Benjamin Graham offers us a “sample” of securities analysis in the 13th chapter of “The Intelligent Investor.”
Four companies
It is practical analysis, based on four live examples in his time (this final edition was published in 1973, after Graham had spent a lifetime in the business). The four companies were:
- ELTRA Corp.: formed by a merger of Electric Autolite and Mergenthaler Linotype enterprises (a low-multiplier company, which is explained later).
- Emerson Electric Co. (EMR, Financial): a manufacturer of electric and electronic products (high multiplier).
- Emery Air Freight: domestic air freight forwarder (high multiplier).
- Emhart Corp.: originally made bottling machinery, but had added builders’ hardware (low multiplier).
We’ll have updates on these companies at the end of the article.
Graham goes through the financials of these companies, chosen to be somewhat diverse, by looking at key ratios that relate to performance and to price. He says:
“The most striking fact about the four companies is that the current price/earnings ratios vary much more widely than their operating performance or financial condition.”
Six criteria
To restate, his most important takeaway is that price-earnings ratios vary quite a bit, much more than their operating results or their financial condition would suggest. Why? Graham explains it happens because of the “superior growth” of the profits of the favored companies. With that, he digs down further:
- Profitability: Earnings on book value. He says, “A high rate of return on invested capital often goes along with a high annual growth rate in earnings per share.”
- Stability: Measured by the highest decline in earnings per share in the previous 10 years, compared with the average of the three preceding years. Absolutely no decline would be 100% stability.
- Growth: Graham references low-multiplier and high-multiplier companies (low leverage and high leverage because of debt) against their growth rates.
- Financial position: Three of these companies are in “sound” financial condition because they have more than $2 in current assets for every $1 in liabilities. The fourth company has a lower ratio, but is in a different category and would have no trouble raising cash.
- Dividends: The guru says, “What really counts is the history of continuance without interruption.”
- Price history: Graham says we should be impressed by the percentage advance in prices among these companies—as measured from the lowest point to the highest point—in the past 34 years.
General observations
- Emerson Electric has “enormous total market value”, and is considered a “good-will giant.” Graham says, “High valuations entail high risks.”
- Emery Air Freight: This company had a price-earnings ratio of almost 40 times, with strong past growth and more strong growth needed to justify the ratio. Before buying, conservative investors must work through potential, adverse developments before making a commitment.
- Emhart and ELTRA: “It appears that neither of these companies possesses glamour, or 'sex appeal,' in the present market; but in all the statistical data they show up surprisingly well.”
Graham believes Emerson and Emery will have better “market action” as well as faster recent growth in earnings. For those reasons, they will be more attractive to many market analysts. He, though, has reservations. Can past growth and current prospects justify a price-earnings of more than 60 times recent earnings?
To that rhetorical question, he replies, maybe for someone who has intensely studied the possibilities and concluded with very firm and optimistic conclusions.
Not, though, for careful investors who want to avoid “the typical Wall Street error of overenthusiasm for good performance in earnings and in the stock market.”
Turning to the other two, ELTRA and Emhart are solid companies with “sufficient value behind their price.” They have long histories of healthy return on capital as well as stability of profits. He adds, “Here the investor can, if he wishes, consider himself basically a part owner of these businesses, at a cost corresponding to what the balance sheet shows to be the money invested therein.”
Finally, Graham contrasts the two high-multiplier companies (Emerson and Emery) with the two low-multiplier companies (ELTRA and Emhart). He says, in his characteristic way:
“The sound basis for preferring ELTRA and Emhart to Emerson and Emery would be the client’s considered conclusion that he preferred value-type investments to glamour-type investment”
Follow-up
As for the four companies' histories since 1973:
Emerson Electric Co. is still in business and still listed on the New York Stock Exchange. It now has a market cap of $43.7 billion and receives 6 out of 10 for financial strength and 5 of 10 for profitability and growth. Here is an excerpt from the GuruFocus dashboard:
Emery Air Freight encountered turbulence: Its operations were shut down in August 2001 because of unsatisfactory fleet maintenance. What was once the biggest air freight forwarder and integrated air carrier in the country was officially shuttered in December 2001. A successor company was bought by UPS (UPS, Financial) in 2004.
ELTRA Corp.: Sold to a firm that became the Allied Signal Corp. in 1980. Allied Signal, in turn, was purchased by Honeywell Inc. (HON, Financial) in 1999.
Emhard Corp.: Acquired by Black & Decker (now Stanley Black & Decker Inc. (SWK, Financial)) in 1989. A number of its brand names were subsequently sold to other entities.
Conclusion
Summing up, Graham focused on these key issues when analyzing companies in chapter 13:
- Profitability
- Stability
- Growth
- Financial position
- Dividends
- Price history
Conclusion
Novice value investors who want to analyze companies now have a starting map. While these companies vary in their details, they will all be assessed according to the same six criteria.
In the end, there will still be hard choices, but simply working through the six criteria will help weed out unworthy candidates early on, making final decisions more effective and more timely.
As always, I recommend reading the complete book, which is readily available.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)
