When Standard Oil was broken up, eight of the resulting companies were small pipeline operators. Wall Street didn't pay much attention to them. Little was known about their finances – and they liked it that way. Their "income accounts" literally consisted of a single line. They didn't provide detailed balance sheets.
Ben Graham spent a lot of time looking through information provided by the Interstate Commerce Commission (ICC), a regulatory body that oversaw the railroads (among other businesses). One day, as Graham was looking through an ICC report, he found some statistics clearly furnished by the pipeline companies. The statistics were accompanied by a note that read "taken from their annual report to the Commission".
Graham realized that the pipelines were filing reports with the ICC that contained information not known on Wall Street. So, he requested a blank copy of the report from the ICC. The blank form included "a table which required the companies to set forth a list of their investments at cost and market value."
Ben left for Washington the next day. He reviewed the reports for all eight pipeline companies. What he found amazed him:
"I discovered all of the companies owned huge amounts of the finest railroad bonds; in some cases the value of the bonds alone exceeded the entire price at which the pipeline shares were selling in the market! I found, besides, that the pipeline companies were doing a comparatively small gross business, with a large profit margin, that they carried no inventory and therefore had no need whatever for these bond investments. Here was Northern Pipeline, selling at only $65 a share, paying a $6 dividend – while holding some $95 in cash assets for each share, nearly all of which it could distribute to its stockholders without the slightest inconvenience to its operations. Talk about a bargain security!"
Northern Pipeline had the greatest amount of securities per share relative to its market price; so, Graham focused on buying shares of that company. He bought slowly but surely. Eventually, he was able to acquire a 5% stake in Northern Pipeline. Not surprisingly, the Rockefeller Foundation was still the largest shareholder. The foundation held 23% of the shares outstanding.
Graham didn't count on a contest. There were no such things as "activist investors" in those days. Besides, Graham didn't see any need for activism. The correct course of action was clear. He would simply explain the situation to management and they would distribute the excess cash.
Graham met with the company's President and General Counsel (they were brothers). He explained the situation and what needed to be done.
The Bushnell brothers explained they couldn't distribute the cash, because the par value of the stock was too high. Graham explained how they could reduce the par value and treat the distribution as a return of capital. The brothers explained they needed the capital. Graham asked for what. The brothers said the investments were a depreciation reserve. Graham said fine – then tell me when you'll need to replace the pipeline. They couldn't say. Approximately? Couldn't say.
Finally, Graham reached the point all activist investors eventually reach, the point where management stops humoring you and starts lecturing you:
"Look, Mr. Graham, we have been very patient with you and given you more of our time than we could spare. Running a pipeline is a complex and specialized business, about which you know very little, but which we have done for a lifetime. You must give us credit for knowing better than you what is best for the company and its stockholders. If you don't approve of our policies, may we suggest that you do what sound investors do under such circumstances, and sell your shares?"
Graham didn't do what sound investors do. Instead he told the Bushnell brothers he would come to their next annual meeting.
He did. Unfortunately, he came alone. When Graham rose to read his report on the company's financial position he was asked to put his request in the form of a motion. He did. No one seconded the motion. The meeting adjourned.
It was an extremely embarrassing – and extremely lucky – episode in his career.
He felt the embarrassment right away. The luck came in the full year he had to round up every last proxy he could.
Graham hired a high paid law firm and got to work soliciting proxies. Naturally, one of his first visits was to the Rockefeller Foundation. The foundation's financial adviser told him the foundation never interfered in the operations of the companies it invested in.
Graham told him he had no interest in Northern Pipeline's operations just its assets – its surplus assets. The proper use of those assets was the concern of the shareholders not the management. It was no use. Graham left the meeting empty-handed. He thought he had failed. Actually, he had just taken the first step in changing Rockefeller Foundation policy and the financial future of all eight pipeline companies – though he didn't know any of that at the time.
In January 1928, on the eve of Northern Pipeline's annual meeting, Graham, his lawyers, and the Bushnells all headed out to Oil City, Pennsylvania where the meeting would be held. It wasn't a big town. The two opposing groups met and agreed to count the proxies that night rather than leave it until the next day. Both groups put their cards on the table; Bushnell's reaction was priceless:
"The management group was surprised and discomfited to see how many of their own proxies had been superseded by later-dated ones given to us. After all this time I still remember old Bushnell's involuntary exclamation of pain when we established our right to one proxy for three hundred shares. 'He's an old friend,' he gasped, 'and I bought him lunch when he gave me his proxy."
The Graham group had obtained proxies for roughly 37.50% of the company's shares. More importantly, the Rockefeller Foundation gave their proxies to the Bushnells – along with a simple message: distribute as much cash as the business can spare.
In the end, Northern Pipeline immediately distributed $50 in cash and essentially promised $20 more would soon follow. Eventually, investors in Northern Pipeline would receive more than $110 in distributions for each share held as of that January.
Not bad for a $65 stock.