I've recently been combing through a selection of articles written by Benjamin Graham between 1918 and 1922. These articles, which were written before Graham's reputation grew, give us a fascinating insight into the way he analyzed securities.
As there is only a limited amount of information available on Graham's style of investing, any additional content is invaluable.
One of the investment scenarios he considered in these articles was "Hidden Assets of Consolidated Gas." The utility company had seen its share price rally to $150 of the back of improved sentiment toward the business and the belief on Wall Street that there was hidden value on the balance sheet. Graham decided to cover the opportunity because the stock had recently declined to $83 per share -- he wanted to try and establish whether or not it was worth taking advantage of this decline.
"If Consolidated Gas was actually worth 150 in 1916, then it should again be worth very nearly that figure in 1920," he wrote.
Understanding the balance sheet
The first place Graham started to hunt for this hidden value was on the balance sheet, which is where he ran into a problem. He noted the company's annual report did not contain enough information to conduct a thorough analysis. Instead, he turned to the data the company provided to the Public Service Commission, which he noted Consolidated Gas "fairly deluges this august body with operating and financial statistics."
Looking at the balance sheet, Graham found his hidden value:
"[subsidiary shares] aggregating $100,000,000, are the real hidden assets, representing the excess of the book value of the subsidiaries' stocks as shown by their own balance sheets over the price at which they are carried in the Con. Gas investment account. N. Y. Edison stock, for example, with a par value of $66,000,000 and a surplus of $36,000,000, is valued on the holding company's books at only $39,000,000 an apparent understatement of no less than $63,000,000, or $63 per share of Con. Gas. These figures give Con. Gas stock a book valuation of fully $234 per share compared with only $113 in the company's balance sheet. To this large figure many claim that at least a large part of the replacement and contingency reserve of $59,290,000 should be added -- which would bring the actual value up to somewhere between $234 and $293 per share."
After unearthing this hidden gem, Graham also discovered that some of the value of the assets on the balance sheet had been inflated. After adjusting for these figures and deducting liabilities (as well as the company's debt and tax due), Graham arrived at the conclusion the shares were undervalued:
"This then is a fairly accurate and official valuation of Con. Gas stock. Were the shares still selling between 140 and 150, one would hardly characterize this result as particularly bullish; but with the stock below par these figures have a different significance and should provide a basis for intelligent confidence in the intrinsic merits of this issue."
He went on to say that if normal operations accounted for the company return, then there was no reason to believe it could not achieve the $13 per share in earnings that it did in 1916, the year when shares traded up to $150.
With this being the case, and considering the state of the company's balance sheet, the future author of "Security Analysis" concluded that Consolidated Gas was a "Well managed utility, enjoying exceptional advantages" with "hundred dollars per share and more of real value behind this issue." He finished the article by summarizing that with "better times ahead, the investor at these levels should find the stock a very satisfactory purchase."
