations in taxation; differ- ences in language, culture, and political stability; unusual hours at which trades are executed; complexity of foreign exchange transactions; cur- rency risks; and logistics involved in managing custody of foreign securi- ties. Why bother? Oddly enough, it was Omaha, Nebraska’s Warren Buffett who cleared a path for me through this minefield. A guest lecturer in Professor [713] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by T

restrictions on capital movements; variations in taxation; differ- ences in language, culture, and political stability; unusual hours at which trades are executed; complexity of foreign exchange transactions; cur- rency risks; and logistics involved in managing custody of foreign securi- ties. Why bother? Oddly enough, it was Omaha, Nebraska’s Warren Buffett who cleared a path for me through this minefield. A guest lecturer in Professor [713] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. McDonald’s class, Buffett was not and still is not a specialist in global investing. Buffett, a student of Graham and Dodd’s at Columbia in the 1950s, had, by the early 1980s, evolved from being purely a balance sheet investor to being an investor who was seeking companies with exceptional business franchises that were run by honest, capable, and shareholder-friendly managements. Such companies are rare, so why limit yourself to just the United States? Because there is almost always a scarcity of great opportunity—Buf- fett says you are lucky to have 20 great ideas in your investing lifetime— a narrow search could result in less-than-optimal diversification. Investors can—and indeed, must—“compensate” for a sparse set of opportunities through a broad-based search. A deep and growing understanding of particular industries allows an investor to evaluate both domestic and foreign opportunities within a circle of competence. There may be local variations in tastes and laws, but the fundamental economics of producing, marketing, and distributing most goods and services transcend national boundaries. Using a focus like Buffett’s on the underlying economics of busi- nesses also helps an investor cope with national differences in account- ing and disclosure practices. Local accounting can be analyzed in the context of results of similarly situated companies in other countries. For example, if the implied returns of a Germa

re may be local variations in tastes and laws, but the fundamental economics of producing, marketing, and distributing most goods and services transcend national boundaries. Using a focus like Buffett’s on the underlying economics of busi- nesses also helps an investor cope with national differences in account- ing and disclosure practices. Local accounting can be analyzed in the context of results of similarly situated companies in other countries. For example, if the implied returns of a German beer company appear to deviate from those of French, British, and Italian brewers, there is a rea- sonable chance that the nuances of financial statements were misunder- stood and that further analysis of those numbers is required. Of course, discrepancies could also be explained by the local regulatory environ- ment or divergent consumer preferences. When results for an important subsidiary are not fully identified in the income statement, the numbers can be better understood by studying similar businesses in other coun- tries. For example, the profitability of brewing companies depends criti- cally on local distribution networks and local market share. A brewery subsidiary with a small share in a distant market is not likely to represent significant value. Finally, focusing on underlying business operations leads an investor to develop a global network of industry contacts that may help fill in the gaps in financial reports. Graham and Dodd—and Buffett—are properly concerned with the tendency of some managements to cling tightly to corporate assets, to withhold dividends, and to make acquisitions whose sole purpose seems to be to increase the prestige and salaries of management. That is why Buffett looks for managers who emphasize the long-term protection and enhancement of their business franchises and are primarily concerned with the effectiveness of a company’s capital allocation process. When investing in foreign companies, you really need the kind of managers that

the tendency of some managements to cling tightly to corporate assets, to withhold dividends, and to make acquisitions whose sole purpose seems to be to increase the prestige and salaries of management. That is why Buffett looks for managers who emphasize the long-term protection and enhancement of their business franchises and are primarily concerned with the effectiveness of a company’s capital allocation process. When investing in foreign companies, you really need the kind of managers that Buffett covets because corporate governance rules and manage- ment practices are generally less responsive to shareholder concerns than they are in the United States. If management does not get it right, you cannot count on your fellow shareholders to make it happen. Also, while cultural and language differences make it difficult to ren- der judgments based on direct contact with overseas managers, man- agement’s long-term record is available. You can judge past decisions, based on your knowledge of the industry’s best practices. Furthermore, as Buffett has frequently noted, simple businesses with strong franchises can be run by any idiot. Absent a track record, language and cultural dif- ferences make it difficult to identify, say, French, Czech, or Thai superstars from lesser lights. So Buffett’s “simple business, strong franchise” approach offers an extra measure of protection when investing abroad. Global Investing in Practice Since embarking on my own course of investing abroad over 20 years ago, I have encountered challenges relating to currency fluctuations, accounting practices, corporate disclosure, trading, and execution as well as my share of administrative barriers. While each of these challenges has abated over the years as non-U.S. markets have become somewhat more oriented to global investors, they all remain obstacles for many investors seeking to go global. Currency Risk I have often been quizzed by prospective investors about how I planned to protect again

er 20 years ago, I have encountered challenges relating to currency fluctuations, accounting practices, corporate disclosure, trading, and execution as well as my share of administrative barriers. While each of these challenges has abated over the years as non-U.S. markets have become somewhat more oriented to global investors, they all remain obstacles for many investors seeking to go global. Currency Risk I have often been quizzed by prospective investors about how I planned to protect against the risk of adverse foreign currency fluctuations. While some American investors prefer to hedge all foreign currency exposure back to U.S. dollars, I believe investor interests are best served by diversi- fying currency holdings. Given that Americans are exposed to multiple currencies in the goods and services they purchase, it only makes sense to have some foreign currency exposure. Gaining that exposure has not been easy. Prior to the euro’s arrival in 1992, investing in European companies required conversion, for instance, into a host of currencies. Managing multiple currency positions is cumber- some and sometimes subject to high transaction costs. That is why I event- ually gave up on, for instance, Figaro, Philip Morris’s Slovakia-based confec- tionery subsidiary. Maintaining Slovak currency exposure was too costly. Another factor is that, even if one were inclined to hedge, it would be surprisingly complicated to figure out a proper hedge. Most companies operate in multiple countries having different currencies. For example, investors who try to hedge away Nestlé’s Swiss franc exposure (its shares are listed in Switzerland) will have trouble knowing what currency to hedge against, as less than 5% of Nestlé’s revenues are in Swiss francs. Moreover, sometimes the most compelling investment opportunities arise when currencies are reeling and, thus, costly to hedge. For instance, in the early 1990s I invested in the Norwegian stock market after prices had collapsed as

countries having different currencies. For example, investors who try to hedge away Nestlé’s Swiss franc exposure (its shares are listed in Switzerland) will have trouble knowing what currency to hedge against, as less than 5% of Nestlé’s revenues are in Swiss francs. Moreover, sometimes the most compelling investment opportunities arise when currencies are reeling and, thus, costly to hedge. For instance, in the early 1990s I invested in the Norwegian stock market after prices had collapsed as a result of a shipping-industry crisis brought on by the Gulf War. The Scandinavian currencies were then under such pressure that a hedge—which was priced to build in further currency declines— would be prohibitively expensive. A strong argument could be made that not only were Norway’s stocks undervalued, its currency was too. The very thing that would cause Norwegian shares to rise—the end of the Gulf War—would also be bullish for the currency. Accounting Standards When I first began to invest abroad, U.S. investors would ask, “Can you rely on foreign company accounting?” Even then my answer was, “Com- pared to what?” While there are many shortcomings in foreign account- ing standards, in some cases they are actually more conservative than U.S. accounting rules. Meanwhile, our prized standards have not averted such accounting debacles as Enron’s and WorldCom’s frauds. Nonetheless, early accounting standards in foreign markets did make investing abroad tricky. One area of difficulty involved unconsolidated subsidiaries. Often, you could find no reference to such partially owned subsidiaries either on the income statement or the balance sheet, even though they represented a considerable amount of a company’s intrinsic value. Varied rules for treatment of goodwill, amortization, and deprecia- tion made apples-to-apples comparisons difficult for companies based in different countries. For instance, when I started investing in the Dutch brewer Heineken in the late 1980s, the c

involved unconsolidated subsidiaries. Often, you could find no reference to such partially owned subsidiaries either on the income statement or the balance sheet, even though they represented a considerable amount of a company’s intrinsic value. Varied rules for treatment of goodwill, amortization, and deprecia- tion made apples-to-apples comparisons difficult for companies based in different countries. For instance, when I started investing in the Dutch brewer Heineken in the late 1980s, the company looked less profitable than its U.S. com- petitors. But Heineken logged what were effectively excessive deprecia- tion charges because it used replacement cost accounting. Once adjusted under Generally Accepted Accounting Principles (GAAP), the brewer’s profitability shined through. That was an easy adjustment, enabled by good financial disclosure in the Heineken reports. Often, however, foreign companies fail to provide sufficient segment- level disclosures or worse yet they fail to disclose unconsolidated sub- sidiaries at all, and that makes these adjustments far more speculative. In such cases, investors have to insist on a wider margin of safety to protect against risks that arise from incomplete disclosure. Fortunately, world- wide accounting standards have improved over the years to require broader reporting of results by business segment and more disclosure of unconsolidated subsidiaries. Information Unavailable In some countries, information on public companies is often unavailable, and what is available is of poor quality. Some financial statements are not translated into English, especially in relatively small markets such as Norway and the Czech Republic. I have frequently hired translators to tell me what is in those reports. With the advent of Bloomberg and other data suppliers, more information is becoming available sooner and in English. However, news releases are often in the local language only. It is also hard for U.S. investors to arrange meetings

en unavailable, and what is available is of poor quality. Some financial statements are not translated into English, especially in relatively small markets such as Norway and the Czech Republic. I have frequently hired translators to tell me what is in those reports. With the advent of Bloomberg and other data suppliers, more information is becoming available sooner and in English. However, news releases are often in the local language only. It is also hard for U.S. investors to arrange meetings with manage- ment. I recall my first visit to Heineken in the late 1980s. When I was introduced to the vice chairman, he asked “What are you doing here?” in a way that showed he meant it. Indeed, he had likely never seen Ameri- can investors before, and he could not quite imagine why they might have an interest in the company. Similarly, when initially investing in the U.K.-based breakfast cereal manufacturer Weetabix, only once was I able to meet with anyone from management. Weetabix and Heineken were each controlled by their founding fami- lies, and there was little an investor could do to get management’s ear. Nonetheless, a careful read of each company’s reports showed that both were carefully run, shareholder-minded businesses. I can live with investor-shy managements, but I require a greater mar- gin of safety in making such investments. Still, there are limits. I recall visit- ing South Korea in the late 1990s following the Asian currency collapse. Meeting with senior management from one of South Korea’s leading candy makers, Lotte Confectionery, I asked management about prospects for the next year’s cash flow. The interpreter and management spoke for nearly 30 minutes, after which I got a one-word response: “Better.” Lacking any insight into the discussion that led to that insufficient answer, I walked away from this otherwise promising company. Who’s Got Custody? When I started investing abroad, few foreign companies had their shares listed in the United States in

t from one of South Korea’s leading candy makers, Lotte Confectionery, I asked management about prospects for the next year’s cash flow. The interpreter and management spoke for nearly 30 minutes, after which I got a one-word response: “Better.” Lacking any insight into the discussion that led to that insufficient answer, I walked away from this otherwise promising company. Who’s Got Custody? When I started investing abroad, few foreign companies had their shares listed in the United States in the form of now-common American Depositary Receipts (ADRs). That meant many American fiduciaries were effectively unable to invest abroad since they typically need to have domestic custody of shares. While I invest in both ADRs and local shares, some of my clients are able to hold only ADRs. Worse yet: some coun- tries have restrictions that really handcuff foreign investors. This was so in the mid-1980s when my investors who held shares in James Burroughs PLC (producer of Beefeater’s Gin) were barred by law from accepting a stock swap offer by Whitbread. Instead, they could take only cash. As such, they were denied the chance to participate in subse- quent acquisitions of Whitbread by Allied Domecq and of Allied Domecq by Pernod Ricard. Instead, they were forced to pay taxes on an unwill- ingly realized gain. Similarly, I have difficulty investing in some develop- ing markets (for example, India and China) due to the local securities markets’ regulations restricting foreign investments. U.S.-based investors have also been limited in the types of instruments in which they can invest. For instance, when I first invested in Nestlé in the mid-1980s, as non-Swiss investors we could not buy actual shares, only “participation certificates.” This was also true for both Weetabix and the Dutch-based media company De Telegraaf. Because a certificate holder would have fewer rights than a shareholder, I lowered the price I would pay to maintain a sufficient margin of safety in these sit

ts. U.S.-based investors have also been limited in the types of instruments in which they can invest. For instance, when I first invested in Nestlé in the mid-1980s, as non-Swiss investors we could not buy actual shares, only “participation certificates.” This was also true for both Weetabix and the Dutch-based media company De Telegraaf. Because a certificate holder would have fewer rights than a shareholder, I lowered the price I would pay to maintain a sufficient margin of safety in these situations. Completing foreign trades and maintaining foreign holdings remains a challenge today, even with the tidal wave of funds flowing into over- seas markets. Commissions remain fixed at high levels in most of them, and many of those markets levy fees and taxes atop the commissions. Finally, many U.S-based custodians charge extra fees for settling foreign trades; they also attempt to profit further on currency transactions. Col- lecting foreign dividends is typically delayed and subject to hefty com- missions for converting dividends into dollars. Moreover, tax-exempt investors, such as pension funds and endowments, have a miserable time trying to recover taxes on foreign dividends that are withheld by local authorities. Taxable investors can solve this by claiming a credit on their U.S. taxes for foreign taxes paid. Finally, it is difficult to vote proxies for foreign holdings as custodians often are notified of corporate actions late or not at all by their foreign subcustodians. Despite a litany of administrative and technical difficulties that remain even to this day, concerns regarding corporate governance and securities regulation are overblown. International corporate governance protections for investors, especially in Europe, increasingly resemble those in the United States. Nonexecutive board chairs exist in practice in many countries, a trend that is gaining steam in the United States. Addi- tionally, although European markets lack new mandates for corporate boa

Despite a litany of administrative and technical difficulties that remain even to this day, concerns regarding corporate governance and securities regulation are overblown. International corporate governance protections for investors, especially in Europe, increasingly resemble those in the United States. Nonexecutive board chairs exist in practice in many countries, a trend that is gaining steam in the United States. Addi- tionally, although European markets lack new mandates for corporate board conduct such as those recently promulgated in the United States under Sarbanes-Oxley, the reality is that their principles-based systems of corporate governance provide every bit as much protection as our coun- try’s rules-based structure. “Be Right Once”: Weetabix I always approach investing with a mindset that Warren Buffett once described as “being right once.” Find businesses selling at reasonable prices with superior brands that possess genuine competitive advantage, conservative capital structures, and an owner-minded management team that has evidenced a history of respecting shareholder interests. Let these owner-minded managements reinvest the abundant free cash flow their brands generate. Each business’s intrinsic value should grow over time, ideally at a rate high enough to deliver attractive investor returns far into the future. An example of such a company is Weetabix. I became aware of Weetabix about 20 years ago through my wife who, like everyone who spent their childhood in England, retains remarkable loyalty to its eponymous breakfast cereal, which is similar to Nabisco Shredded Wheat. It’s not my taste. But, through market research into the breakfast-cereal industry and through conversations with Weetabix’s global competitors, I discovered that Weetabix possesses not only intensely brand-loyal consumers but also a substantial share of the U.K. breakfast-cereal market. Could I invest in this company? I was impressed with the summary financials in a compan

dhood in England, retains remarkable loyalty to its eponymous breakfast cereal, which is similar to Nabisco Shredded Wheat. It’s not my taste. But, through market research into the breakfast-cereal industry and through conversations with Weetabix’s global competitors, I discovered that Weetabix possesses not only intensely brand-loyal consumers but also a substantial share of the U.K. breakfast-cereal market. Could I invest in this company? I was impressed with the summary financials in a company handbook, but getting more detailed information was difficult. What I discovered was that over the five years prior to my investment, Weetabix’s revenues had grown by over 60%. More important, operating income had gone from 2.2 pence a share loss in 1982 to 38.6 pence a share profit in 1986. Nonetheless, Weetabix’s operating margin, at just under 10%, was still modest by industry standards. That suggested further possible upside for margins. In addition, Weetabix’s balance sheet was conservative, with cash balances of 7 million pounds, which amounted to over 10% of its market capitalization. What’s more, the shares sold at a rea- sonable price-to-earnings ratio of 7, and a 14% free-cash-flow yield. On balance, Weetabix had a strongly branded product in its home market. Moreover, the company’s performance was improving under the manage- ment of Sir Richard George, an heir to Weetabix’s controlling family. My first investment in Weetabix illustrates how difficult it can be to invest abroad. First and foremost, Weetabix voting shares were rarely, if ever, traded. The nonvoting certificates, which my clients owned, traded on a market called OFEX, which was not one of the main exchanges— Weetabix shares indeed traded by appointment. The spreads between the bid and offer prices were enormous. On top of the wide spreads, transaction costs were high. Two brokers split the trading in Weetabix shares between them, so there was really no way to shop around for a better price. Despit

road. First and foremost, Weetabix voting shares were rarely, if ever, traded. The nonvoting certificates, which my clients owned, traded on a market called OFEX, which was not one of the main exchanges— Weetabix shares indeed traded by appointment. The spreads between the bid and offer prices were enormous. On top of the wide spreads, transaction costs were high. Two brokers split the trading in Weetabix shares between them, so there was really no way to shop around for a better price. Despite these obstacles, the stock was such a bargain that I became a very large buyer of shares. But there were other frustrations: for about a decade, I had enormous difficulties perfecting settlement for the shares I purchased, and collecting dividends was excruciating. Another reason Weetabix back then was so cheap was an investor bias against family-controlled companies. Investors often fear that family members in control of a public company may be indifferent to the share price or they may even divert assets to their personal benefit. Interest- ingly enough, I prefer to invest in family-controlled entities. Provided that you attach your interests to an honest clan, family control can actu- ally lead to better, not worse, long-term decisions that benefit sharehold- ers, not management. After all, a family controlling a company is free to make long-term decisions without worrying what others think. Finally, Weetabix management was unusually uncommunicative with investors. There were no fancy lunches at gilded brokerage offices within the City of London. There were few corporate news releases besides mandatory half-year and full-year results. There were no opportunities to meet with management at analyst meetings. Indeed, the annual chair- man’s letter to shareholders in the annual report provided the bulk of the information investors would receive. Numerous efforts notwithstand- ing, it was years before I met the CEO, even though my clients then held nearly 16% of the shares ou

ancy lunches at gilded brokerage offices within the City of London. There were few corporate news releases besides mandatory half-year and full-year results. There were no opportunities to meet with management at analyst meetings. Indeed, the annual chair- man’s letter to shareholders in the annual report provided the bulk of the information investors would receive. Numerous efforts notwithstand- ing, it was years before I met the CEO, even though my clients then held nearly 16% of the shares outstanding. While such inaccessibility discouraged many investors, I appreciated management’s practice of focusing on the company’s operating prospects and letting results speak for themselves. As I saw no evidence of self-dealing over the years, I was comfortable with management’s suc- cess at building shareholder value. Best of all, the very difficulty that caused the stock to be undervalued when I first learned of it caused it to remain undervalued over time. I was delighted with the chance to con- tinue to add to holdings at market prices below intrinsic value. By the time Weetabix’s shares were acquired in 2003, my original investment had increased tenfold. Summing Up The bottom line is that Graham and Dodd’s—and Buffett’s—principles are equally suited to international markets as they are to the U.S. market. Indeed, because so many investors are scouring the U.S. markets for bar- gains, some foreign markets remain considerably less efficient, domi- nated by short-term trends, rumors, and overreactions to new developments. What could be better for value investors? This page intentionally left blank ABOUT THIS EDITION his project began in late 2006 when I was approached by an editor at McGraw-Hill about putting together a new edition of Security Analysis. I agreed to take on this project as lead editor, and over the months that followed, we assembled a team of three additional edi- tors: a prominent financial writer and historian, a leading

mors, and overreactions to new developments. What could be better for value investors? This page intentionally left blank ABOUT THIS EDITION his project began in late 2006 when I was approached by an editor at McGraw-Hill about putting together a new edition of Security Analysis. I agreed to take on this project as lead editor, and over the months that followed, we assembled a team of three additional edi- tors: a prominent financial writer and historian, a leading value-investing academic, and an experienced financial journalist. We also had modern- day practitioners comment on the original text, thereby providing a fresh perspective based on their own approaches to value investing. We added a new essay on global value investing. Because these contributions were submitted and edited during the second half of 2007 and early 2008, you will not see references to the deepening credit crisis and sharp financial market sell-off that very nearly bankrupted the venerable investment bank Bear Stearns in March 2008. The reason is that instead of focusing myopically on very recent develop- ments, we took a long-term view that would be applicable in both good markets and bad, and, like Graham and Dodd, we concerned ourselves chiefly with “concepts, methods, standards, principles, and, above all, with logical reasoning.” We decided to base this sixth edition on the second edition of Secu- rity Analysis, published in 1940, because it was the most comprehensive edition, and we also decided not to alter the text of this classic work. By proceeding in this fashion, we hope that readers will gain both an appre- ciation for the magisterial accomplishment of Graham and Dodd in their [725] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. exact words as well as insight into what is still relevant and important even in today’s vastly changed world. This project has brought together 11 contribu

e edition, and we also decided not to alter the text of this classic work. By proceeding in this fashion, we hope that readers will gain both an appre- ciation for the magisterial accomplishment of Graham and Dodd in their [725] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. exact words as well as insight into what is still relevant and important even in today’s vastly changed world. This project has brought together 11 contributors in a collaboration that is emblematic of the nature of the value-investing community. Many of us are business rivals, but we are also friends and colleagues. All of us know that no one of us possesses all the answers; we vividly remember our biggest mistakes as if they happened yesterday. Similarly, we recog- nize that none of us has perfected the art of value investing; there are always new challenges, and there is always room to improve. By assem- bling the diverse perspectives of these experienced and able contributors and editors, we hope to make this sixth edition of Security Analysis a rich, varied, and highly informed tapestry of investment thinking that will be a worthy and long-lived successor to the five preceding editions. Seth A. Klarman Lead Editor May 2008 owe much to the coeditors and contributors who found time in their busy lives to share their insights and experiences for the readers of this edition. On behalf of all of them, I would like to acknowledge our authors, Benjamin Graham and David Dodd. Through their writings and legacy, they have touched each of us in important ways; obviously, with- out them, this collaboration would never have happened. I would also like to thank Warren Buffett for his very personal foreword and, more important, for serving as the living embodiment of Graham and Dodd’s principles of value investing, sound reasoning, high integrity, and gen- erosity through the avenues of teaching and philanthropy. In addition, I

our authors, Benjamin Graham and David Dodd. Through their writings and legacy, they have touched each of us in important ways; obviously, with- out them, this collaboration would never have happened. I would also like to thank Warren Buffett for his very personal foreword and, more important, for serving as the living embodiment of Graham and Dodd’s principles of value investing, sound reasoning, high integrity, and gen- erosity through the avenues of teaching and philanthropy. In addition, I must acknowledge a debt to Leah Spiro, who had the idea to bring together leading practitioners of value investing to tell us how they apply Graham and Dodd’s principles today. This collaboration was difficult to orchestrate, and some doubted it could be done. Indeed, the project would have faltered if not for her persistence and leadership. My thanks also goes to the many professionals at McGraw-Hill—includ- ing Philip Ruppel, Herb Schaffner, Laura Friedman, Seth Morris, Lydia Rinaldi, Anthony Landi, Jane Palmieri, and Maureen Harper—who ensured that this would be a work of which we could all be proud. Seth A. Klarman Lead Editor [727] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank Seth A. Klarman, president of the Boston-based Baupost Group, L.L.C., manages a series of successful investment partnerships using Graham and Dodd principles. In his preface, Klarman discusses the timelessness of their philosophy, the changes in the environment with which value investors must work, and the unanswerable questions that will always require value investors to work hard. He is also the author of Margin of Safety, a classic investment book. Klarman is the lead editor of this sixth edition. James Grant, founder and editor of Grant’s Interest Rate Observer, has been writing about markets and financial figures for over 30 years. He is the author of five books

Klarman discusses the timelessness of their philosophy, the changes in the environment with which value investors must work, and the unanswerable questions that will always require value investors to work hard. He is also the author of Margin of Safety, a classic investment book. Klarman is the lead editor of this sixth edition. James Grant, founder and editor of Grant’s Interest Rate Observer, has been writing about markets and financial figures for over 30 years. He is the author of five books, including biographies of financier Bernard Baruch and President John Adams. He is a founding general partner of Nippon Partners, a hedge fund that invests in Japan. Grant’s introduction takes us back to Graham and Dodd’s era to put Security Analysis in a his- torical perspective. He also served as an editor of this sixth edition. Roger Lowenstein, one of America’s top financial journalists, gives us his keen insights into contemporary value investing. Lowenstein is a fre- quent contributor to the New York Times Magazine, Portfolio, and Smart Money. He is also the bestselling author of the books Buffett: The Making of an American Capitalist and When Genius Failed: The Rise and Fall of Long-Term Capital. His most recent book is While America Aged. Lowen- stein is also an outside director of the Sequoia Fund. [729] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. Howard S. Marks, CFA, chairman and cofounder of Oaktree Capital Man- agement based in Los Angeles, was an early investor in high yield bonds and a devotee of Graham and Dodd. At first glance, those two ideas appear to be antithetical, but Marks says that’s not the case. His intro- duction to Part II, which is about fixed income investments, explains how the ideas in Security Analysis can be applied profitably to today’s corpo- rate bond market. J. Ezra Merkin, managing partner of Gabriel Capital Group in New York City, is one of today’s leading investor

ital Man- agement based in Los Angeles, was an early investor in high yield bonds and a devotee of Graham and Dodd. At first glance, those two ideas appear to be antithetical, but Marks says that’s not the case. His intro- duction to Part II, which is about fixed income investments, explains how the ideas in Security Analysis can be applied profitably to today’s corpo- rate bond market. J. Ezra Merkin, managing partner of Gabriel Capital Group in New York City, is one of today’s leading investors in corporate bankruptcy and distressed securities. In “Blood and Judgement,” which is the introduction to Part III, Merkin lays out various bankruptcy scenarios using real examples and analyzes them as investment opportunities from a value buyer’s perspective. Bruce Berkowitz is the founder of Fairholme Capital Management and the manager of the Fairholme Fund, a value mutual fund. This Miami- based investor offers his insights on corporate dividends and their modern-day equivalent, free cash flow. Using examples and anecdotes from his own experience, Berkowitz provides this key update to Graham and Dodd’s wisdom. Glenn H. Greenberg, CFA, cofounder and managing director of New York–based Chieftain Capital Management, admits flat out that he never read Security Analysis in business school and that even midway through his career, he found the text a bit fusty. Going back to the book after more than three decades on Wall Street, he finds it remarkable for its enduring sound advice. His introduction to Part V shows us how to assess companies and their income statements with a value investor’s eye. Bruce Greenwald is the Robert Heilbrunn Professor of Finance and Asset Management at Columbia Business School, and he also heads the Heil- brunn Center for Graham and Dodd Investing. In his introduction to Part VI, About the Contributors [731] he tears apart the corporate balance sheet and shares his unique insights on this most important of financial statements. He is the author o

ntroduction to Part V shows us how to assess companies and their income statements with a value investor’s eye. Bruce Greenwald is the Robert Heilbrunn Professor of Finance and Asset Management at Columbia Business School, and he also heads the Heil- brunn Center for Graham and Dodd Investing. In his introduction to Part VI, About the Contributors [731] he tears apart the corporate balance sheet and shares his unique insights on this most important of financial statements. He is the author of Value Investing: From Graham to Buffett and Beyond. He also served as an editor of this sixth edition. David Abrams heads his own investment partnership, Boston-based Abrams Capital Management. In “The Great Illusion of the Stock Market and the Future of Value Investing,” which is the introduction to Part VII, Abrams offers his early experiences in and lessons from the investment business and makes the dry subject of warrants and options come alive. Thomas A. Russo is a partner in Gardner Russo & Gardner, which is based in Lancaster, Pennsylvania, and is a general partner of Semper Vic Partners, L.P. Russo has specialized in global value investing for over 20 years. His essay introduces the part of the book that was never written— value investing in global markets. The subject was small bore in Graham and Dodd’s day, but it is of great importance now. Jeffrey M. Laderman, CFA, served as an editor of this sixth edition. He is a 25-year veteran of BusinessWeek and has written and edited articles on everything from stock market crises to trading scandals. He is now the editor of On the Markets and The View, publications that go to the clients of Smith Barney and Citi Private Bank respectively. This page intentionally left blank ABOUT THE AUTHORS Benjamin Graham was a seminal figure on Wall Street and is widely acknowledged to be the father of modern security analysis. The founder of the value school of investing and founder and former president of the

d articles on everything from stock market crises to trading scandals. He is now the editor of On the Markets and The View, publications that go to the clients of Smith Barney and Citi Private Bank respectively. This page intentionally left blank ABOUT THE AUTHORS Benjamin Graham was a seminal figure on Wall Street and is widely acknowledged to be the father of modern security analysis. The founder of the value school of investing and founder and former president of the Graham-Newman corporation investment fund, Graham taught at Columbia University’s Graduate School of Business from 1928 through 1957. He popularized the examination of price-to-earnings (P/E) ratios, debt-to-equity ratios, dividend records, book values, and earnings growth, and also wrote the popular investors’ guide The Intelligent Investor. David L. Dodd was a colleague of Benjamin Graham’s at Columbia University, where he was an assistant professor of finance. Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank INDEX A A. E. Staley Manufacturing Company, 514–517, 518 Abbott Laboratories, 29, 34 Accounting standards, global investing and, 717–718 Acme Steel, 461n Adams-Mills, 502 Adelphia, 274, 275 “The Adelphia Story” (Leonard), 274n Advance-Rumely Corporation, 693n The Adventure Company, Ltd., 100n Aeolian Company, 199n, 243 Aer Lingus, 399 Aeronautical Corporation of America, 639–640 Affiliated Fund, Inc., 248, 309n Ahmeek Mine, 488 Ajax Rubber Company, 329 Alaska Juneau Gold Mining Company, 90, 465, 487n Albertson’s, 275 Alexander, Greg, 50–51 Alleghany Corporation, 248n, 645, 646 Allied Chemical and Dye Corporation, 94n, 463n Allied Domecq, 719 Allied Owners Corporation, 203n Allis-Chalmers Manufacturing Company, 693n Alton, 212 Amalgamated Laundries, Inc., 686 Amazon.com, 53–54, 347 American Airlines, 504 American and Fore

99 Aeronautical Corporation of America, 639–640 Affiliated Fund, Inc., 248, 309n Ahmeek Mine, 488 Ajax Rubber Company, 329 Alaska Juneau Gold Mining Company, 90, 465, 487n Albertson’s, 275 Alexander, Greg, 50–51 Alleghany Corporation, 248n, 645, 646 Allied Chemical and Dye Corporation, 94n, 463n Allied Domecq, 719 Allied Owners Corporation, 203n Allis-Chalmers Manufacturing Company, 693n Alton, 212 Amalgamated Laundries, Inc., 686 Amazon.com, 53–54, 347 American Airlines, 504 American and Foreign Power Company, 115, 649–651, 694 American Arch Company, 94 American Austin Car Company, 638–639 American Bantam Car Corporation, 626, 638–639 American Book, 92n American Can, 23, 93, 350, 351, 353, 354–355, 458–459, 461, 606 American Car and Foundry Company, 200n, 457, 458–460 American Cigarette and Cigar, 532n American Commercial Alcohol Corporation, 598, 599 American Depositary Receipts (ADRs), 719 American Electric Power Corporation, 318 American European Securities Company, 248 American Express, 40 American Founders, 647–648 American Gas and Electric, 151 American Glue, 585 American Hide and Leather Company, 334 American Home Products, 34 American Ice Company, 454 American Laundry Machinery Company, 480, 509n, 573, 672 [735] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. American Light and Traction Company, 652 American Locomotive Company, 91, 454–455, 481n American Machine and Foundry, 160n, 245 American Machine and Metals, Inc., 421–423, 424–425 American Maize Products Company, 514–517 American Metals Company, 429 American Rolling Mill Company, 597 American Safety Razor, 502 American Seating, 330, 674 American Smelting and Refining Company, 429, 606 American Steel Foundries, 93, 460 American Sugar Refining Company, 160n, 377–378, 457–458, 459–460 American Sumatra Tobacco, 93n American Telegraph and Cable Company, 211 American Telephone and Telegraph Company (AT&T), 23, 44, 77, 96, 117, 314n, 315, 3

ine and Metals, Inc., 421–423, 424–425 American Maize Products Company, 514–517 American Metals Company, 429 American Rolling Mill Company, 597 American Safety Razor, 502 American Seating, 330, 674 American Smelting and Refining Company, 429, 606 American Steel Foundries, 93, 460 American Sugar Refining Company, 160n, 377–378, 457–458, 459–460 American Sumatra Tobacco, 93n American Telegraph and Cable Company, 211 American Telephone and Telegraph Company (AT&T), 23, 44, 77, 96, 117, 314n, 315, 321, 545, 590n American Terminals and Transit Company, 113n American Tobacco Company, 201n, 218–219, 250, 305, 306, 444, 445, 532n, 676 American Type Founders Company, 221 American Water Works and Electric Company, 504–505, 513–514, 693 American Water Works Company, 90 American Woolen, 91, 606 American Zinc, 509n American Zinc, Lead and Smelting Company, 197n, 332–333 Amortization: of bond discount, in income account, 433–434 of good-will, 471 of leaseholds and leasehold improvements, 470–471 of oil and ore reserves, 464–469 of patents, 471 Anaconda Copper Mining Company, 316, 317, 465, 594 Anacostia and Potomac River Railroad Company, 210 Analytical technique, limitation by character and purposes of commitment, 81–82 “Analyzing the Stock Market” (Gartley), 699n Anderson, Benjamin M., 6n Ann Arbor Railroad Company, 448n–449n Annual reports as information source, 91–94 Appraisals of real estate, 185 Archer-Daniels-Midland Company, 592–593, 598 “Are Oil Earnings Reports Fictitious” (Braunthal), 467n Argentina, 175 Armour and Company of Delaware, 221, 421 Armour and Company of Illinois, 221 Arndt, Michael, 272n Ashland Home Telephone, 245n Asian stocks, selling down of, investing and, 50–51 Asset(s): mispricing of, capitalizing on, 621–622 realizable value of, 560–562 Asset valuation: importance placed on, 539–540 of intangible assets, 543 modern information resources for, 542 related to earnings power, 543–544 Associated Gas and Electric Company, 115, 205n, 319, 434 Associat

unthal), 467n Argentina, 175 Armour and Company of Delaware, 221, 421 Armour and Company of Illinois, 221 Arndt, Michael, 272n Ashland Home Telephone, 245n Asian stocks, selling down of, investing and, 50–51 Asset(s): mispricing of, capitalizing on, 621–622 realizable value of, 560–562 Asset valuation: importance placed on, 539–540 of intangible assets, 543 modern information resources for, 542 related to earnings power, 543–544 Associated Gas and Electric Company, 115, 205n, 319, 434 Associated Oil Company, 160n Atchison, Topeka and Santa Fe Railway Company, 149–151, 158n, 200n, 203, 204, 212, 302–303, 309n, 321, 350, 351–352, 353, 355, 377–378, 379–380, 388, 658 Atlantic Coast Line, 444 Atlas Tack, 680n Austin Nichols and Company, 198 Australia, 175 Austria, 175 Automated Data Processing, 340 AutoZone, 58 Ayres, Leonard P., 702 B B. F. Goodrich, 245, 606 Badger, R. E., 193n Bagehot, Walter, 143 Balance sheet, 93–94 asset valuation and (see Asset valuation) as check on published earnings statement, 437–438 checking effect of losses or profits on financial position and, 600–607 checking up on reported earnings per share on, 598–600 comparison over time, 598–613 long-range study of earning power and resources and, 607–613 usefulness of, 538–539 Baldwin Locomotive Works, 90, 457, 459, 606 Balsam, Jerome, 265n Baltimore and Ohio Railroad Company, 239, 244, 257n Bangor and Aroostook Railroad, 177–178, 679 Bank debt, large, as sign of weakness, 594–596 Bank loans of intermediate maturity, 597–598 Bankruptcy: bondholders and, 231–236 price patterns produced by, 686–687 price-value discrepancies and, 685–687 protective committee and, 240–241 tendency to sell below fair value and, 236–237 varieties of, 268–270 voluntary readjustment plans and, 237–239 (See also Distressed investing) Bankruptcy Abuse Protection and Consumer Protection Act of 2005, 270n Bankruptcy Act of 1898, 270n Barclay v. Wabash Railway, 199n Bargain hunting, 50–53 Barker Bros. Corp., 522–523 Barnhart

te maturity, 597–598 Bankruptcy: bondholders and, 231–236 price patterns produced by, 686–687 price-value discrepancies and, 685–687 protective committee and, 240–241 tendency to sell below fair value and, 236–237 varieties of, 268–270 voluntary readjustment plans and, 237–239 (See also Distressed investing) Bankruptcy Abuse Protection and Consumer Protection Act of 2005, 270n Bankruptcy Act of 1898, 270n Barclay v. Wabash Railway, 199n Bargain hunting, 50–53 Barker Bros. Corp., 522–523 Barnhart Bros. and Spindler Company, 221 Barnsdall Oil Company, 451–452, 620–621 Baruch, Bernard M., 16 Basic-stock inventory accounting, 429–430 Bayuk Cigars, Inc., 303 Bear Stearns, 725 Belding, Heminway Company, 329 Belgium, 174, 175 Bemis Brothers’ Bag, 92n Bendix Aviation Corporation, 423 Berkey and Gay Furniture Company, 252, 330 Berkshire Hathaway, 40, 287n, 342, 344–345 Berle, A. A., Jr., 199n, 576, 577 Bethlehem Steel Company, 305–306, 461, 462, 481n, 579, 682–683, 691–692 Better Business Bureau of New York City, 259n Beuhler, Alfred G., 392n Bloomberg, 718 Bloomberg, Lawrence N., 558n Bloomingdale’s, 43 “Blue-sky flotation,” 259n Boeing Airplane Company, 678 Bolivia, 175 Bon Ami, 93n Bond(s), 123–140 amortization of discount on, 433–434 avoidance of loss and, 143 buying on depression basis, 154–164, 266 collapses of, causes of, 157–161 collateral-trust, 182–183 common sense and, 135–137 conflicting views on financing by, 161–162 convertible (see Convertible issues) durability of Security Analysis and, 137–140 early maturing, danger of, 596–597 equipment obligations, 180–182 evolution of investment standards and, 125–126 exclusion by New York statute, 171–172 Federal Land Bank, 213–214 as fixed-value investment, 141–143 of foreign corporations, 176 foreign-government, 173–175 high-grade (see High-grade bonds) income, 202–208 investing vs. speculating and, 102 investment absolutes and, 126 investment standards for, 169–179, 180–189 investment vs. speculation and, 126–128

curity Analysis and, 137–140 early maturing, danger of, 596–597 equipment obligations, 180–182 evolution of investment standards and, 125–126 exclusion by New York statute, 171–172 Federal Land Bank, 213–214 as fixed-value investment, 141–143 of foreign corporations, 176 foreign-government, 173–175 high-grade (see High-grade bonds) income, 202–208 investing vs. speculating and, 102 investment absolutes and, 126 investment standards for, 169–179, 180–189 investment vs. speculation and, 126–128 investment-trust, protective provisions for, 247–252 legal rights of bondholders and, 230–231 low-priced, limitation of profit on, 323–324 mortgage, 215–218 Oaktree Capital Management investment methodology for, 130–135 pragmatic approach for, 128–130 protective covenants and (see Protective covenants) railroads, unsound financial policies followed by, 162 real estate, 183–189 as safe investment, rejection of rule by Graham and Dodd, 43 sound, unavailability of, 161 speculative, 28, 324–325 subordination to bank debt in reorganization, 243 of subsidiary companies, 226–227 “underlying,” 152–153 undervalued, market exaggerations due to, 683–685 working-capital requirements and, 245–246 zero-coupon, 284 Bond and Mortgage Guarantee Company, 216 Bond prices, interest rates and, 25–27 Book value, 548–558 of common stocks, treatment of preferred stocks and, 550–551 computation of, 548–550 current-asset value and cash-asset value and, 553–554 exaggeration by pyramiding, 649–650 practical significance of, 555–558 of preferred stocks, 551–553 Borg Warner, 456 Borman, Frank, 265 Bosland, Chelcie C., 4, 17, 362n Botany Worsted Mills, 430 Bowker Building, 185n Bradlees, 276–278 Braunthal, Alfred, 467n Brazil, 175 “A Break in the Action” (Castro), 271n Breeden, Richard, 279–280 British Companies Act of 1929, 386n–387n Brooklyn Heights Railroad Company, 209 Brooklyn Rapid Transit Company, 209, 492 Brooklyn Union Elevated Railroad, 78–79, 146–147, 209, 685, 693 Brooklyn Union Gas Company,

nificance of, 555–558 of preferred stocks, 551–553 Borg Warner, 456 Borman, Frank, 265 Bosland, Chelcie C., 4, 17, 362n Botany Worsted Mills, 430 Bowker Building, 185n Bradlees, 276–278 Braunthal, Alfred, 467n Brazil, 175 “A Break in the Action” (Castro), 271n Breeden, Richard, 279–280 British Companies Act of 1929, 386n–387n Brooklyn Heights Railroad Company, 209 Brooklyn Rapid Transit Company, 209, 492 Brooklyn Union Elevated Railroad, 78–79, 146–147, 209, 685, 693 Brooklyn Union Gas Company, 321, 322 Brooklyn-Manhattan Transit Corporation, 79, 595, 693 Brown Brothers Harriman & Co., 7 Budd Manufacturing Company, 246n Buffalo Sabres, 274 Buffett, Warren, 40, 53, 54, 58, 137–138, 273, 287, 345, 396, 622, 629, 713–714, 715, 720 Bulgaria, 175 Bunte Brothers, 674 Burchill Act, 233n Burlington, 212 Burtchett, E. F., 193n Bush, George H. W., 286 Bush Terminal Building Company, 421 “Business man’s investment,” 167 Butler Bros., 675 Butte and Superior Copper Company, 677, 679 Butte and Superior Mining Company, 491 “Buy-and-hold” investing, 133 Buyer as element in security analysis, 76 C Cable Television Hall of Fame, 274 Calumet and Hecla Consolidated Copper Company, 487–488 Campeau, Robert, 43 Canada, 174, 175, 233n Canadian Pacific Railway, 158n, 210n, 211, 226 Capellas, Michael, 279 Capital Administration Company, 550 Capital Consumption and Adjustment (Fabricant), 454n Capital Income Debentures, 115n Capital structure, 406–407, 507–519 arbitrary variations in, alteration of value of enterprise by, 508 limitation on comparison in same field, 658, 659 optimum, principle of, 508–510 shortage of sound industrial bonds and, 510 speculative (see Speculative capital structure) top-heavy, earnings appraisal and, 511–512 total market value of securities and, 334–335 Capitalization, allowance for changes in, 503–505 Cash flows, 56 Cash-asset value, 553–554 Cassel, Gustave, 3 Castro, Janice, 271n Caterpillar Tractor, 90n Cates, Staley, 267n Celanese Corporation of America, 9

alue of enterprise by, 508 limitation on comparison in same field, 658, 659 optimum, principle of, 508–510 shortage of sound industrial bonds and, 510 speculative (see Speculative capital structure) top-heavy, earnings appraisal and, 511–512 total market value of securities and, 334–335 Capitalization, allowance for changes in, 503–505 Cash flows, 56 Cash-asset value, 553–554 Cassel, Gustave, 3 Castro, Janice, 271n Caterpillar Tractor, 90n Cates, Staley, 267n Celanese Corporation of America, 92n, 94, 309 Celluloid Corporation, 309 Central Branch Union Pacific Railway, 153 Central Leather, 606 Central Railroad of New Jersey, 451 Central States Electric Corporation, 306, 307, 313–314, 318, 647, 693n Century Communications, 274–275 Century Ribbon Mills, Inc., 327, 328 Cerberus Capital Management, 280 Cerro de Paso Copper Corp., 465 Chamberlain, Lawrence, 102n Chance, value of analysis and, 72–73 Chandler (Federal Bankruptcy) Act of 1938, 208n, 230n, 231–232, 234 Chandler Railroad Readjustment Act of 1939, 238n Chapter 11 of the Bankruptcy Code, 271 Chesapeake and Ohio Railway Company, 158n, 293, 448, 461, 645, 646, 693n Chesapeake Corporation, 313, 509n, 645, 646, 693n Chevron, 271 Chicago, Burlington and Quincy Railroad Company, 158n, 445, 447 Chicago, Milwaukee, St. Paul and Pacific Railroad Company, 203n, 209, 242, 319 Chicago, Milwaukee and St. Paul Railway Company, 242 Chicago, Rock Island and Pacific Railway Company, 596, 646, 684 Chicago, Terra Haute, and Southeast- ern Railway Company, 203n, 209 Chicago and Eastern Illinois Consolidated, 152 Chicago and Eastern Illinois Railroad, 199n Chicago and North Western Railway, 153, 182, 202n, 249n Chicago Great Western Railroad Company, 97, 694 Chicago Herald and Examiner, 147n Chicago School, 281 Chicago Yellow Cab Company, 461n Chieftain Capital Management, 397 Chile, 175 Chile Copper Company, 636n China, 175 Choctaw and Memphis Railway Company, 684–685 Chrysler, 512n Cities Service Company, 595 Citigroup, 346 Ci

rn Railway Company, 203n, 209 Chicago and Eastern Illinois Consolidated, 152 Chicago and Eastern Illinois Railroad, 199n Chicago and North Western Railway, 153, 182, 202n, 249n Chicago Great Western Railroad Company, 97, 694 Chicago Herald and Examiner, 147n Chicago School, 281 Chicago Yellow Cab Company, 461n Chieftain Capital Management, 397 Chile, 175 Chile Copper Company, 636n China, 175 Choctaw and Memphis Railway Company, 684–685 Chrysler, 512n Cities Service Company, 595 Citigroup, 346 City of Detroit, 683 Classification of securities, 112–119 conventional, objections to, 112–115 new, suggested, 115–119 Clover Leaf Corporation, 645 Cluett Peabody, 383n Coca-Cola Company, 29, 59–60, 397, 483, 500, 551, 676 Collateral-trust bonds, 182–183 Collins & Aikman, 93n Colorado Fuel and Iron Company, 194, 203, 596, 694 Colorado Industrial Company, 596, 694 Columbia, 175 Columbia Gas and Electric Company, 434n Comcast, 274, 275, 401–402 The Commercial and Financial Chronicle, 97 Commercial bankers as investment advice source, 259 Commercial Investment Trust Corporation, 290n, 311, 598 Commercial Mackay Corporation, 235n Commercial Solvents, 555–557 Commissions, reports to, as information source, 94–95 Common stock(s), 28–35, 338–392 basis of valuation and, 349 book value of, preferred stocks and, 550–551 future of corporate profits and, 31 individual growth as basis for investing in, 368–372 interest rates and, 34 investment prestige of, 349 as long-term investments, 358–359 low-priced, 520–526 margin of safety as basis for investing in, 372–375 market behavior of standard and nonstandard issues of, 677–679 price-earnings ratios for (see Price-earnings ratios) quality differentials and, 31–34 “secondary” or little-known issues of, 672–677 secular expansion as basis for investing in, 367–368 selling below liquidating value (see Sub-liquidating value common stocks) speculative (see Speculative common stocks) speculative senior issues distinguished from, 325–327 timing of

-priced, 520–526 margin of safety as basis for investing in, 372–375 market behavior of standard and nonstandard issues of, 677–679 price-earnings ratios for (see Price-earnings ratios) quality differentials and, 31–34 “secondary” or little-known issues of, 672–677 secular expansion as basis for investing in, 367–368 selling below liquidating value (see Sub-liquidating value common stocks) speculative (see Speculative common stocks) speculative senior issues distinguished from, 325–327 timing of investment in, 34–35 valuation of, 497 Wall-Street method of appraising, 410–411 watering of, plowing back due to, 383–384 Common stock analysis, 348–365 dividends and, 376–392 history of, 349 instability and, 350–353 merits of, 348–349 new-era theory of investing and, 356–365 prewar conception of investing and, 354–356 Common Stock Indexes (Cowles), 362n, 527n The Common Stock Theory of Investment, Its Development and Significance (Bosland), 4, 17, 362n Common Stocks as Long Term Investments (Smith), 17, 361 Common-stock dividends, 376–392 arbitrariness of dividend policies and, 382–383 plowing back, 381, 383–384 withholding of, 378–381 Commonwealth and Southern Corp., 195 Commonwealth Edison Company, 292–293, 296 Companies (see Enterprises) Companies’ Creditors Arrangement Act, 233n Comparative analysis: general limitations on, 668 of public utilities, 660–668 quantitative elements in, 665 of railroads, 654–659 variations in homogeneity affecting, 665, 667–668 Competition, real estate bonds and, 217 Congoleum Company, 684, 691 Congoleum-Nairn, 684 Congress Cigar Company, Inc., 316 Consolidated Edison Company of New York, 94, 244n, 444n Consolidated Gas Company of New York, 94, 444n Consolidated Oil Corporation, 466n, 635 Consolidated reports, 443–452 allowance for nonconsolidated profits and losses and, 445–446 degree of consolidation and, 444 earnings distortion by parent- subsidiary relationships and, 447–449 former and current practices and, 444 special dividends pa