Benjamin Graham set himself a challenge in chapter 18 of the “The Intelligent Investor,” a challenge in which he compared eight pairs of companies. They often appeared next to each other on stock exchange lists or had relationships of some kind. What they all had in common are lessons for investors. He told us:
“We hope to bring home in a concrete and vivid manner some of the many varieties of character, financial structure, policies, performance, and vicissitudes of corporate enterprises, and of the investment and speculative attitudes found on the financial scene in recent years.”
Real Estate Investment Trust and Realty Equities Corp. of New York
This was an almost classic case of the tortoise and the hare, financial world version. The first, Real Estate Investment Trust, was “a staid New England trust,” while Realty Equities Corp. of New York was “a typical New York-based sudden-growth venture.”
The latter turned itself into a conglomerate (this type of company used to be popular, but investors have since turned against them). It borrowed a lot money, made a lot of acquisitions (some disastrous, as might be expected) and earned Graham’s disapproval.
Air Products and Chemicals (APD, Financial) and Air Reduction Co.
These were two companies with similar names and similar lines of business. Products was the newer of the two and had less than half the sales volume of Reduction, but its shares sold for 25% more. Graham concluded that most analysts would think Products looked more promising than Reduction, but would it be more attractive at its higher relative price? Not for him; Graham noted Reduction’s greater profitability and stronger growth.
American Home Products Co. and American Hospital Supply Co.
Graham noted that both companies were considered “billion-dollar good-will” companies, serving the health market in different ways. Based on comparative prices, he argued that American Home offered more in terms of current earnings and dividends. He went on to offer this lesson:
“The very low book value of Home illustrates a basic ambiguity or contradiction in common-stock analysis. On the one hand, it means that the company is earning a high return on its capital—which in general is a sign of strength and prosperity. On the other, it means that the investor at the current price would be especially vulnerable to any important adverse change in the company’s earnings situation.”
His bottom line? Both companies were overvalued at their current prices. “This does not mean that the companies were lacking in promise," he said. "The trouble is, rather, that their price contained too much 'promise' and not enough actual performance.”
H & R Block Inc. (HRB, Financial) and Blue Bell Inc.
One of these companies provided income-tax services, while the other manufactured work clothes and uniforms. What they have in common was being relative newcomers to the New York Stock Exchange and different genres of success stories.
Graham said, “Blue Bell came up the hard way in a highly competitive industry, in which eventually it became the largest factor. Its earnings have fluctuated somewhat with industry conditions, but their growth since 1965 has been impressive. The company’s operations go back to 1916 and its continuous dividend record to 1923.” Despite the impressive record, Graham considered it undervalued with a price-earnings of 11 (compared to nearly 17 for the S&P composite index at that time).
H & R’s record since coming onto the NYSE in 1961 (seen from the perspective of the early 1970s) had been even more impressive, but perhaps had become overvalued by 1969. “At that time the stock market’s attitude toward this fine performer appeared nothing less than ecstatic,” he wrote. Graham liked both stocks but was drawn toward Blue Bell because of its more modest valuation.
International Flavors & Fragrances (IFF, Financial) and International Harvester Co.
One company created flavors for other companies, while the second manufactured trucks, farm machinery and construction equipment. Graham asked why the flavors company had a market cap greater than the manufacturing company, even though the latter was long-established and a component of the Dow Jones Industrial Average. To make the contrast even more dramatic, Graham pointed out that Harvester’s earnings in 1969 were greater that Flavor’s total sales. So, why the difference?
“The answer lies in the two magic words: profitability and growth. Flavors made a remarkable showing in both categories, while Harvester left everything to be desired.”
Further, he noted Flavors had stuck to its core business, whereas Harvester had engaged in “corporate wheeling and dealing, acquisition programs, top heavy capitalization structure, and other familiar Wall Street practices of recent years.”
McGraw Edison and McGraw-Hill Inc.
At the time the final edition of “The Intelligent Investor” was published in 1973, McGraw Edison operated a public utility and equipment business, as well as housewares. McGraw-Hill published books, films, magazines, newspapers and provided information services. Graham described them as “two large and successful enterprises in vastly different fields.”
Hill had roughly double the market capitalization of Edison, which belies Edison’s higher sales and larger net earnings. Graham ascribes this to “the multiplier of earnings,” which was more than double for Hill. In turn, he points to strong market enthusiasm for book publishers, several of which had gone public in the later 1960s. Unfortunately, the enthusiasm was “overdone”, Graham said:
“McGraw-Hill continues to be a strong and prosperous company. But its price history exemplifies—as do so many other cases—the speculative hazards in such stocks created by Wall Street through its undisciplined waves of optimism and pessimism.”
National General Corp. and National Presto Industries (NPK, Financial)
Another odd couple created by their adjacency to each other on an early 1970s list of stocks. General was a big conglomerate while National Presto was identified with diverse electrical appliances and ordnance. Both companies had diversified into various industries, General much more so than Presto.
Graham directed our attention to the capital structures of the two companies. Presto was simple: just one and a half million common shares. General, though, had common shares as well as convertible preferreds, stock warrants, a “towering” convertible bond issue and nonconvertible bonds.
How, then, were we to estimate General’s true market value given all these instruments? The simple answer was that we couldn't with any certainty.
Whiting Corp. and Willcox & Gibbs
Comparing these two, Graham said:
“...makes one wonder if Wall Street is a rational institution. The company with smaller sales and earnings, and with half the tangible assets for the common, sold at about four times the aggregate value of the other. The higher-valued company was about to report a large loss after special charges; it had not paid a dividend in thirteen years. The other had a long record of satisfactory earnings, had paid continuous dividends since 1936, and was currently returning one of the highest dividend yields in the entire common-stock list.”
Whiting was the paragon in this pairing, sticking closely to its materials handling business as well as generating satisfactory earnings and paying continuous dividends for nearly 40 years at that time. The problematic company was Willcox & Gibbs, a conglomerate, which diversified to the point of absurdity, with an “extraordinarily large number” of subsidiaries.
Conclusion
Does anyone still wonder why conglomerates, so popular in Graham’s time, have largely vanished? The complexity of these structures and the attendant difficulties of accurately valuing them spoke to Graham’s approach to investing.
Graham wound up chapter 18 by comparing Wall Street analysts with his kind of analysts:
“Most security analysts try to select the issues that will give the best account of themselves in the future, in terms chiefly of market action but considering also the development of earnings. We are frankly skeptical as to whether this can be done with satisfactory results. Our preference for the analyst’s work would be rather that he should seek the exceptional or minority cases in which he can form a reasonably confident judgment that the price is well below value. He should be able to do this work with sufficient expertness to produce satisfactory average results over the years.”
(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.)
