Chapter 18 : A Comparison of Eight Pairs of Companies

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Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham compares eight pairs of companies. Some of the companies are similar in market , while others are only similar by name. His point throughout, is to instruct as he did in his teaching days. Ben Graham took practical examples of current companies, and would set them side by side in order to show the strengths and weaknesses of each firm. In some events this would also lead to a stark contrast in what you’d want in an issue, compared with what attributes that may lead your account statements into the red. 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, Chapter 17

Instead of pulling out each of the eight pairs of companies for review, I’ll highlight some of the major points for each pair and offer some of the more broad advice that is gleaned from Graham’s work. If you’re interested in the actual comparisons of each firm, I strongly advise that you pick up a copy of The Intelligent Investor and work through this chapter as it gives some very real examples that can be used to train.

Comparison 1:

Graham begins by having a look at two firms. One, long-established and appropriately leveraged firm: Real Estate Investment Trust and one conglomerate company with a similar name: Realty Equities Group of New York. The latter being highly leveraged by almost 10x the amount of the Trust. In this case, Graham recognizes how conservative the Trust was, and how Wall Street didn’t seem to care for its comfortable , but lower price appreciation over time. What’s interesting is that when one compares the balance sheet of both companies , one can readily see that while the Trust does seem conservative, the conglomerate (who’s likes of business included 8 unrelated industries) has a number of red flags, including but not limited to:

• Massive use of warrants
• Revenues that were half that of the trust
• Assets almost 4x less than the trust (price of common at 12.5x all total assets, compared to the Trust with a multiplier of on 1.6x)
• Price / Book value multiplier of 9.5x (compared to 1.3 for the Trust)

In general, while Wall Street was in love with the fluffy valuations the market was setting for the conglomerate, the Trust was the one really delivering value. It didn’t take long for Mr. Market to realize the conglomerate was overvalued based on their earnings and their assets. In the end, the conglomerate ended up trading at $2 a share compared to its 1960 price at 32.5 and the Trust held close to its 1960 price and paid a dividend over 1.20 the whole time.

Comparison 2:

The next pair reviewed was Air Products and Chemicals (Products) and Air Reduction Co. (Reduction). This is the first comparison of similar companies that Graham offers in the chapter. While differing in age, both companies are similar in industry and offerings. As we see through comparison, the following exists:

• With less than half the volume of Reduction, Products sold at 25% more than the aggregate of Air Reduction’s stock
• Air Reduction had greater profitability and growth record
• Products sold at 16.5 x earnings , Reduction at only 9.1x earnings
• Products sold well above its asset backing, whereas Reduction could be bought at 75% book value

Graham remarks that Reduction paid a better dividend, which could be seen as Products choosing to retain more of their earnings. He also believed that Reduction was better positioned with it’s amount of working-capital.

In this case, Reduction is the cheaper buy, but also not the quality compared to the overpriced Products. What ended up happening was that Air Products did better than Reduction during the 1970’s market and declined only 16% compared to that of Reduction at 24%. In 1971 however, Reduction rose 50% over its ’69 close figures, compared to only a 30% rise from Products. So had you bought Products for it’s “Quality” it would have weathered the downturn better, but not rose as high in the upturn. In this case, buying Reduction would have put you 12% over Products.

Comparison 3:

Graham then moves to comparing companies only similar in name again. In this case, American Home Products Co. and American Hospital Supply Co. Both selling items related to Home or Hospital respectively, although Hospital was also a manufacturer. He chooses these two because they are a set of “Good-Will” giants.

Together, they both had some good things going for them: a great financial position and 100% earnings stability (no earnings setbacks for 10 years). Graham seems displeased with Hospital’s rate of earnings on it’s capital at 9.7%. He adds thought that Hospital’s growth rate was much better than Home’s . Graham identifies that when comparative price is brought into the picture, it appears Home is a better buy when compared to current and past earnings and dividends. Graham adds to his lesson by referencing the fact that Home does have a very low book value and therefore it “illustrates a basic contradiction in common-stock analysis: On the one hand, it means that the company is earning a high return on its capital — which is a sign of strength and prosperity. On the other, it means that the investor at the current price would be especially vulnerable to any important adverse change in the company’s earnings situation.” In this case, both companies are selling at multipliers of over 5x their book value with Home bring at 12.5x!

These multipliers mixed with Graham’s review foreshadow his conclusion. For Graham, both issues were overpriced at their current prices for any investor looking to keep “conservative standards”. His primary issue with them was that the price contain too much “promise” and not enough actual performance. This is where the “good-will” factor comes in. Pay close attention here. You see, to Graham, maybe these companies did have good promise, the problem was though , that their goodwill also meant that they’d have to perform exceptionally well in terms of dividends or tangible assets to “realize” their good-will of over $5 billion. It was Home that eventually won out.

Comparison 4:

Again, we see a comparison of two companies in two different industries. For the fourth set, Graham chooses to compare H & R Block and Blue-Bell Inc. He compares H & R’s rocket success , with the grueling time-tested competition that Blue-Bell had to go through to reach similar levels of success as H & R. At the end of ’69 , Graham states that the market wasn’t in love with Blue, giving it only a PE of 11 , compared to a 17 against the S & P composite. On the other hand, H & R had been cruising with multipliers of over 100x.

Graham lays it out plainly: “ True, Block showed twice the profitability of Blue per dollar of capital and its percentage growth in earnings over the past five years was higher. But as a stock enterprise, Blue Bell was selling for less than one-third the total value of Block, although Blue Bell was doing four times as much business, earning 2.5 times as much for its stock, had 5.5 times as much in tangible investment and gave time times the dividend yield on the price.”

What’s cool here, as we get to peer into the mind of the Dean is that he notes both companies seemed great to an analyst but for two very distinct reasons. H & R would look excellent from a MOMENTUM perspective. Blue would have looked great from the perspective of someone buying into the business itself. It’s obvious which one Graham would have picked: Blue Bell. They both weathered the storm of the market well, but Blue Bell ended up in superior position.

Comparison 5:

Here Graham compares two companies near each other on the NYSE list. One familiar: International Harvester and one unfamiliar: International Flavors and Fragrances. This is a very unique case as Flavors was selling for a higher market value (total capitalization) than Harvester even though International had over 17 times the stock capital and over 27 times the annual sales of Flavors. A seeming indicator of Mr. Market going on his usual tirades. The reason for this seeming disparity is captured in Flavor’s remarkable showing of profitability and growth.

• Flavors had a profit of 14.3% of sales , compared to 2.6% for Harvester
• Flavors earned 19.7% on its stock capital against only 5.5% for Harvester
• Over a 5 year period, Flavors net earnings doubled, Harvester’s had barely moved

In this case again, we see a concern with Graham for both companies. He felt that Flavors, while successful, was “lavishly valued” and Harvester, while selling at a discount was showing earnings too mediocre to make it truly attractive. Great lessons in the concept that even if an issue is on discount, it may not be attractive based on our standards of value (remember, it’s earnings hadn’t grown much at all).

Comparison 6:

Here we compare McGraw Edison with McGraw-Hill. Edison handles utilities and housewares, while Hill handles books and information services. The point Graham mainly wanted to emphasis in this comparison was he concept of being weary of overoptimism. At the time, Hill had been selling for more than Edison which seemed strange given their comparable offerings. The sentiments at the time was to buy into publishing companies which pushed their prices higher and higher even though their profits were receding. While Hill did recover in a decent position two years later, it’s decline was enough to prove that buying in at high prices based on optimism is likely only to lead to failures down the road. Edison, while not as glorified, was a steady-eddy that paced itself well and closed near its high just after fully recovering in 1971.

Comparison 7:

As we move into the realm of intriguing comparisons, Graham takes us along to compare Presto and General. Presto , making electrical components and the ordinance , and General being a massive conglomerate of a wide array of products. What is interesting about General, is their use of warrants and convertibles on their books. When one analyzes the company in an illogical way, they see that the companies book seem rather normal. However, when one takes a factoring approach of the warrants as part of the common stock package, suddenly the market capitalization becomes more than 3 times its total book value. A sign of something to look out for as you compare your firms. With Presto, something else interested Graham. The fact that they had previously been doing work as a manufacturer of electronic components and then had taken on ordinance contracts with the government meant that the FFO was seriously bolstered by their “War Work”. What’s important to note from Graham’s analysis is that he focuses primarily on his margin of safety as it compares to the FFO from the War Work. If the ordinance deals were to go away, how might that affect the investor’s prospects. In this case, one would be wise to analyze the soundness of Presto without the ordinance FFO and then determine if the organization is still in it’s sights for investment.

Comparison 8:

The final comparison was of Whiting Corp and Willcox and Gibbs. In this case, Graham uses this as a classic example of Mr. Market’s oddities. “The company with smaller sales and earnings and with half the tangible assets for the common, sold at about four times the aggregate value of the other.”

We see that even though Willcox is heading into a large loss “after special charges” and hadn’t paid a dividend in thirteen years. Whiting on the other hand , had a great record and was at one of the highest dividend. It’s amazing to see Mr. Market overvaluing a business that, on paper, was far subordinate to the issues of Whiting. Graham enlightens us that owning Whiting might be a suitable for the enterprising investor as part of a grouping of sound and attractive secondary-issue investment.The shake of it was that Willcox ended up falling to a price that would be hard to justify while Witing advancing to $24.5 , a gain of 19% a year.Graham finishes the chapter by showing his preference that an analyst focus solely on exceptional or minority cases in which he can form a confident judgement that the price is well below value.

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