1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Robert Abbott
Robert Abbott
Articles (383)  | Author's Website |

‘The Intelligent Investor’: Chapter 17 Reviewed

Four follies—Benjamin Graham warns us against what are now known as popular delusions

July 06, 2018

In titling this chapter “Four Extremely Instructive Case Histories,” Benjamin Graham said he was making a pun because these four histories provide extreme examples of companies getting into trouble. It is the 17th chapter of his classic book, “The Intelligent Investor.”

The companies are:

  • Penn Central (Railroad) Co: An example of the “most elementary” warnings being missed as the stock price soared.
  • Ling-Temco-Vought Inc: What’s wrong with rapid and shabby growth of an empire, as well as shoddy bank lending.
  • NVF Co.: A small-cap company takes on a too-big acquisition, not to mention big debts and curious accounting devices.
  • AAA Enterprises: Financing a small company that had little more valuation strength than the word “franchise.”

Penn Central

When America’s biggest railroad went bankrupt in 1970, it was a shock for both the financial world and American society at large. Yet, it did not surprise Graham, who wrote:

“Our basic point is that the application of the simplest rules of security analysis and the simplest standards of sound investment would have revealed the fundamental weakness of the Penn Central system long before its bankruptcy.”

He lists some conventions that were ignored by management and analysts:

  • Interest charges: Penn Central earned roughly 2 times interest charges in 1967 and 1968; in his previous book, “Security Analysis,” Graham and co-author David Dodd had stipulated 5 times coverage for railroad stocks.
  • Income taxes: The company had paid none over many years and that “should have raised serious questions about the validity of its reported earnings.”
  • Bonds: Graham argues its bonds might have been exchanged in 1968 and 1969 for far better secured issues, without giving up price or income.
  • Price-earnings: At its peak in 1968, the company had a price-earnings ratio of 24—yet it was not paying any income taxes.
  • Missing the basics: Penn Central’s operating performance was under par: it’s transportation ratio was 47.5% versus 35.2% for its peer, Norfolk & Western.
  • Strange transactions: Graham says only that there were “some strange transactions with peculiar accounting results. Details are too complicated to go into here.”

Graham’s conclusion about Penn Central: “Moral: Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.”

Ling-Temco-Vought Inc.

What began in 1947 as an electrical contracting company had morphed into a conglomerate giant by 1961. A few years earlier, starting in 1956, founder James Ling went on an acquisitions binge, using large amounts of debt. The company eventually became the LTV Corp., which ceased operations after a second bankruptcy in December 2000. Graham is discussing the company as it stood in the early 1970s. Interesting sidebar: Ling sold his first $1 million worth of shares from a booth at the Texas State Fair.

Graham points out the follies:

  • Accounting gimmickry: In 1961, the company decided to “throw all possible charges and reserves into the one bad year.” In his commentary, Jason Zweig is even more blunt:
    “The sordid tradition of hiding a company’s true earnings picture under the cloak of restructuring charges is still with us. Piling up every possible charge in one year is sometimes called 'big bath' or 'kitchen sink' accounting. This bookkeeping gimmick enables companies to make an easy show of apparent growth in the following year—but investors should not mistake that for real business health.”
  • More gimmickry: At the end of 1967, the company valued net tangible assets at $7.66 per common share. However, if the preferred stock, good-will and bond discount were accounted for, the tangible assets were worth only $3 per share.
  • Dilution: Near the end of 1967, the company and two banks offered another 600,000 shares at a price of $111.00 per share. Three years later, the price had plummeted to $7.12.
  • Bank loans: These debts jumped from $161 million at the end of 1967 to $414 million, bringing the company’s total long-term debt to $1.24 billion.
  • Big losses: The losses incurred for just two years, 1969 and 1970, were greater than total profits throughout the company’s full existence.

While not absolving the company’s management, Graham aims his guns at the commercial bankers who loaned too much money. He says the banks ignored the company’s coverage of interest, the current ratio and the relationship between stock equity and total debt.

NVF Co.

In 1968, a little “vulcanized fiber and plastics” company, NVF, decided it wanted to take over a company seven times its size. NVF carried a significant debt load, as did the company it targeted, Sharon Steel Corp. Sharon’s management opposed the offer, but NVF ultimately won in 1969.

Graham has several comments on this deal:

  • Minnows trying to swallow whales: the author says, “The acquiring company had assumed responsibility for a new and top-heavy debt obligation, and it had changed its calculated 1968 earnings from a profit to a loss into the bargain.” Among the wonders of this deal: NVF lists $58.6 million of deferred debt expense, while its complete stockholders equity stood at $40.2 million.
  • The company leaves out of its main financial statements that $20.7 million of “excess of equity over the cost of investment in Sharon.”
  • Accounting gimmicks: Graham lets us know there are more shady dealings in the footnotes, including material amounts.

Unusual items: Taking on debt to buy up warrants and buying them at a time when its bonds were selling for less than 40% on the dollar (an indication of forthcoming financial trouble). And that was just one of the questionable items.

AAA Enterprises

An ambitious college student, Jackie Williams, started a business selling mobile homes. He incorporated the company in 1965 and began franchising a couple of years later. To grow some more, he inflated the share count and got a stock exchange house to sell 500,000 shares at $13. The price of the shares promptly popped to $28, giving the company an $84 million capitalization, despite having a book value of only $4.2 million.

Who wants to buy into this initial public offering, with shares soon selling at 115 times their current (and so far, largest) earnings per share? It turns out lots of investors—or should we call them, speculators—did. With this funding, the company went into other lines of business, including a plant that manufactured mobile homes and a chain of retail carpet stores.

In the first nine months of 1969, AAA earned $686,000, but then in the final quarter lost $4.4 million. That consumed all the capital that had been poured into the company, leaving IPO investors with 8 cents per share on an investment that cost them $13 per share. Financial troubles continued and the company was bankrupt in less than two years. Graham’s comments are scathing:

“The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some 'action' in progress. It will fall for any company identified with 'franchising,' computers, electronics, science, technology, or what have you, when the particular fashion is raging.”

Given these kinds of disgraces, he asks whether the Securities and Exchange Commission should not be given more power to protect the public from itself.

He also castigates the investment house that took AAA public: “Should not responsible investment houses be honor-bound to refrain from identifying themselves with such enterprises”

Conclusion

Again, the more things change, the more they stay the same. In his commentary written in 2003, Zweig deals with some of the companies caught up in the dot-com bubble.

Just a few years later, many more were caught up the housing bubble and bust that led to the 2008 financial crisis.

And, as I look out at the landscape of 2018 with my bearish eyes, I expect another set of such follies to descend upon us again.

(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

Visit Robert Abbott's Website


Rating: 5.0/5 (1 vote)

Voters:

Comments

Please leave your comment:


Performances of the stocks mentioned by Robert Abbott


User Generated Screeners


alexvemailapprox R2k by mkt cap
BNPEV/EBIT- PE Screener
dan264491ROIC
pbarker46REITs, Canada
kislevamnonlooks goos
kislevamnontoo much
kislevamnonbad p to b & p to s
DANGORDON12-15-18 LOW BOOK VAL
jtepper2High margin businesses
kislevamnonbad : p to B big 90
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat

{{numOfNotice}}
FEEDBACK