This is the eighteenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the seventeenth chapter, which is on pages 422 to 437, and the Jason Zweig commentary, on pages 438 to 445.
The real question in value investing is how do you identify the lemons that are mixed in with the ‘values’?
Obviously, when you’re digging into “value” companies, you’re seeking out companies that are currently undervalued by the stock market. This can happen for a lot of reasons: these companies are boring, these companies are not experiencing rapid growth, or, more ominously, something nasty is afoot with this business.
The problem with teasing out companies that are up to shenanigans is that there’s no ready made recipe for identifying them. This is where homework comes into play. You need to study the individual companies you invest in. Careful study of a company will often identify fundamental problems in their business plan – and if you see those things, you can stay away.
In this chapter, Graham discusses four examples of this kind of careful study:
Penn Central (Railroad) Co., which is an example of a corporate giant that’s rotting from the inside
Ling-Temco-Vought, Inc., which is a company that builds an empire on paper, but is actually pretty fragile
NVF Corp., which is an example of corporate acquisitions gone bad
AAA Enterprises, which is an example of a “hot” stock that’s getting elevated beyond all reason
Chapter 17: Four Extremely Instructive Case Histories
Here’s how Graham sniffed out the rat in each company.
Penn Central (Railroad) Co.
A careful reading of the company’s annual reports reveals that the company had been paying virtually no income tax for a decade. That’s a huge warning sign – if they’re not paying income tax, they’re either taking advantage of a ton of tax breaks (which you should be able to discover easily) or they’re not really earning much income at all.
How did they do it? They were reporting earnings without “charges” that were going to be taken several years down the road. These “charges,” however, were merely disguising that the company wasn’t really bringing in any income.
What can you do to avoid this? If you see a company reporting good earnings but also talking about “charges” for mysterious reasons that will be dealt with in future years, be very careful. They could be just extending the life of the company on paper when it’s actually in serious trouble.
The warning signs? In 1966, the company stated that their assets were less than 5% of the stock value of the company. This means that if the company went bankrupt, the common stocks would pretty much be worthless – something to avoid like the plague if you’re investing for value.
Another warning sign: large investors started dumping the stock in droves. If you see big investors selling all of their stock in a company, you might want to consider doing the same. Watch out for big changes in institutional investing in the public reports on the company.
In 1969, the company reported a loss far bigger than the total profits in the history of the company. In one year, it lost more money than it ever earned – a sure sign something’s seriously wrong.
The way to avoid this is simple: avoid any stocks that are valued far beyond their asset value. Avoid any stocks that are being sold in droves by institutional investors. Avoid stocks that suddenly report a huge loss seemingly out of nowhere.
Here, NVF used a number of accounting gimmicks to hide the fact that they were acquiring companies with a huge amount of debt and unsteady business.
How did they do that? The most flagrant sign was that the company claimed an “asset” called “deferred debt expense” that was actually larger than the entire equity of the company. If you started digging into the annual report and figuring out what the items are, you soon realized that the company was actually claiming some debts as assets – and when you got that all straightened out, it became clear that the company was worthless.
You can avoid this by avoiding any company that has unexplainable items on their annual report. If you can’t get a rational explanation of what an element of a company’s annual report is, avoid that company.
If you can’t determine why exactly people are investing in a company, don’t invest. That’s basically the story here, in which a tiny company played a hype game and wound up being valued at 115 times earnings – a number that’s not realistic no matter what the company.
This was all based on potential – much like the “dot com” stocks of 1999 and 2000. Graham’s point? Avoid companies that are selling nothing more than potential. If you can’t see real assets and real business there, don’t invest.
Commentary on Chapter 17
Zweig spends his commentary making modern analogies for each of these disasters.
Zweig compared Penn Central (Railroad) Co. to Lucent. Both companies were among the largest in America, but once you started digging into the books, it became clear that the large company was rotting from the inside, with apparent earnings that weren’t actually based in reality.
He compared Ling-Temco-Vought, Inc. to Tyco, both of which built a big paper empire that wasn’t really based on real-world assets, but instead based on mergers and shuffling.
He compared NVF Corp. to AOL-Time Warner, the best modern example of a merger that completely made no sense in which the minnow swallowed the whale.
Finally, the easy one: AAA Enterprises could have been compared to a lot of dot-com companies (my favorite disaster was Boo.com), but Zweig analogized it to eToys, another classic dot-com disaster.
What’s the lesson? These same tactics keep getting used and keep fooling investors. Be careful.
Next Friday, we’ll take a look at Chapter 18: A Comparison of Eight Pairs of Companies.