Chapter 17: Four Extremely Instructive Case Histories

**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 lays out four companies: Penn Central Co., Ling-Termco-Vought Inc., NVF Corp., and AAA Enterprises. He uses these as clear examples of what to look out for when looking into the past mistakes other investors have made. They also point out some of the major factors that Graham looks to mitigate by using the Intelligent Investor value-investment approach. 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, Chapter 13, Chapter 14, Chapter 15, Chapter 16

Penn Central

We start with the Penn Central Co. which Graham uses to prove that the Intelligent Investor who understands how to analyze the financials in the value-investing style, should be able to clearly see that the railroad was going to have problems and would have done well to steer clear of Penn Central unlike many others did.

Right out of the gate, Graham indicates a major concern with Penn’s coverage on their bonds. He remarks that the minimum coverage set for railroad bonds was 5 times before income taxes and 2.9 times after income taxes at regular rates. With Penn, their coverage ratio was less than two times , and they hadn’t even been paying income taxes. Graham remarks even further that the sheer fact that the company hadn’t been paying taxes was a serious red-flag in the validity of their reported earnings in the first place!

He moves on and elaborates on the fact that the Penn Central bonds could have easily been exchanged for better bonds with no sacrifice to price or income in 1969–69. He is clear that a bondholder could have easily picked up other bonds, that earned better interest and were priced lower than Penn Central, making it clear that for the price, Penn Central bonds were performing worse than lower-priced bonds and therefore were likely overvalued at the time.

The fourth issue Graham has with Penn Central is that in 1968, their earnings ratio was 24x, he remarks this is highly speculative given they hadn’t been paying income taxes! He moves on to another point about special charges on their financials that were realized five years after they had occured. Therefore, in 1966, these special charges weren’t on the books, causing a significant distortion in the price , and about $2 billion in equity; when the charges were realized five years later, this caused a “special charge” of $275 Million, or a reduction per share of about $12… Again, we see Graham’s major concerns with “Special Charges” and “Pro Forma” financials.

Going even further to prove how bad an investment in Penn Central would have been, Graham points out just how much better their competitors were doing from the standpoint of business operations. He notes that the transportation ratio (which a railroad typically wants as low as possible) was poor compared to its competitors. While this isn’t a definitive nail in Penn’s coffin given our “second rate issue” stance, it does call to light an important dimension when considering Penn’s value. If we were to consider Penn a “second rate issue” , then their financials still need to be in-tact but they weren’t.

LTV Inc.

Graham uses LTV as a primary example of a company that, through massive expansion and accounting play was able to expand at an astounding rate, with an eventual downside for the company’s investors. Out of the gate, LTV went into expansion mode and didn’t plan to slow down. Sucking up tons of capital from commercial banks, it continued to expand, carrying its loses over years to make each year seem profitable. Finally, when the losses needed to land, the company had a staggering combined debt (short and long) of $1,869 Million. These losses in ’69 and ’70 exceeded total profits since the formation of the company in 1961. Graham believes this is an issue of malicious accounting practices, as well as poor practice by the commercial banks to continue to lend to the company in the first place when the company’s coverage ratios were at unacceptable levels for a long time, yet the banks continued to lend. In this case, the Intelligent Investor would have immediately seen unacceptable levels of debt and been able determine that this was a significant risk.

NVF

Graham’s NVF example highlights his concerns with small companies that look to take over giants. In this case, NVF sought to acquire Sharon Steel which was seven times the size of its primary business. The way they did this was by offering NVF junior 5% bonds with additional warrants to buy 1.5 shares of NVF stock at $22 per share. While Sharon’s management tried to defend the company, the votes came in favor of the NVF takeover. This meant that NVF 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 a bargain.” Graham indicates that the market knew the risk though, and this could easily be seen in that the new 5% bonds did not sell higher than 42 cents on the dollar.

Things get even more twisted for NVF when in their 1968 report, they create an asset of “deferred debt expense” of $58,600,000 which is greater than the entire “stockholder’s equity” line item. Here , we have to ask, what would an “owner” be buying into if they don’t even have any stake left after the debt expense? Furthermore, NVF omitted a $20,700,000 line item that should have been in Shareholder’s Equity. Therefore, the statement of tangible equity for NVF stock was $2,200,000. This takes NVF’s equity from a stated $17,400,000 down to $2,200,000 — meaning we go from $23.71 / share to $3 per share on the 731,000 shares. Then we need to take into account the warrant that were issued for the acquisition of Sharon Steel which were valued at the time to be about $12 dollars a piece, but when we consider the more realistic value should have been around the $3 price point, we see a drastic reduction in what those warrants were actually worth. Therefore, using accounting practices that seem to be malicious, NVF took Sharon Steel’s original owners for a fictitious ride using overvalued warrants and incorrect financial reports that eliminated a massive portion of the investors original, and real, equity position.

AAA Enterprises

In this case, Graham points out that the firm began its operations in an honest way. The issues with valuations really came about when the firm made its IPO. In this case, Graham’s issues are primarily with the underwriters of the original shares. Graham argues here that basically, the firm’s IPO really only benefited the firm and its underwriters because the IPO was at 8x earnings on the low end, and 19x on the high end. All this for a company that wasn’t showing strong earnings. Graham includes the fact that after the IPO, the stock price still doubled , meaning the underwriters and brokerage-house clients were able to make an easy profit with no real backing to those numbers. Essentially, making up money based on a buying public that “hopes” more than it calculates the risk.

After its IPO, and using its now inflated share price, the firm was then able to enter a few new markets including carpeting and mobile homes. These ventures turned out to be profitably worse than even the initial business and caused a massive loss on the books over the next year , however the share price remained very high. As the company was failing, the investing public still had their “hope” to hang onto and was still comfortable dumping their money into a straw man company that was being propped up only by its founder’s cash infusions that he had sourced from the original IPO!

Graham makes his point on IPOs very clear here, and really questions the ethics and standards of financial underwriters, especially when it comes to IPOs. I really like this part as Graham provides a unique perspective of how investment banking used to be; companies that had their reputation to look out for, and would only underwrite business they actually believed in, instead of taking the companies public just for the short term IPO gain, to the detriment of the investing public. I think we can readily see this even today with the SNAP IPO and it’s losses on its first reporting quarter.

The commentary

Zweig analyzes a number of companies the same way Graham does. Many of his insights are of the same type as well: IPOs, companies using strange accounting techniques and companies over-expanding to the detriment of their shareholders on both sides of the acquisition.

We can gather a few major lessons from Zweig’s analysis:

• Analyze a company’s “customer financing” . Are they expanding this line of credit to their customers? In Lucent Technologies case, they had $350 Million in guarantees for money its customers had borrowed elsewhere… What if their customers could never repay this , how might that transform the books?
• Does the firm list its assets as you would, or are they turning expenses into assets?
• Do the firm’s nonrecurring costs actually fit their business model? Or are they simply using these line-items to hide recurring costs? If the headings on their financial tables don’t match their fundamental business, we should raise a red flag.
• Does an acquiring company’s share price make sense, or is it so overinflated that there’s risk involved with the acquisition?

Generally, I found this a good chapter to reach deep into a business and pull out all the red-flags we’ve learned about in the past chapters. The examples in this chapter call into attention some very central topics to value investing.

1. Understanding what is behind the numbers on the financial statements
2. Buying in as an owner, not as a speculator
3. Remembering to analyze competitors

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.

Recommend the article if you found value in it and don’t forget to subscribe to the publication if you would like to follow along!

-David