Chapter 13: A Comparison of Four Listed Companies
**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here
Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham expounds on what key accounting ratios can be used to help determine the strength of a company. He helps us put together how performance and price tend to related to one-another and how they can sometimes be asynchronous in their movement. Here’s the list of preceding posts if you’d like to get caught up:
- Intro and Chapter 1 , Chapter 2, Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, Chapter 9, Chapter 10, Chapter 11, Chapter 12
Analyzing four companies:
Graham sets up this chapter so that we’re analyzing the strength of four companies throughout the chapter. These companies are : ELTRA , Emerson Electric, Emery Air Freight and Emhart Corp. Throughout, we review the companies, from the standpoint of a conservative common-stock investor. This chapter is really neat because you get to “follow-along” with the valuation of these enterprises and get a feel for how you may choose to implement these methods in your own portfolio. We’ll use the tables below to take a closer look at Profitability, Stability, Growth, Financial Position, Dividends and Price History.
Chief Elements of Performance
Graham has us focus on the six elements that we listed above. All of which we can begin to determine from their financial postings, found in the EDGAR database. Easy huh….? We’ll start with Profitability, and finish with historical information on dividends and price.
Profitability
For profitability, we’ll be honing in on this data from our figures:
When looking at the Net per share / book value line item , we’re measuring the companies’ net income as a percentage of their tangible book value. In this case, Emerson and Emery are higher.
Graham writes that “all companies except Emery showed better earnings on their book value in 1969 than in 1961” and mentions that while that is true Emery’s figures were still quite high. However, if we’re looking for consistency, the downturn in earnings on book value for Emery should throw an initial red flag.
Graham expands on noting profitability when looking at Manufacturing firms. In this case we’re looking at “ratio of operating income to sales” from the S & P Listed Stocks reports. We want to be especially careful to note the difference between operating income and net income to sales. In either case, all companies show satisfactory results , with Emerson leading the pack. I wanted to try and find the operating income data , not the net income data for Emerson, but wasn’t able to find any data older than 2009. Even when using the Net/Sales , 1970 data, we see that Emerson is leading the pack:
With the exception of the single downturn in earnings from Emery, all businesses get a “green-for-go” in the realm of profitability.
Stability
The measurement of stability is us asking the question of how likely the per-share earnings are to steadily grow over the time of our investment. Stability is measured by the maximum decline in per-share earnings in any one of the past ten years, against the average of the three preceding years. Therefore , no decline translates to 100% stability. The examples of ELTRA and Emhart had only moderate shrinkages in their “poorest year” of 1970 of 8% versus a 7% shrinkage of the DOW.
Growth
All companies listed show good growth rates, the ELTRA and Emhart Corp. (the low multiplier companies) show good growth while the high multiplier companies show even better growth rates. ELTRA shows great earnings but a low earnings ratio indicating that high PE ratios are not always needed for high earnings growth. The key is to strike a balance between growth potential and higher earnings ratios.
Financial Position
Here we look at the Capital and Debt associated with a firm. In this case, for the manufacturing companies, we expect to see a standard ratio of $2 of current assets for $1 of current liabilities.
Graham remarks that Emery Air Freight’s ratio is lower ($20,400,000 / $11,800,00 = 1.7 x) but it is in a different industry than the other three and with its past performance would easily be able to raise needed capital. Although this is speculation, what’s important to note is that we’re checking how easy a firm might be able to get required capital if they needed it. In this case most of these companies have double their liabilities in current assets.
We also want to check into the debt and dilution factor of each company. In this case, each company has a low amount of debt compared to their working capital. For example, Emerson’s ratio of 5.6x is calculated in the following:
As we consider dilution: “Emerson electric had $163M of market value of low-dividend convertible preferred shares outstanding at the end of 1970.” In order to properly evaluate the company shares, the dilution factor was taken into account as usual (by treating the preferred as converted into common) which decreased recent earnings by about $.10 / share , or 4%.
Dividends
When considering dividends, our number one priority is focusing on the history of uninterrupted dividend payments. The longer the consistent payouts , the better. The payout percentage variations by year may be a good indicator of management producing consistent positive results through the operations of the business and can also be considered when reflecting on whether management is making the right magnitude and decisions with the retained earnings. Dividend yield should also be used as a comparison between competitors of like size and position to help evaluate the soundness of the dividends.
Price History
Taking a close look at the price history of each of our sample companies gives us a good understanding of what the price has done in past market fluctuations and gives us an established baseline of what today’s prices should mean to us.
What we’re looking for here is the price advance on each issue since its inception to the current price (lowest → highest difference over all years). As an example, when looking at Emery, we break it down by taking its high price of $66 and dividing it by its low price of 1/8 to give us 528 or a ratio of 528 to 1 between the high and low.
If applicable, see any price shrinkages that have occured during bear market cycles and compare these shrinkages to similar companies and competition to see how they actually weathered the bear market decline.
General Observations of the Four Companies
For Emerson Electric, Graham indicates that because the stock’s total market valuation was high, we may want to take a closer look at it. Again, not being concerned one way, or the other, just being aware that:
- high valuations entail high risk.
- The growth required for large returns on high valuations is even higher so a price slide could really do you in. Remembering we make or lose our money on the buy, not the sell.
Our take on Emery Air Freight is that while the earnings multiplier is the highest , it is theoretically the best candidate of our four for the best growth. However, there is a bit of a contradiction in that while their earnings growth and potential seem very promising , their growth is starting from only 1/2 million , therefore , “it often proves much more difficult to continue to grow at a high rate after volume of profits have already expanded to high totals.” To me , this means we may yet see high earnings growth in the short term, but overcoming the plateau may be difficult in the long-term. Graham remarks that the impressive earnings and market price growth Emery enjoyed, continued to persist into the bear market of 1970.
What about Emhart and ELTRA? Well, they weren’t any thing sexy, but they have a great track record of earnings and profits and are positioned well to be reliable investments. Especially because we’re concerned with maintaining our principal at all costs.
How did S & P feel about each company?
Graham believes analysts will like Emerson and Emery because
- “better market action”
- Their recent growth in earnings
However, under our principles of conservative, value investing, reason number 1 is not a valid reason for selection (this is for speculators) and reason number 2 has validity but with limits. Basically, earnings growth is great but when multipliers are x 60 and higher, when is high, too high?
Emerson and Emery may be good for people with in-depth knowledge of these businesses. But not for the careful investor who wants to be reasonably sure in advance that he is not committing the typical Wall Street error of over-enthusiasm for good performance in earnings and in the stock market.
Furthermore, he notes that Emerson has a massive bump from its $1B in intangible assets and that is something of concern for this value investor!
When looking at ELTRA and Emhart though, he feels that:
- These companies seem to have sufficient value behind their price to constitute reasonably protected investments. Graham focuses the reader on remembering that we’re looking to be part owners in these businesses, we are not speculating. He states that at the time, we could be part owners of these enterprises and have the additional benefit of buying shares for both of these companies for little more than their book value (low price / book value) multipliers.
When we look at some dimensions of ELTRA and Emhart, Graham is pleased to announce that:
- The rate of earnings on invested capital has long been satisfactory
- The stability of profits has long been satisfactory
- The past growth rate has also been satisfactory
He further explains that these two companies will also meet seven statistical requirements for inclusion in the defensive investor’s portfolio. We’ll analyze them in Chapter 14, but they are:
- Adequate size
- A sufficiently strong financial condition
- Continued Dividends for at least 20 years
- No earnings deficit in the past ten years
- Ten-year growth of at least one-third in per-share earnings
- Price of stock no more than 1 1/2 times net asset value
- Price no more than 15 times average earnings of the past three years
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 investments.
Zweig’s Commentary
The first thing Zweig does is take a look at Emerson Electric. He essentially remarks that Emerson’s track record was great before, and remained great but in an e-commerce boom, Emerson was not what the public wanted to buy. “Their stock lagged the S&P by 49.7% during ’98 & ’99. However , their business was doing gangbusters. In ’99 Emerson sold $14.4 B in goods and services, up by nearly $1B from ’98, which broke down to $1.3B in net income, an increase of 6.9% from ’98. EPS rose from $6.69 to $14.27. Major indicators like their net-profit margin and return on capital stayed robustly high at about 9% and 18% respectively. What is even more impressive was that their earnings had now seen increases of 42 years in a row and they had raised dividends 43 years in a row! We can consider Emerson an example company of what to look for. Their price didn’t keep up during the e-commerce boom, but likely because it wasn’t what the “high-growth wanting” public wanted, the underlying business was rock solid.
After the review of the companies Graham listed, Zweig moves into more modern companies for a similar analysis. We start with EMC. He remarks that EMC’s growth was explosive but much of this price growth was touted by management as “infinite growth”. Zweig goes so far to remark about EMC’s retained earnings strategy:
Their type of retained earnings strategy often is used to “ provide funds for the continued growth of the company’s top managers’ wealth.”
Even while the executives were saying that growth and profits would be “unlimited”, the key indicators like profit margin and return on capital was beginning to falter. Another prime example of the public choosing to buy stock at ever increasing prices that is drive by emotions fueled by management, not by sound logic.
Zweig moves into talking about Expeditors United and states that their essential business was doing gangbusters, just no-one saw the value in them until their profits really ramped up and by then it would have been a bit late for the value investor to get in since their price multiplier was 39 times their net income in ’99. The point here being again, the time to buy would have been when no-one was looking, the multipliers were low even though the business was great.
Finally, Emerson didn’t lose much, EMC tanked, Expeditors did well and Exodus flopped. The point: Be the owner, not the speculator and find food, healthy businesses that you want to be with for the long-term.
As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.
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-David
